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Foundations for Determining the Link between Risk Management and Value Creation 43
ensure that its probability of default is kept at a sufficiently low
level. 179
However, the decision to absorb risks internally should be based on
competitive advantages that reimburse the bank more than the associated
costs, that is, when value is created. A bank should have appropriate instruments
to identify uneconomic risk taking, which allows it to decide when
risk absorption is not the right choice and to decide when it is better to
transfer risk to the market, or to avoid it altogether. 180 Again, we can observe
that the complete hedging of all risks should almost never be an option,
or as Culp and Miller put it, “most value-maximizing firms do not
hedge.” 181
We have seen in this section that there are many other ways to conducting
risk management than just hedging. 182 Again, the decision as to which
approach is most appropriate and which instrument should be chosen should
be based on the trade-off between costs and value created. The key, however,
is to have a competitive advantage vis-à-vis the market in order to be
able to create value. 183 In order to find this out, the bank needs to monitor
both risks and returns.
Empirical Evidence
We have seen in the previous two sections that—from a theoretical point of
view—there is no clear and detailed answer as to how banks should structure
and conduct their risk management in order to increase value. In this
section we will discuss whether and what empirical evidence there is on the
link between risk management and value creation. 184
Despite everything that has been written about corporate risk management,
researchers and academics know very little about how risk manage-
179 Note that equity finance is costly. We will discuss this point in more detail in
Chapter 3.
180 See Allen and Santomero (1996), p. 21. We will address this issue in Chapter 6.
181 See Culp and Miller (1995), p. 122.
182 Note that some risks can be hedged at low costs, others are expensive or impossible
to hedge.
183 Hedging/selling in liquid markets is a zero NPV transaction and does not create
value in itself; it just shifts the bank along the Capital Market Line (CML). It seems
problematic to systematically earn a positive return in highly liquid and transparent
markets that exceed the costs of doing so.
184 For an overview and summary of the theoretical and empirical evidence, see
Smithson (1998).