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Rationales for Risk Management in Banks 125
only makes sense as long as the costs for doing so are lower than the present
value of the expected tax savings. 381 In reality, this appears to be unlikely,
because the costs of risk management seem to be much higher than the small
gains from tax savings. Since the actual convexity of the tax schedule is much
lower than depicted in Figures 3.9 and 3.10, the difference between the
straight line (i.e., the unhedged position) and the curved line (i.e., the hedged
position) is even smaller. Also, except for Graham and Smith (1996), 382 there
is very little or only contradictory 383 empirical evidence that strongly supports
the concept that taxes should represent a significant rationale for
conducting risk management. Therefore, and because it is also very difficult
to allocate tax obligations to a single transaction level, taxes are ignored in
the further analysis of risk management below.
Other market inefficiencies and transaction-cost-based benefits (cost
of implementing risk management and guaranteeing a stable risk profile)
also appear to be of less significance. The benefits stemming from the reduction
of the agency costs of equity and debt (overinvestment, the risk preference
problem, asset substitution, underinvestment) are important from an
incentive-setting point of view and for the alignment of the interests of the
various stakeholders in a firm. But, when viewing the contribution of riskmanagement
actions to the benefits of avoiding the consequences of management
self-interest and capital market imperfections from a pure value
creation perspective (counterbalancing it with the tremendous costs 384 ), it
seems unlikely that the benefits are significant enough. 385
Likewise, the coordination of investment and financing 386 (and its associated
agency and transaction costs) seems less relevant in a banking
context. Here, the estimates of the large costs of financial distress, which
originate from the likelihood of default, and the value increases stemming
from their avoidance seem to significantly outweigh the costs. Even when
weighted with the (relatively small) probability of default (for banks 387 ),
381 See Damodaran (1997), p. 785.
382 Graham and Smith (1996) employ an accounting data-driven simulation-based
analysis to find that roughly 12% of the firms in their sample could achieve tax
savings from risk management, if the firms were able to adequately control the volatility
of their income through derivative instruments.
383 Some studies (e.g., Nance et al. [1993] or Geczy et al. [1995]) find that the expected
tax liability is negatively correlated with the availability of internal funds, and
hence firms with a convex tax function conduct less risk management.
384 See the “Role and Importance of Risk and Its Management in Banks” section in
Chapter 2.
385 See Allen and Santomero (1996), p. 18.
386 As discussed by Froot et al. (1993) and (1994).
387 As we have observed above, banks typically have high credit ratings.