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

Rationales for Risk Management in Banks 111
the indirect costs average ca. 30% of the failed bank’s assets. 308
Even though his approach might be the only feasible one—given
the difficulty of estimating the exact amount of indirect costs,
some of which are simply unobservable—it appears to be unrealistic
that book values (as of initiation of the assets) represent
the true value of assets just before the financial distress situation
and are, therefore, a good predictor. Similar studies of Oliver,
Wyman & Company come to the conclusion that the sum of both
direct and indirect costs average 27%, 309 indicating that the asset
value just before default may be much lower than the book value.
So far, we have only discussed the components of Equation (3.4). However,
what we are really interested in is the second component in Equation
(3.3): the present value of the expected financial distress costs. This brings
us to the question: 310 What is the correct time horizon for estimating the
default probability and what is the appropriate discount rate to derive the
present value (PV) of the payments/cash flows associated with default? We
will return to this question in a valuation context in Chapter 5.
Although the distribution of unhedged firm values as depicted in Figure
3.7 does not matter per se to well-diversified shareholders or bond holders,
both investor groups will become concerned if negative deviations incur losses
that materially raise the probability of financial insolvency. This is mainly
due to the fact that the costs of financial distress can cause a significant
reduction in a firm’s value. 311
No matter whether the risks causing these (negative) deviations are
specific or systematic, in the presence of default costs the capital markets
have a comparative advantage over the firm to bear risks: if the risk is specific,
it can be diversified in the capital markets, and hence the cost of having
the markets bear this risk is zero (i.e., no risk premium will be paid). However,
the costs of bearing this specific risk within the firm are equal to the
present value of the bankruptcy costs associated with them. If the risk is
308 See James (1991), pp. 1225 and 1228. The mean of his sample is 30.51% and the
median 27.68%. Starr et al. (1999), p. 7, estimate for a different sample of failed
U.S. banks, an average loss of 13.8% of assets.
309 Even though the Oliver, Wyman & Company sample is much smaller than James’,
it spreads over longer periods of time (than just 1985–1988) and across continents
(as opposed to just reflecting the U.S. experience). Note that the Oliver, Wyman &
Company method has a different background and is used to quantify the loss given
default, the fraction of the exposure amount that a bank is likely to recover in the
event of default, see Ong (1999), p. 56.
310 This question is also not addressed in the James (1991) approach.
311 See Smith (1995), p. 20.