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

152 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
Since decreases in asset values are associated with economic losses, the
various stakeholders have to bear these losses in the sequence of the seniority
of their claims:
1. As we will shortly see, the bank should set aside an insurance pool
that covers all expected (actuarial) losses (especially from credits).
This pool is the first tranche that is hit by losses and is fed by deducting
“insurance premiums” from (expected) returns on the portfolio
of assets.
2. Incurring losses that exceed the resources of this insurance pool then
eat up (expected) returns.
3. Once there are no revenues left, shareholders—as residual
claimholders—will have to bear all subsequent losses. 81
4. Since the bank has bought insurance 82 to cover the declines in the
value of some assets, 83 insurance companies will bear some of the
subsequent losses.
5. Then junior debt holders—knowing that they bear the highest probability
of being hit by losses exceeding equity (and insurance)—bear
the next tranche of losses.
6. Senior debt holders are next hit by even higher losses. Note that 5.
and 6. are both uninsured creditors of the bank.
7. Since at some level of losses between 5. and 6. the likelihood of a
“bank run” will increase dramatically, the government/regulatory
bodies will step in and try to rescue the bank (see the previous description).
Nonetheless, if depositors are hit by losses, deposit insurance
in almost all banking systems will cover all losses up to a
certain amount (either provided by the government, as in the U.S.
for US$ 100,000 per customer, 84 or by private organizations formed
by the banking industry 85 ).
8. Only deposits and savings exceeding this amount are then nonrecoverable
for the insured customers, who then have to bear losses exceeding
this amount.
81 Once the shareholder funds are eaten up, (economic) default occurs.
82 A good example is credit (re-) insurance for a decline in the value of credit assets
(for instance, provided for export financing by government (backed) agencies like
EXIM (Export-Import Bank) in the United States or Hermes in Germany). Some
other insurance policies will cover losses before the equity tranche is hit (e.g., fire
insurance for the bank’s buildings).
83 In most cases the shareholders also have to bear the deductible before the claim on
the insurance can be exercised.
84 See Stulz (2000), p. 4-5.
85 For instance the “Einlagensicherungsfonds” in Germany, see, for example, Obst
and Hintner (1991), p. 689.