Risk Management and Value Creation in ... - Arabictrader.com

142 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
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deposits and savings. 24 These credit-sensitive customers increase the
importance of risk management and hence the amount of equity
capital to be held by the bank. 25
Bond holders: Bond holders are also concerned about the likelihood
of the repayment of their interest and principal. However, they are
less credit sensitive because they are (and want to be) compensated
for the risk they bear—often depending on the seniority 26 of their
claim. External bond ratings are a useful, but only an imperfect,
estimate of a bank’s ability to repay its bond obligations. A bank
with a higher default risk will need to pay its bond holders a higher
rate of interest or will need to hold more equity capital instead.
Therefore, a bank needs to understand how the uncertainty of outcomes
(risk) of its activities affects its overall default risk and the
degree of risk management required by that stakeholder group.
Shareholders: Shareholders, as residual claimholders of a bank, are
aware that their return 27 will fluctuate with the profits and losses of
the bank, that is, they choose points further out on the risk-expected
return frontier 28 than either of the other two stakeholder groups
discussed so far, knowing that they are the first to be hit by adverse
events. Shareholders are thus the stakeholder group that is least credit
quality sensitive as long as they are compensated appropriately for
their risk taking in the market. 29
Regulators: Banks differ from most other firms because they are
protected by a regulatory safety net. By that we mean all government
actions 30 that are intended to ensure the safety and soundness
of the banking system, such as explicit 31 as well as implicit 32 deposit
insurance, payment guarantees, access to the discount window, and
so on, all of which protect banks from bankruptcy and the costs of
24 See Merton (1995b).
25 See Merton and Perold (1993), p. 16.
26 For the sake of the argument, we distinguish between senior and junior bond holders,
even though these groups might be further differentiated by the kind and quality of
collateral backing their repayment.
27 Shareholders care about dividend payments and share price appreciation. Share
prices are determined by the bank’s (expected future free) cash flows and the (expected)
volatility of these free cash flows.
28 See Berger et al. (1995a), p. 27.
29 See Merton and Perold (1993), p. 16.
30 Other than regulatory capital requirements.
31 Which is only available in that form in the United States.
32 Implicit deposit insurance induces government intervention if a bank is considered
too big to fail. See Diamond and Rajan (1999), p. 39.