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

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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-
290 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS cally faced by banks (market, credit, and operational risk). We thereby determined the contribution of a transaction to the overall risk of the bank’s existing portfolio. We also introduced a new top-down approach, which is a variant of the Merton default model, to be able to check the aggregated results from this bottom-up procedure. Applying this (theoretical) top-down model to a real-life example, we found that the results are coherent given the few observable data points. We then returned to the question of how we can measure the value creation potential of a bank’s risk-management transaction in a world where total risk matters. We briefly discussed the traditional capital-budgeting tools in banks and concluded that they are not suitable measures in such a world. Computing a project’s NPV using the CAPM and accepting all positive NPV projects is not the right solution for a bank that is concerned with lower-tail outcomes and hence economic capital. Because of this and because, when a bank evaluates a project, the cost of the project’s impact on the total risk of the bank needs to be taken into account, banks developed the practical heuristic RAROC as a capital-budgeting tool. Because the denominator of this modified return-on-equity ratio uses the required economic capital amount, it takes into account both the concern with total risk and the risk contribution of a transaction to the bank’s existing portfolio. In order to determine whether a transaction creates value, RAROC is compared to a CAPM-determined (bankwide) equity hurdle rate, in a manner similar to the EVA ® -approach, as a single-period variant of the traditional valuation framework. However, when we closely examined this risk-adjusted performance measure, we found that in order to make RAROC comparable to such an equity return, one has to accept a set of (implicit) assumptions. For instance, even though economic capital is a fictional amount of money, RAROC assumes that it is the same as “cash” equity capital provided by the shareholders, that the bank holds exactly this amount of equity in reality, and that all cash flows will flow to it as well. We showed upon further investigation that even if one accepts these (rigid) assumptions, the standard RAROC approach is biased and may lead to accepting negative NPV projects when this is inadvisable. Moreover, we identified the fact that there are many more fundamental theoretical concerns with RAROC when it comes to the determination of value creation. RAROC compares a risk measure that has its foundations in the neoinstitutional finance theory with a hurdle rate that was derived in the neoclassical world under very different assumptions. Whereas RAROC only considers the risk contribution to the total risk of the bank’s existing portfolio, the neoclassical theory is only concerned with the systematic risk of a broad market portfolio. Obviously, this discrepancy leads to inconsistent results.
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isk management and value creation i
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Copyright © 2002 by John Wiley & S
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preface From an empirical as well a
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acknowledgments No book is solely t
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x CONTENTS Goals of Risk Management
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xii CONTENTS Definition of RAROC 24
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xiv FIGURES Figure 5.5 Figure 5.6 F
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symbols ↑ ↓ α β i xvi Increas
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xviii SYMBOLS ln Natural logarithm
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abbreviations APT BIS bn bps CAPM C
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2 RISK MANAGEMENT AND VALUE CREATIO
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CHAPTER 2 Foundations for Determini
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Foundations for Determining the Lin
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Page 316 and 317: eferences Aguais, Scott D., and Ant
Page 318 and 319: References 295 Blanden, Michael (19
Page 320 and 321: References 297 and Abuses,” Journ
Page 322 and 323: References 299 Froot, Kenneth A., a
Page 324 and 325: References 301 risiken aus Handelsg
Page 326 and 327: References 303 Investments in Stock
Page 328 and 329: References 305 Institute of Technol
Page 330 and 331: References 307 Sharpe, William F. (
Page 332: References 309 Wall, L.D., and John
Page 335 and 336: 312 INDEX Approach (continued) top-
Page 337 and 338: 314 INDEX Capital: Tier-1, 139, 146
Page 339 and 340: 316 INDEX Credit: derivatives, 178,
Page 341 and 342: 318 INDEX Expectations: homogeneous
Page 343 and 344: 320 INDEX Incentive(s), 22, 33, 45,
Page 345 and 346: 322 INDEX Managers, poorly diversif
Page 347 and 348: 324 INDEX Overinvestment, 75, 79, 8
Page 349 and 350: 326 INDEX Reserve(s) (continued) lo
Page 351 and 352: 328 INDEX Risk, liquidity, 3, 165 R
Page 353 and 354: 330 INDEX Sharpe ratio, 244, 252 Sh
Page 355: 332 INDEX Value at risk (VaR) (cont
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