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Rationales for Risk Management in Banks 115 ■ Therefore, risk management at the firm level can create shareholder value, when it guarantees a certain (observable) risk profile to which shareholders need to adjust their portfolios only once, 332 which will, in turn, save transaction costs. Likewise, the firm (and especially banks) can set their long-run “target” capital structure when they commit to a certain risk profile (and hence rating). By only taking risks that are in line with this risk profile, 333 the firm can avoid the costly adjustment of the current capital structure to achieve this target in the short run. 334 Managers/firms are often not willing to disclose inside information to investors (and hence the public in general) because this proprietary information could be exploited by competitors. This is also true with regard to the detailed disclosure of risk exposures, riskmanagement policies, and which risk-management tools are used within firms and to what degree. This is especially true for banks, for whom the management of risk is the most important source of competitive advantage. Given the current reporting of firms and banks, risk transparency (inside and outside the firm) is only rarely found, and so investors have to try and reveal this private information, which is—due to transaction costs—costly. However, risk management can be used as a substitute for the publication of internal information. 335 As long as it guarantees a stable risk profile of the firm and the costs for conducting the necessary risk management are lower than the costs associated with the information disclosure, it can increase the value of the firm. 336 The same argument is valid for another facet of the same problem on a different (not the firm) level: Banks, in particular, use risk management to create assets or products with stable distributions so that customers can save on both transaction and participation 337 costs. 332 See Mason (1995), pp. 31–32. 333 See Shimko and Humphreys (1998), p. 33. 334 See Froot and Stein (1998a), p. 60. 335 Albeit there are many advantages of increasing the transparency (especially of banks) via better disclosure and educating the analysts’ community—as suggested by Shimko and Humphreys (1998), p. 33—it can be counterproductive and even dangerous to do so for strategic and competitive reasons. 336 See DeMarzo and Duffie (1992) and Smithson (1998), pp. 9–10. 337 As defined in Allen and Santomero (1996), p. 1.
116 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS Taxes and Other Market Imperfections as Rationales for Risk Management In the first part of this section, we will discuss the effects of taxes and how risk management can help to reduce them in order to increase firm value. In the second part of this section, we will turn to other market imperfections neglected so far and discuss how risk management can be used for value creation within their context. Taxes So far, we have neglected the fact that firms have to pay taxes. Since taxes are an important component of doing business and tax savings can substantially influence the firm value, optimally all valuations should be conducted on an after-tax basis. Equation (2.1) for determining the firm value, therefore, needs to be adjusted in one of the following two ways: ■ ■ Both the cash flows in the numerator and the discount rate(s) in the denominator are now to be estimated on an after-tax basis. Alternately, we can—while ignoring for the moment financial distress costs as derived in the last section—use an adjusted present value (APV) approach to derive the after-tax firm value: 338 Firm Value = Firm Value without Taxes 339 – PV(Tax Effects) (3.5) As is immediately obvious from Equation (3.5), decreasing the present value of the tax payments can increase the firm value. However, that is an overall firm objective. The question in this section is how risk management can help to achieve this goal. There are two conditions necessary—as we will describe in more detail below—for a risk-management strategy to generate tax benefits: 340 ■ ■ The tax schedule must be convex. Some portion of the range for pretax income needs to lie within the convex section of the tax schedule. A convex tax schedule is defined as one in which the firm’s average effective tax rate rises as pretax income 341 rises, 342 that is, when the marginal tax rate exceeds the average tax rate, as depicted in Figure 3.8. 338 See Brealey and Myers (1991), pp. 458+. 339 As derived in Equation (2.1). 340 See Smithson et al. (1990), pp. 366–367. 341 As taken from the financial reporting. 342 See Smithson et al. (1995), p. 102, and Smithson (1998), p. 7.
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isk management and value creation i
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Copyright © 2002 by John Wiley & S
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preface From an empirical as well a
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acknowledgments No book is solely t
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x CONTENTS Goals of Risk Management
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xii CONTENTS Definition of RAROC 24
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xiv FIGURES Figure 5.5 Figure 5.6 F
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symbols ↑ ↓ α β i xvi Increas
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xviii SYMBOLS ln Natural logarithm
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abbreviations APT BIS bn bps CAPM C
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2 RISK MANAGEMENT AND VALUE CREATIO
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CHAPTER 2 Foundations for Determini
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Foundations for Determining the Lin
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eferences Aguais, Scott D., and Ant
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References 295 Blanden, Michael (19
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References 297 and Abuses,” Journ
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References 299 Froot, Kenneth A., a
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References 301 risiken aus Handelsg
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References 303 Investments in Stock
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References 305 Institute of Technol
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References 307 Sharpe, William F. (
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References 309 Wall, L.D., and John
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312 INDEX Approach (continued) top-
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314 INDEX Capital: Tier-1, 139, 146
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316 INDEX Credit: derivatives, 178,
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318 INDEX Expectations: homogeneous
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320 INDEX Incentive(s), 22, 33, 45,
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322 INDEX Managers, poorly diversif
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324 INDEX Overinvestment, 75, 79, 8
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326 INDEX Reserve(s) (continued) lo
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328 INDEX Risk, liquidity, 3, 165 R
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330 INDEX Sharpe ratio, 244, 252 Sh
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332 INDEX Value at risk (VaR) (cont
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