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

Capital Budgeting in Banks 279
in Figure 6.9 157 ) are lower than the total risk costs they incur, it will pay for
the bank to do so. This contradicts the conclusion of the neoclassical theory
that spending time and money to eliminate firm-specific risks will destroy
value in any case. 158 Note that we dealt with this issue in the “Operational
Risk” section of Chapter 5 when we discussed the benefits of self-insurance
(internal risk pooling) versus third-party insurance for event risks.
Implications for Capital-Budgeting Decisions We have seen that, when total risk
matters, banks can increase their value through risk management. However,
this fact makes risk management inseparable from capital-budgeting decisions.
On the one hand, as previously indicated, capital-budgeting decisions
on transactions should only be taken after all noncompensated risks 159 have
been shed via risk-management actions. On the other hand, the bank may
only be able to buy a risk—where it does have a compensated informational
advantage—as a part of a “risk”-bundled product. 160 However, the bank
may not be able to shed the other, noncompensated risks that are also associated
with that “bundled” transaction later, because the costs of doing so
would exceed the total risk costs as indicated by Equation (6.17) and as
described in Implication 2. However, these risks impose a real cost on the
bank. Therefore, the bank cannot and should not separate risk management
from the capital-budgeting decision. Applying our two-factor model with all
its implications ex ante would prevent the bank from investing in such risks
beforehand—unless the compensation of the informational advantage were
to exceed the additional total risk costs imposed by the unsalable risk components
of the package.
Implications for Capital-Structure Decisions Because the actual capital structure
determines the total risk costs for the bank, neither risk management nor
capital-budgeting decisions can be made without considering the actual capital
structure.
157 Note that the three types of risk in Figure 6.9 are only schematically put into
places where they are most likely to be found. Deviations might well be possible. For
instance, there might be both highly illiquid or highly specific market risk, and so on.
158 Consider, for example, a transaction that has hedgable specific risk. The traditional
NPV rule does not consider such risks and, as shown previously, hedging at
a cost would destroy value. However, hedging this risk, even at a cost, would make
sense if the reduction in total risk costs outweighed the costs.
159 Noncompensated risks are those risks that are cheaper to sell off than to keep
internally.
160 As an example, this might be a credit in a specialized lending area of the bank,
where the bank has no specific skills, but that has sophisticated interest rate and
foreign exchange features associated with it.