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Capital Structure in Banks 237 context of value creation—at a consistent time horizon. 471 They are, therefore, measures that can be considered a common currency for risk across all types of risk. However, an implicit assumption in the calculation of economic capital is that the portfolio of transactions under consideration is kept constant over time until H, the end of the measurement period. This assumption was less of an issue when VaR was first developed in the trading arena, 472 where only very short horizons are relevant (often only hours or days). On the contrary, practical experience shows that—at least so far 473 —credit portfolios are kept fairly constant over time 474 and (still) constitute the bulk of a bank’s risk exposure. It is also worthwhile to mention here that economic capital calculated on VaR basis seems only appropriate for banks, because only they are concerned about the reduction in the total value of their portfolio of assets. Industrial companies, which are concerned about preserving the level of cash flows to finance valuable projects, 475 should choose other measures of total risk. 476 Yet another problem with economic capital is that it typically only considers the risk contribution to the overall bank portfolio and not to the broad market. It is, therefore, difficult to use it as the basis for the valuation of assets. 477 SUMMARY We have derived an adequate risk measure for the bank’s concern with total risk in this chapter. Even though we identified risk capital as the most appropriate measure, we concluded that (the shortcut measure) economic capital is the only practical way to determine the economically based capital re- 471 We only suggested a framework to calculate the capital requirement at a one-year horizon, H. Since value creation occurs multiperiod, we will have to extend this approach beyond H below. 472 See Culp and Miller (1998), pp. 28–29. 473 Before the broad usage of credit derivative instruments that significantly increased the liquefaction in the credit markets. 474 Even though credit portfolios grow over time, their riskiness hardly changes significantly because of the consistent application of credit guidelines. 475 As described by Froot et al. (1993). 476 See Culp and Miller (1998), p. 35, or for a more extensive discussion, Stulz (2000), Chapter 4. 477 Froot and Stein (1998a) suggest a mix of the two approaches, which we will address below.
238 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS quirement for banks. 478 We developed and discussed a detailed methodology to determine the required economic capital from a value-creation perspective from the bottom up, differentiated by three types of risks, and discussed how these results can be checked via a newly suggested top-down approach. Since economic capital can be interpreted as an “insurance premium” paid by the bank’s stakeholders, which “insures” them against a bank run, it should be part of the performance and value measurement. However, since this insurance does not appear on a bank’s balance sheet (because it is only provided implicitly), it needs to enter a bank’s economic “P&L” statement (which determines the value creation) in another way. Otherwise, if the underlying assets perform well, “economic profits” are overstated, 479 because decreasing the cost of total risk is costly for banks 480 and should therefore be reflected in the bank’s capital-budgeting framework. 481 Thus, computing a project’s NPV using CAPM and accepting all positive NPV projects does not seem to be the right solution for a bank that is concerned with total risk, and hence economic capital. 482 We will discuss possible solutions to this problem in the next chapter. 478 This might also be the reason why it has developed as the standard approach at best practice institutions in the financial industry. 479 If not, “economic profits” are understated. See Merton and Perold (1993), pp. 24–25. 480 See Stulz (1999), p. 9. 481 See Froot and Stein (1998a), p. 58. 482 See Stulz (2000), p. 4-21.
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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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