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

288 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
conducting corporate risk management in order to create value. Under the
strict assumptions of this theory, risk management is irrelevant, unnecessary,
and can even be harmful, because investors could replicate or reverse
all of a bank’s risk-management actions at no (extra) cost. Incurring higher
costs for conducting risk management at the bank level would, therefore, be
a value-destroying proposition. We also found that in the neoclassical world
capital-budgeting, capital-structure, and risk-management decisions can be
separated, and the application of the traditional valuation framework (DCFapproach)
is justified, since only the systematic risk to a broad market
portfolio counts.
However, since under the strict assumptions of the neoclassical theory
there would be no reason for banks to exist, we also explored the
neoinstitutional finance theory as it relaxes many of these unrealistic assumptions.
Here, we were able to find manifold reasons why risk management
at the corporate level can increase the value of a bank. This is so because
risk management can now decrease the present value of the agency costs of
equity (allowing banks to increase their leverage without increasing the
probability of default) and debt (using risk management as an equity substitute)
as well as those of transaction costs. Risk management can thus reduce
the expected payments to the various stakeholders of a firm.
We identified the likelihood of default as the central component among
the reasons for conducting risk management. It builds the foundation for
practically all of the rationales for corporate risk management in the
neoinstitutional world. However, its most compelling manifestation is its
ability to address the direct and indirect (transaction) costs that are associated
with financial distress situations—particularly when viewed from a costbenefit
perspective, because value gains seem to be most profound when a
firm tries to avoid these costs via risk management. This is especially true
for banks, since the central role of (relative) creditworthiness in the provision
of financial services and the potential loss of their franchise value lead
to high default costs and to high costs for (unexpected) external financing
(which is most costly in situations when it is needed most). Both of these
costs cause banks to behave as if they were risk averse, even though they are
not in and of themselves, and (since these costs are higher for banks than for
other firms) to conduct relatively more risk management.
Therefore, firms, and especially banks, are trying to avoid financial
distress situations or are trying to decrease the likelihood of their occurrence
by using risk management. Since these “lower-tail outcomes” can be caused
by both systematic and (firm-) specific risks, banks do worry about total
risk, and the composition of their existing bank portfolio matters when
they make capital-budgeting decisions. Actions aimed at addressing both of
these issues can be observed in reality, but are unexplained in the neoclassical
world. In a world where these two concerns matter, risk management