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154 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
Alternately, the bank could decide to split up the losses so that each
stakeholder group would reach its required level of confidence, but would,
however, have to bear some of the losses, while being compensated for doing
so on fair economic terms. We will describe below how the bank could achieve
this. 92 We can define Risk Capital as the minimum capital amount that has to
be invested to buy insurance that fully protects the value of a bank’s net
assets against a decline in value, 93 so that completely default-free financing
of these net assets can be obtained. 94 Risk capital therefore differs from
regulatory capital (which attempts to measure risk capital according to a
particular accounting standard 95 ) and from cash capital (i.e., up-front cash
that is required to execute the transaction and that is a component of the
working capital of a bank).
96, 97
Risk capital is, thus, completely determined by the shape of the distribution
of the changes in the value (i.e., the riskiness) of net assets. Note that,
as long as the liabilities of a bank are fixed and not contingent on the payoff
of the bank’s (gross) assets (which is usually the case), the gross assets
show the same fluctuations as the net assets. It is, therefore, sufficient to
know the distribution of the value changes in the gross assets to determine
the required amount of risk capital of a bank.
However, when the liabilities are completely contingent (e.g., mutual
funds usually make all of their payoffs completely contingent on the value
development of their gross assets, that is, customer returns exactly match
the fund’s portfolio returns 98 ), the riskiness of the net assets is reduced to
zero (even though the gross assets are risky). Therefore, under such circumstances,
the bank would not have to hold any risk capital. 99
Despite the fact that in reality a bank’s liabilities are partly fixed and
partly contingent (i.e., the riskiness of the net assets will, in general, differ
from the riskiness of the gross assets), we are assuming for our further discussion
that all bank liabilities are fixed. Note that, since the underlying
92 For definitions of risk capital that ignore this global approach, including all stakeholder
groups, see, for example, Lister (1997), p. 19, and Johanning (1998), p. 46.
93 As indicated in Figure 5.2.
94 See Merton and Perold (1993), p. 17. Note that net assets are defined as gross
assets minus (default-free) customer liabilities in this context.
95 However, the regulatory approach has, as stated previously, a different focus and,
therefore, measures up to a different level, because the regulators’ view is very similar
to that of uninsured creditors.
96 Therefore, the amount of initially provided cash capital (both debt and equity) is
irrelevant in that context from a purely economic point of view.
97 See Merton and Perold (1993), p. 17.
98 The returns are (usually) net of an administration fee for managing the portfolio.
99 See Merton and Perold (1993), pp. 23–24.