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Implications of the Previous Theoretical Discussion for This Book 133 in the neoinstitutional world, firms with a nontrivial probability of financial distress may not be able to invest in projects they would in the neoclassical world, because they may not be able to raise funds to invest in such projects or may be able to do so only at a price so high that it is not worthwhile. Sixth, in the neoinstitutional world, with costly external finance and where total risk (including specific risk) matters (and is costly due to financial distress costs), not only systematic risks, but also unmarketable (i.e., nonhedgable) idiosyncratic risks will impose real costs on the firm. Therefore, firms can increase their value through risk management by decreasing these total risk costs. Capital-budgeting procedures should, therefore, take the cost of a project’s impact on the total risk of the firm into account. 20 Seventh, this makes risk management inseparable from capitalbudgeting decisions and the current capital structure choice (see Figure 4.1). 21 Because both risk-management and capital-structure decisions can influence Systematic RISK Specific Capital Structure Capital Budgeting Value Creation Risk Management Figure 4.1 The interdependency of capital budgeting, capital structure, and risk management when risk management can create value. 20 See Froot et al. (1993), p. 1650, and Stulz (1999), p. 7. 21 For instance, negative NPV projects under this paradigm could be turned into positive NPV projects by reducing their contribution to total risk. See Stulz (1999), pp. 8–9.
134 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS total risk costs, capital budgeting can also no longer only be concerned with the systematic components of a firm’s cash flow (as depicted by the arrow in the left-hand part of Figure 4.1), as it is in the neoclassical theory. Therefore, the CAPM and the traditional DCF methodology might no longer be universally valid as a capital-budgeting tool, 22 and using the traditional NPV rule might not always be the correct way to decide whether or not to undertake a project and whether value is created. Removing any of the perfect market assumptions, typically, but not always, destroys the intellectual foundations for the capital-budgeting rules used in the neoclassical world. 23 Therefore, one needs to evaluate the magnitude of the deviations from traditional capital-budgeting principles and establish where and when they apply. On the one hand, there are certainly (capital) markets where the assumptions of the neoclassical world are not completely unrealistic and liquid assets are traded. Here, only the systematic component counts and Equation (2.1) can still be applied. Similarly, if there were no costs for holding equity capital, firms would tend to hold a capital buffer that is large enough so that there would be no issue with default risk. In such a situation, risk management can be separated from the investment decisions, and the neoclassical paradigm still applies. 24 The firm’s (quasi) aversion to risk should not enter the decision-making process, and only the risks’ correlation with systematic factors should matter when risks are marketable. On the other hand, if holding equity is costly for tax or agency reasons, risk management typically cannot be separated from capital budgeting. 25 Also, there are other (capital) market segments where comparative advantages 26 lead to the fact that specific risk counts and the costs of financial distress have to come into play. Therefore, it can be more expensive for the firm to bear risk within its own portfolio than it is for the market, because the firm has to consider the costs of financial distress when holding risk. Corporate risk-management considerations and the constitution of the existing portfolio should then enter into the pricing of those risks (that cannot be hedged and for which total risk counts). Therefore, one can conclude that a bank should always sell or hedge marketable (liquid) risk or only keep it when the price also compensates the 22 See Froot et al. (1993), p. 1650. 23 See Stulz (1999), p. 2. As we have mentioned, in the neoclassical world we assume that capital-budgeting, risk-management, and capital-structure decisions can be determined independently. 24 See Froot and Stein (1998a), p. 58. 25 See Froot and Stein (1998a), p. 58. 26 Note that competitive advantages can only persist in illiquid markets, where there are information asymmetries.
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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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