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274 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
budgeting decisions of a transaction i as the sum of the CAPM-determined
rate of return (R E,i
) on the invested shareholder capital (V E,i
) and the total
risk costs. These, in turn, are the product of the required economic capital
of the transaction (EC i
) and the (proportional) financial distress costs of the
bank (FDC). 140 Therefore:
Required Return i
= R E,i
⋅ V E,i
+ FDC ⋅ EC i
(6.17)
Clearly, in this model, holding risk within a bank portfolio is always
costly. Even though the first component of the required return is the fair
market price—which is not costly in an economic sense—the second component
reflects the costs associated with the contribution of the transaction
to the total risk costs of the bank’s portfolio, which is driven by the actual
capital structure. Hence, the price for holding risk on one’s own books always
exceeds the costs as paid in the market.
Even though this insight might contradict conventional financial theory,
it can, on the one hand, explain the interdependence of risk-management,
capital-budgeting, and capital-structure decisions in a bank when total risk
matters (as depicted in the left-hand part of Figure 6.9). On the other hand,
this fact sheds some more light on the normative theory of risk management
in banks. Let us first consider the implications of this model for the riskmanagement
decisions of a bank.
Implications for Risk-Management Decisions Since holding risks on the bank’s own
books is costly, risk management can create value because it can reduce these
costs. A bank has the following options to do so:
■
■
Reduce the risk in its own portfolio, and hence the amount of required
economic capital 141 and, therefore, the total risk costs
Reduce the cost of total risk for a given level of economic capital
The ultimate consequence of the first option would be to sell all the
bank’s business and invest the proceedings into risk-free assets. Note that
this is something Wilson predicts as a consequence of using RAROC as a
performance measure. 142 However, this would include selling risks where
140 Again, we do not specify here how these costs are determined. This is an issue
for further research; see the “Areas for Further Research” section later in this chapter.
Here, it is a constant percentage assigned to the required amount of economic
capital.
141 See Merton and Perold (1993), p. 27.
142 See Wilson (1992), p. 114.