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

Conclusion 289
could indeed increase the bank value by reducing total risk and the costs
associated with it.
However, these total risk costs can also be influenced by the actual capital
structure. Given that banks hold risks on their books, increasing financial
leverage also increases the probability of incurring the costs of financial
distress. Therefore, holding equity capital commensurate with the risks on
the bank’s books is sensible from both an economic and a regulatory point
of view and can thus be considered as an alternate form of risk management.
Additionally, when risk management can create value, it can also
influence capital-budgeting decisions. Therefore, capital-structure, capitalbudgeting,
and risk-management decisions cannot be separated, and the
traditional valuation framework might not be applicable in such a world.
Even though the neoinstitutional theory provides the rationale for conducting
risk management at the bank level in order to increase value, we
concluded that it only forms the basis for the design of a comprehensive
risk-management approach for banks and, hence, for a normative theory
(whose derivation was the second goal of this book). It is only a partial
solution to our initial problem, because it does not provide detailed instructions
on which risk-management instruments should be used and to what
degree, and how value creation should be measured in such a world.
The prevention of (costly) financial distress situations requires an adequate
total risk measure, because (especially in a non-normal world) neither
systematic nor specific risk captures the concern with lower-tail outcomes
well. We have derived such an appropriate risk measure for the bank’s
concerns in a value creation context. We found that “risk capital” is—from
a theoretical point of view—the relevant and correct measure both for quantifying
total risk and to determine the economically required amount of capital
in banks, because it considers the concerns of all bank stakeholder groups.
Risk capital splits up the bank’s overall default risk into various tranches
and makes them default free by buying (implicit) asset insurance from the
various stakeholder groups so that each group bears that part of the default
risk it wants to bear.
However, since the required negotiation process among the various stakeholders
appeared to be extremely complex, we identified the shortcut measure
“economic capital” as the only feasible practical proxy. It concentrates
the concern with lower-tail outcomes on a single critical threshold level where
a bank run would be triggered. This similarity to the value at risk concept
might be the reason why economic capital has developed as the standard,
best-practice approach at leading institutions in the financial industry.
We subsequently presented various ways how economic capital can be
determined for banks in a valuation context. We first developed and discussed
a detailed methodology to estimate the required economic capital in
a consistent bottom-up way, differentiated by the three types of risk typi-