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

226 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
capital by adjusting the top-down approach based on option theory. In short,
we will first estimate realistic values for V A
and σ A
and then employ the
results to infer a theoretical default point DP using the normalized distance
to default (DTD) 436 in combination with the observed (i.e., actual, not riskneutral)
default probability. Even though all of the eventual input parameters
for deriving economic capital are inferred, we will use real, observable
data as a starting point for the estimation.
We start with Equation (5.45) and assume that the total value of a bank’s
assets is the sum of the value of its debt and its equity. If all assets were
traded, equity would be the difference between the market value of the bank’s
assets (on- and off-balance sheet) and the market value of the bank’s liabilities
(also on- and off-balance sheet). 437 Even though we would like to use
market values as best estimates, they are often not observable. For instance,
market values of bank liabilities are very difficult to determine, because a
bank’s liabilities mostly consist of customer deposits and other short-term
obligations that are not publicly traded and that have a nominal yield typically
below their fair market return. It is, therefore, rather difficult to determine
the market value of these obligations. 438 However, since banks have to
repay the nominal amount of these obligations, it is fair to take the book
value of these obligations into account, rather than their unobservable market
value, as a first proxy. Additionally, banks have significant off-balance sheet
obligations that we need to consider in estimating the default point and hence
the probability of default (PD).
As a starting point for the estimation, we use balance-sheet and offbalance-sheet
data from annual financial statements: 439
BV A
BV OBS
= Book value of total assets
= Book value of off-balance sheet liabilities
We must also consider the split of the on-balance sheet liabilities. We assume
that if a bank is approaching default, basically all of the short-term
and customer liabilities become due immediately (bank run) and 50% of the
other liabilities 440 (see the previous discussion of the default point and the
436 An exact definition will be given below.
437 This equation does implicitly assume that the bank has to repay even the insured
deposits in the case of default. See Berger et al. (1995b), p. 411.
438 See Copeland et al. (1994), p. 479. Also see Berger et al. (1995), p. 412.
439 Even though balance sheet information is often manipulated (known as “window
dressing”) around the reporting dates.
440 These other liabilities can be mostly viewed as subordinated debt (or Tier-2 capital
in the definition of the Basle Accord) and are characterized by having a long
maturity and being difficult to redeem quickly in times of crisis. See Berger et al.
(1995), p. 409.