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

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.