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Capital Structure in Banks 155 asset (and its riskiness) that is the basis to determine the required amount of risk capital is always the same, risk capital does not at all depend on the form of the financing of the (net) assets. We also assume that all of the required risk capital is initially provided by the shareholders as residual claimholders of the bank. However, as we have already indicated above, since holding equity capital for all possible circumstances is too expensive, the shareholders decide to buy asset insurance 100 either (explicitly) from external third-party insurers or (implicitly) from the bank’s other stakeholders. By doing so, shareholders redistribute the risk of the loss of the risk capital to the other stakeholders of the bank. The other stakeholders initially required a completely risk-free investment. Therefore, they could only ask for the risk-free rate to compensate them for their investment. By taking some of the default risk, they now require compensation above the risk-free rate, which should be commensurate with their respective risk taking. Note that this difference above the risk-free rate is an insurance premium paid by the shareholders (from the risk capital resources they provided in the first place). It is not equivalent to the liability held by a specific stakeholder group (which is an accounting view of the problem), but rather represents the economically measured decline in asset value that hits the respective tranche in the order of seniority. The same result can be achieved when we view this redistribution of taking tranches of the bank’s overall default risk as a sequence of reinsurance contracts. 101 Here, the shareholders will sell all default risk they do not want to bear to the next most junior tranche, which in turn will also sell the remainder of the default risk they do not want to hold to the next most junior tranche, and so forth. What is important here is that all stakeholders agree on the overall amount of risk capital that is necessary to back the amount of losses that can be accumulated by the bank’s assets. How this overall amount is split between the various stakeholders is the result of a negotiation process until an (economic) equilibrium is reached. This negotiation process can be very complex 102 and is not the focus of this book. However, as an indication of how that process for reaching equilibrium might work, one can think of the following: Even though the creditors decide to bear the risk of being hit by losses for a fair economic compensation, they might not be willing to also bear the expected value of financial distress costs. Therefore, they will de- 100 As shown—under simplifying assumptions—by Merton and Perold (1993), p. 19, the provision of asset and liability insurance is economically equivalent and therefore has the same price. 101 See Merton and Perold (1993), p. 23, footnote 15, and their list of references to the literature. 102 Therefore, we present a “reduced” version for determining risk capital below.
156 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS mand a higher compensation in the form of higher interest rates on their debt and will, in doing this, shift the entire costs of financial distress to the shareholders, who may choose to reduce these expected costs by decreasing the leverage. Therefore, banks may decrease their leverage to assure creditors that the bank is safe and to align the interests of shareholders and debt holders. 103 The beauty of this eventual synthesis of interests of the various individual views of the stakeholder groups is that, in the end, everybody holds exactly that part of the overall risk of losses that they want to bear. For instance, shareholders are economically only interested in the “normal” fluctuations in the bank’s asset value (i.e., the “normal” volatility of returns), for which they are compensated in the capital markets. Since they are residual claimholders, they are willing to bear all losses—however, only up to a certain amount. If that amount is exceeded, other stakeholders have to step in and bear all subsequent losses. Economic Capital Even if all stakeholder groups individually bear the part of the losses they want to bear, they all have an interest that the bank is not being hit by a “bank run” because that would immediately result in the discontinuation of the bank’s operations. Therefore, all stakeholders are collectively interested in the point when this critical threshold 104 is reached and how much capital (at minimum) they need to hold in order to avoid this occurrence. Economic default is triggered when the market value of the equity falls below the market value of the liabilities. However, this event might not coincide with a bank run, even though it results—at least—in a default on the bank’s junior liabilities. Since these junior liabilities are, even from a regulatory perspective, accepted as a buffer to protect the other stakeholders from experiencing losses (Tier-2 capital), one could argue that banks have (implicitly) received a “guarantee” 105 that specifies that they can continue to operate even after defaulting on their subordinated liabilities. 106 The bank’s credit standard is typically expressed by the (external agency) rating of its senior (uninsured) debt. This benchmark is the basis for most market participants’ and bank customers’ business decisions. 107 It is, there- 103 See Berger et al. (1995b), pp. 396 and 399. 104 Meaning the threshold that triggers a bank run. 105 In the absence of such a guarantee, defaulting on subordinated debt would automatically result in insolvency. 106 One could further argue that such a guarantee would result in costly legal actions from the junior debt holders to recover their losses, which would increase the likelihood of a bank run. 107 Even though external agency ratings might be also available for junior bonds.
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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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