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Rationales for Risk Management in Banks 109
b. Financial distress situations fundamentally change the incentives
of the firm’s various stakeholders, and the higher the
default probability, the higher the costs of maintaining contractual
relationships with them: 297
■ These indirect costs are likely to be higher for firms that
sell products with warranties and long-term service contracts
or that provide services for which quality is an
important attribute, but that is difficult to determine in
advance. Customers who are unsure whether they can take
advantage of these services in the future (because of the
threat of bankruptcy) are willing to pay only a lower price
for the products, decreasing the firm’s (operating) cash
flows and hence its value. The quality of service might
also become another facet of the underinvestment problem:
for example, troubled airlines tend to avoid investing
in further maintenance, because the benefits of doing so
disproportionately accrue to the bond holders. Rational
customers expect this behavior and will avoid doing business
with such a firm.
■ Financial distress can also lead to the loss of valuable (key)
employees with specialized knowledge and labor skills
needed by the firm. They would only be willing to stay
with the company for a higher compensation.
■
Likewise, financial distress will trigger unfavorable credit
terms, delivery schedules, and service by suppliers, whose
production facilities are customized to the troubled firm.
For example, when suppliers provide specialized input and
there are long periods of time between incurring production
costs and the ultimate receipt of the revenues, they
will demand either cash in advance or collateral, increasing
the troubled firm’s liquidity problems.
For banks, additional aspects of indirect costs need to be considered.
On the one hand, the business of troubled banks might
immediately vanish (as described above) since credit-sensitive
customers and suppliers of funds stop doing business with a bank
that approaches bankruptcy. Also, the same argument is true for
bank customers as it is for the airline customers: Reputation plays
a significant role in whether a customer will put money into a
bank in the first place. Therefore, there is either a significant
reduction in the bank’s cash flows the closer it is to bankruptcy
297 See Mason (1995), p. 31.