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

272 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
these costs will lead to a mistake in the capital-budgeting decision-making
process. Hence, the value of a project for a bank is the “traditional” NPV
(as determined in the neoclassical world) minus the cost of total risk.
Even though Stulz leaves open how these costs of total risk can be
quantified in reality, he proves that the total risk costs can be approximated
for small changes in the portfolio by a constant incremental cost of economic
capital per unit of economic capital. 133 Note that these costs of total
risk do not disappear, irrespective of whether we deal with risk in liquid or
illiquid markets. This puts holding risk within a bank portfolio always at a
disadvantage vis-à-vis the market.
We can summarize these three two-factor models as follows. All models
agree that a “total risk” component in addition to the neoclassical capitalbudgeting
approach is necessary in a world where risk management does
matter to banks in order to create value. Even though none of these approaches
shows how one could exactly quantify these total risk costs in
practice, the “Stulz” approach appears to be the most plausible and promising
for practical purposes for the following reasons:
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It integrates a total risk measure (economic capital) that is already
widely used throughout the banking industry into the new capitalbudgeting
decision rule.
Despite the fact that the total risk component does not vanish in
liquid markets, as, for example, in the “Froot and Stein” model, 134
it has (as we will show) the best potential to identify transactions
where the bank has competitive advantages and can really create
value.
As already mentioned, neither the “Merton and Perold” model nor
the “Froot and Stein” model seem appropriate for practical purposes.
Both models are impractical because of the unavailability of observable
market data to determine the costs of the second pricing factor.
Additionally, the latter model seems inappropriate because of its
unrealistic conclusion that the bank will only hold nonhedgable risk.
Evaluation of RAROC in the Light of the New Approaches
RAROC was initially judged to be a good starting point for a capitalbudgeting
tool in banks, because it reflects the concern with total risk. After
evaluating its usage in the light of the new, two-factor models presented
above, it appears that RAROC only works correctly in a directional sense
133 See Stulz (2000), p. 4-23, assuming that we can determine the total cost of risk
for the total amount of economic capital at the bank level.
134 As mentioned above, the exact workings of this effect are unclear.