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

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.