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

200 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
1. Third-party insurance of risks (“outsourcing” of risks): By paying a
premium (i.e., at a cost), banks can (fully) insure event risks externally.
Banks are then no longer subject to the event risks insured
and, hence, are not required to hold event risk capital for that part
of their event risks. Because insurance companies can build a portfolio
of assets that benefits more from diversification effects than
can be achieved within a bank and because insurance companies might
have accumulated more expertise in evaluating these risks, they can
offer the insurance contracts at a lower price. 318
2. Self-insurance of risks: For a number of reasons, including cost considerations,
a bank may choose not to buy external insurance for
some risks. This can make sense especially if the bank can achieve
the benefits of risk pooling on its own—and more economically than
provided by a third party. 319
3. Controlling risk internally: Some risks, such as internal fraud, are
best managed internally through tight guidelines and controls. However,
establishing and running these instruments also comes at a cost.
Since 2. and 3. can considerably reduce the bank’s exposure to certain
event risks (by limiting the adverse effects through either internal insurance
or better/more effective controls), the bank only needs to hold economic
capital for the remaining part of its event risks. 320 Therefore, before calculating
the required amount of capital, we need to consider the effects of
these other options. And the bank needs to determine which option or combination
of options it prefers to choose—especially in terms of what is most
economically appropriate from a value-creation point of view.
With regard to the two types of event risks defined previously, banks
should choose the following options:
■
Banks should manage the small and more frequent event risks by
using their internal experience of what can go wrong. Banks should
align their processes within a total quality management (TQM) 321
framework and should always try to stay within a predetermined
“three sigma” range, where only acceptable losses occur. 322 For these
318 See Damodaran (1997), p. 789.
319 See Damodaran (1997), p. 789.
320 This is in line with the previous theoretical discussion, where we concluded that
this tranche can be excluded from our considerations.
321 See, for example, Mitra (1993) for a book-long discussion.
322 In order to do so, you need to identify the driving variables and determine the
causes of variation in performance (i.e., to collect data internally).