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126 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
bankruptcy costs are substantial and can, therefore, explain a large part of
the risk-management activities, which makes them the most plausible rationale.
388
The direct and indirect costs from financial distress situations are the
most compelling argument for using risk management to reduce the expected
value of these (transaction) costs and to increase firm value. Since risk
management can achieve this by reducing the firm’s default probability, it
can increase the firm’s debt capacity. 389 By allowing for an increase in the
leverage, risk management can, additionally, reduce a firm’s tax obligations 390
and, moreover, can implicitly mitigate almost all of the agency problems
(e.g., reduce the agency cost of free cash flows) that have been discussed.
Also, this use of risk management can allow a firm to move closer to its
optimal capital structure, 391 which, in turn, minimizes its cost of capital and
can increase its firm value. However, the lower costs of capital need to be
balanced with a potential increase in the expected costs of financial distress
and the costs for risk management. 392 A possible optimum state where firm
value is maximized could be where the marginal costs of debt (i.e., costs of
financial distress) equal the marginal benefits of debt (i.e., reduction in agency
costs). However, it is not clear why alternate strategies such as increasing the
amount of equity 393 are not superior, given the costs associated with risk
management. 394
388 See Allen and Santomero (1996), p. 18.
389 See, for example, Damodaran (1997), pp. 786–787, Froot et al. (1993), p. 1632,
Pritsch and Hommel (1997), p. 675.
390 See Mason (1995), p. 31. Note that here risk management is no substitute for
capital.
391 Although it has been long discussed in finance theory, there seems to still be no
conclusion on what such an optimal capital structure would look like.
392 The gains in value from moving to the optimal debt ratio can be, according to
Damodaran (1997), p. 786, substantial and justify even expensive risk management.
393 Note that equity is a substitute for risk management.
394 See Allen and Santomero (1996), p. 18.