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

Capital Structure in Banks 161
difficult for risk capital. On the one hand, the value of (book) equity (determined
as residual) is usually not equal to the bank’s risk capital (which is
determined by the riskiness of the net assets of the bank). The true economic
values of debt and equity are determined by netting the asset insurance against
the provision of risk-free cash capital and risk capital. However, since most
of the insurance is provided implicitly, it does not appear on the balance
sheet. On the other hand, one is tempted to assume that risk capital borne
by the shareholders is closely aligned with some market-based metric. 128
However, as Merton and Perold show, 129 when they determine the (market)
value of the equity by treating it as a put option on the firm, the value of
the equity can be larger than what is required as insurance contribution (risk
capital from shareholders). This is due to the fact that the other stakeholders
also bear some of the total risk.
Ideally, the economic capital requirement should also be compared to
an economic measure of capital that corresponds to the intrinsic value of the
bank. 130 As discussed previously in the regulatory context, there is no good
approximation for such an actual capital amount because of the lack of data
needed to arrive at such a figure. However, since the use of economic capital
represents a very similar view to the regulatory one—while being more
accurate—we could use an approximation of intrinsic value based on book
capital as the reference for determining capital adequacy. 131 If we take the
regulatory definition of Tier-1 and Tier-2 capital and replace general loanloss
reserves with the insurance pool held for expected losses 132 and subtract
subordinated debt, we can derive such a proxy for actually available equity.
133 But, despite the difficulties with that benchmark already discussed
in the regulatory view, we would still have to add the more difficult to observe
junior debt holders tranche to this amount in order to arrive at a completely
comparable number. 134 For simplicity, it seems sensible to add (back) subordinated
liabilities instead to arrive at the final benchmark. As discussed in
the regulatory view, the market value of equity is too volatile a measure and
128 For the difficulties arising from using market-value-based actual capital numbers,
please refer to the discussion of such numbers in the section on capital adequacy in
the regulatory context above.
129 See Merton and Perold (1993), pp. 22–23.
130 See, for example, Drzik et al. (1998a), p. 27.
131 This seems also to be reasonable because economic capital is a simplified version
of the full-blown risk capital approach.
132 This insurance pool is also based on the riskiness of the loan portfolio.
133 Unlike book equity, this number contains (hidden) reserves and allows for reasonable,
market-driven adjustments to the book value of assets.
134 Of course, the expected revenues are ignored in the regulatory view because they
are too uncertain to count as reliable buffer for losses.