Risk Management and Value Creation in ... - Arabictrader.com

110 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
or it will face unfavorable terms, that is, it has to pay abovemarket
rates for deposits or has to offer below-market rates on
credit to attract customers/business.
On the other hand, banks are subject to systemic risk and
(therefore) threatened by bank runs, both events being associated
with banks in financial distress situations. Because of extensively
lending to and borrowing from each other, banks tend to
be more interconnected than firms in any other industry and,
hence, especially subject to this systemic risk, that is, that adverse
events at one bank will be quickly transmitted to the other
banks in the system. Disregarding deposit insurance and the “toobig-to-fail”
doctrine, 298 depositors are aware of this fragility of
the banking system and will withdraw their deposits more than
they otherwise would 299 when they anticipate a bank is approaching
financial distress. 300 There are presumably considerable 301 (indirect)
costs associated with such bank runs that are—to the best
of my knowledge—unfortunately not quantified by any study.
Additionally, there is significant lost going concern value 302
in bank failures 303 and the costs associated with the withdrawal
of the bank charter and hence the loss of its value. 304 James (1991)
calculates the indirect costs of a bank failure in his study on
FDIC 305 data 306 and measures losses on assets as the difference
between the book value of a failed bank’s assets and the market
value of the asset at the time of the failure (net of direct costs
associated with the failure). 307 He comes to the conclusion that
298 The reasoning behind this doctrine is that regulatory bodies will bail out or otherwise
arrange an orderly termination for failed banks, when the bail-out costs are
considered lower than those of a systemic crisis of the financial system.
299 The Federal Reserve Bank of Cleveland defines a bank run as a withdrawal of
more than 1% of total deposits per working day that cannot be explained by seasonal
or other factors unrelated to depositors’ confidence. See Gup (1998), p. 13.
300 See Gup (1998), p. 132.
301 The social costs of bank failure may be higher than those borne by investors. See
Winton (2000), p. 30.
302 That is, loss of reputation or franchise value and goodwill. This was, for example,
the reason why the market values of banks exposed to the “Russian Crisis” declined
by a multiple of the actual credit exposure of these banks in 1998.
303 See James (1991), pp. 1241–1242.
304 See James (1991), p. 1225.
305 Federal Deposit Insurance Corporation.
306 James (1991) analyzes 412 bank failures during 1985 and mid-year 1988.
307 See James (1991), p. 1226.