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

276 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
capital has an opportunity cost. 145 Therefore, holding enough equity
to make risk management irrelevant is not an option for the
bank. 146
2. Selecting projects according to their impact on total risk: Selecting
projects in order to improve the (internal) diversification of the bank’s
portfolio, to manage risk, is also expensive. On the one hand, as a
market benchmark, one can observe that the diversification discount
for conglomerates vis-à-vis a portfolio of their specialized competitors
is approximately 14%. 147 On the other hand, expanding into
unfamiliar sectors can be very costly, because this often adds an
additional (and costly) management layer or can lead to unexpected
high credit losses. 148 However, in our model, these costs have to be
balanced against the cost savings in total risk costs. Note that, in
contrast, Zaik et al. (1996) claim that RAROC gives the message
that internal diversification pays off in any case—even beyond familiar
business segments.
3. Using derivatives to hedge and other (financial) risk-management
instruments to shed risks: Applying these risk-management instruments
in liquid markets is the most cost-efficient way to reduce
firm-wide risk. Therefore, a bank should evaluate the total risk contribution
of a new transaction only after carrying out these hedging
activities. 149 However, and as we will see in the implications below,
the cost of these instruments has to be lower than the total risk costs
of these transactions.
The application of this model leads us to the following practical implications
for risk management in banks:
145 Shareholders expect the CAPM return on equity—which is not costly in an economic
sense. However, when a bank uses equity to buy back debt, this gives a windfall
to the existing debt holders (making their debt safer) and therefore redistributes
some of the benefits of increasing equity capital to other stakeholders. Moreover, a
part of the tax shield is lost for the bank when debt is bought back. Other information
asymmetries and agency costs (e.g., managerial discretion) as well as the transaction
costs (of issuing new capital) also make new equity expensive. For a detailed
discussion of these effects, see also Chapter 3.
146 See Stulz (2000), p. 4-39.
147 See Stulz (2000), p. 4-40.
148 See, for example, Winton (2000), p. 3. Increased competition may magnify the
“Winner’s Curse” problem faced by a bank on the entry into a new lending area,
making diversification very costly. Banks—facing greater competition—may therefore
find it more attractive to specialize.
149 Note that this is partly what RAROC does via transfer pricing.