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280 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
In our model, both real equity and total risk are costly. Decreasing the
leverage of the bank (i.e., increasing the equity capital ratio) decreases the
total risk costs but increases the overall equity costs. If increasing equity to
decrease the cost of total risk is costly, 161 then, at the margin, the cost of
total risk has to equal the cost of equity, and the capital structure has to be
adjusted until equilibrium is reached. 162 However, this does not mean that
economic capital and actual equity capital also have to be equal. Knowing
the required amount of economic capital, therefore, does not resolve the
problem of the actual capital-structure choice. Note that since increasing
total risk has a significant cost that has to be taken into account in everything
the bank does, higher capital ratios in banks might be less expensive
than is commonly thought of—given that they can lower total risk costs. An
extreme conclusion of this discussion is that if the bank held infinite (real)
capital, it would be risk-neutral, as in the neoclassical world. This is something
that is not reflected in RAROC because the economic capital always
has to earn the CAPM-required return.
New Approaches as Foundations for a Normative
Theory of Risk Management in Banks
We can draw the following conclusions from the application of the suggested
two-factor model:
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Risk management can create value. There is a whole spectrum of
instruments (apart from just derivatives in liquid markets) that can
be used, as long as the cost of applying them is lower than the total
risk costs associated with the transaction.
As shown in the left-hand part of Figure 6.9, capital-budgeting,
capital-structure, and risk-management decisions are interrelated and
need to be determined simultaneously—rather than separately as in
the neoclassical world.
As also shown in Figure 6.9, when total risk matters and is costly to
the bank, the world cannot be reduced to just dealing with systematic
and specific risks. It is rather a question of whether risks generate—via
the bank’s competitive advantages—enough revenues to
compensate for both market and total risk costs, so that it is worthwhile
to hold them internally. Even though these competitive advantages
are likely to exist in illiquid markets, where informational
asymmetries prevail, they can be achieved across the whole risk
spectrum (as shown in the right-hand part).
161 Due to the increase in transaction and agency costs.
162 See Stulz (1999), p. 9.