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

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CHAPTER 6 Capital Budgeting in Banks EVOLUTION OF CAPITAL-BUDGETING TOOLS IN BANKS As we have seen, banks are different from industrial corporations in many respects. This statement is also true for the measurement of (economic) profitability, especially when such performance measures are used in order to determine whether a bank’s chosen (risk-management) activities are consistent with value maximization, that is, when they are used as a capital-budgeting tool. Bank performance measures developed over time in the following way: 1 Until the 1970s, many banks took a purely accounting-driven approach and focused on measuring their (net) revenues or earnings. This, obviously, generated the incentive to maximize earnings by increasing the bank’s assets. Since this approach obviously lacks the connection to a reference asset (e.g., the underlying risks of the transactions), banks subsequently set these (net) revenues in relation to their assets as determined in their balance sheets (i.e., calculating a return on assets [ROA] ratio). As off-balance sheet activities grew substantially 2 and the riskiness of the underlying assets gradually became more important, 3 banks realized that the scarce resource in their business is equity. Therefore, they decided to focus on ROE (return on equity) ratios and measured net revenues in relation to their book equity in order to find out which businesses were most profitable and where to invest. The introduction of the BIS regulatory capital requirements (after 1988) 1 For a more extensive discussion of this evolution, see, for example, Schröck (1997), pp. 77–81. 2 This development obviously made this measure inappropriate. 3 Banks moved (due to increasing pressure on their margins) into types of lending with higher credit risk and experienced increased credit losses, especially during the first country risk crisis during the 1980s. 239
240 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS reinforced the view throughout the banking industry that assets can have very different risks. Even though regulatory requirements do not offer a sophisticated modeling of these risks, 4 they focused the view on the notion that regulatory required capital can be very different from (current) book equity, that these requirements are binding restrictions on the banks’ activities, and that the amount of equity should be linked to the overall riskiness of the bank. These facts subsequently lead to the adjustment of the capital ratios in banks 5 and the calculation of return on regulatory (equity) capital numbers as performance measures. 6 However, increased shareholder pressure forced banks to focus more and more on value creation. Financial institutions realized that accountingdriven ROE measures based on either book or regulatory capital do not have the economic focus of a valuation framework. They fail to take the actual riskiness of the underlying business, the value of future cash flows, 7 and the opportunity cost of equity capital—which needs to be included in order to calculate economic “profits”—into account. But, as already discussed in Chapters 1 and 2, the appropriate flows-to-equity shareholder value framework—which estimates the bank’s (free) cash flows to its shareholders and then discounts these at the cost of equity capital 8 to derive the present value (PV) of the bank’s equity 9 —is often cumbersome to apply in a banking context. Additionally, banks realized that this traditional valuation framework 10 does not address their fundamental problems and that it also does not work from a theoretical point of view, because total risk matters to them. Therefore, we can observe that none of the approaches for calculating a bank’s profitability presented so far adjusts for (total) risk in a systematic way. 11 But we have seen in the extensive discussion of how to determine economic capital in the previous chapter that this fictional capital measure is calculated to reflect exactly the riskiness of the bank’s transactions and also the bank’s concern with total risk. It is, thus, an obvious next step to 4 They are basically determined only by the so-called “risk-weighted assets.” The newly proposed Basle Accord takes a much more risk-oriented view, as described in the last chapter. 5 See the previous chapter. 6 Possible other alternatives not discussed here are to calculate the return on invested equity capital or the return on a market-driven evaluation of equity, such as market capitalization, and so on. 7 See Crouhy et al. (1999), p. 5. 8 As, for example, derived via the Capital Asset Pricing Model (CAPM). 9 So-called Equity Approach or Flows-to-Equity Approach, as described by Copeland et al. (1994), Strutz (1993), Kümmel (1993), and many others. 10 Recall that this neoclassical approach only considers systematic risk. 11 See Crouhy et al. (1999), p. 5, and Grübel et al. (1995), p. 618.
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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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