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

Rationales for Risk Management in Banks 113
bond holders as well as any other stakeholders in the firm. 321 Since the
volatility in firm values is caused by total risk, avoiding specific risk—that
is, a part of it—at the corporate level can increase the firm value. Note that
Equation (3.3) quantifies the contribution of risk management when the firm
is healthy. In the event that cash flows and value decline sharply from current
levels, the value added by risk management increases in absolute terms
and even more on a percentage basis. 322
The Costs of Implementing Risk Management As mentioned previously, the relative
ability of firms and individuals to efficiently implement risk management
323 is influenced by the existence of transaction costs. 324 Poorly
diversified stakeholders, in particular, might prefer the firm to conduct risk
management on their behalf, because the transaction costs are lower for the
firm than for the individual. This seems plausible given the high costs for
acquiring the necessary knowledge (e.g., qualified personnel), the required
technological infrastructure 325 to identify the optimal hedge position, and
the existence of economies of scale in transaction costs to be able to trade,
for example, in derivatives markets (that can additionally require a minimum
deal size and/or turnover). 326 However, besides saving on the costs of
trading, one should keep in mind that risk management by the firm can also
incur agency costs to ensure that the agents (managers and/or traders) transact
appropriately. 327
For financial institutions, the fixed costs of asset evaluation, especially,
mean that intermediaries have an advantage over individuals, because they
allow such costs to be shared across a large number of deals. 328 Similarly,
321 Banks that maximize firm value will, therefore, incorporate the expected costs of
financial distress in their objective function. See Winton (2000), p. 30.
322 See Stulz (1996), p. 13.
323 See Mason (1995), p. 31.
324 For instance, transaction costs can prevent individuals from diversifying their
portfolio perfectly. See, for example, Perridon and Steiner (1995), p. 247, who refer
to Garman and Ohlson (1981).
325 However, it is debatable which part of the investment in information systems is
sunk costs. Computer systems are necessary for firms to know who their customers
are, for reporting, for controlling, and also for regulatory purposes, with risk management
being just one of the many reasons for building the technological infrastructure.
326 See Mian (1996), pp. 422+.
327 See Allen and Santomero (1996), p. 17. Recent scandals, as represented in the
Wheel of Misfortune on page 57, are extreme examples of such agency costs.
328 For instance, banks can—given their specialized knowledge—evaluate loans more
efficiently than individual investors.