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124 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
By doing so, risk management can reduce the expected payments to the
various stakeholders of the firm and can additionally ensure that enough
(internal) cash flows are generated to fund positive NPV projects, 375 all of
which will increase the firm value. We have also seen that, because of these
benefits (that can be achieved by conducting risk management at the corporate
level), firms behave as if they were risk averse, even though they are not
in and of themselves. Therefore, these benefits form the basis for the design
of a comprehensive risk-management approach for banks, to which we will
return in Chapter 6.
However, as we have also indicated in the beginning of this section on
the neoinstitutional rationales, there are also costs associated with implementing
risk management, which could outweigh the benefits. 376 These costs
can be thought of as the transaction costs directly associated with riskmanagement
actions, such as the sum of any out-of-pocket fees, 377 the implicit
cost of the bid-ask spread when trading, the opportunity cost of management’s
time in the administration of the risk-management program, 378 significant
investments in the systems environment, 379 and so on. Following the line of
reasoning from the neoclassical section, one should keep in mind that as the
transaction costs of reducing risk increase, risk management becomes less
attractive, because one does not have to pay these transaction costs for risks
borne within the firm. 380
Since we explicitly allowed for such costs (including also the costs for
writing, enforcing, and monitoring contracts), they should be considered when
making the decision whether risk management is useful and value enhancing
on the basis of a cost-benefit analysis. However, it is very difficult to estimate
exact dollar amounts on both the cost and the benefit side. Therefore,
we evaluate and rank the various benefits discussed in this section and depicted
in Figure 3.2 on a subjective and relative basis from worst to best
with regard to their potential for value creation (for firms and, where appropriate,
for banks).
The tax argument seems to provide the weakest rationale for conducting
risk management at the firm level. Even though taxes are otherwise a
very important source for value creation, conducting risk management for
achieving additional tax savings seems less than convincing. This approach
375 See Stulz (2000), p. 4-3.
376 See Shimko and Humphreys (1998), p. 33.
377 Option premiums paid are not costs of conducting risk management because they
represent a fair market price for the respective product.
378 See Smith (1995), p. 27.
379 See Allen and Santomero (1996), p. 17. Footnote 325 of this chapter discusses
whether these costs should be viewed as sunk costs.
380 See Stulz (2000), p. 3-2.