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

Deposits & savings from insured customers
Returns
Senior uninsured creditors
Shareholders
Capital Structure in Banks 151
Expected
Return
Probability
Deposits & savings covered by
deposit insurance
Junior uninsured creditors
Insurance
Expected Losses
Losses
100%
0
Gains
Risk Capital
Figure 5.2 Stakeholder tranches and risk capital.
Note: The distribution is only schematically correct. In particular, the Expected
Return of the distribution should be much farther to the left than
actually depicted.
be easily seen, the bank has a positive expected return on its assets. 79 However,
since the bank holds a risky portfolio, the outcomes fluctuate around
this expected value. Because a large part of a typical bank’s portfolio consists
of credit assets, which can experience rare, but very severe downside
events, the distribution is skewed to the left and is non-normal. The bank
will, therefore, suffer large losses with a positive probability and will default
80 at some threshold level. At that critical point, the bank will incur
distress costs, which are the main driver and rationale behind conducting
risk management and why total risk matters to banks. However, the more
capital a bank holds (in this case the critical threshold level is moved to the
left), the less likely it becomes that losses will exceed the default point and
trigger default. Holding more capital, therefore, makes the bank safer, which
is consistent with the regulatory view.
79 Otherwise, the bank would/should exit/restructure its current business.
80 Unlike regulatory default—which occurs when a bank’s net assets (i.e., book assets
minus book liabilities) fall below the required minimum (regulatory) capital amount
set by the regulators—a bank enters economic default when the market value of its
assets falls below the market value of its liabilities.