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

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Rationales for Risk Management in Banks 57 False profits Accounting fraud Lawsuits $737 MM $350 MM Kidder $300 MM Cendant $42 MM Misreported revenue Trading losses $1 BN Barings Bankers Trust BANKS CORPO- RATIONS Bausch & Lomb Phar- Mor $350 MM Charge-off Rescue fund required $3.5 BN LTCM Morgan Grenfell ASSET MGMT INSUR- ANCE ENERGY COs MG PCA $236 MM Claims $300 MM Confed Life Lloyd’s $1 BN Questionable trades $1.3 BN £3.2 BN Trading losses Losses Settlement Figure 3.1 The wheel of misfortune. Source: James Lani (1999): The Wheel of Misfortune, www.erisks.com. Used with permission. The wheel describes (from the inner to the outer circles) the industry of firms experiencing large losses, the company name, the amount of money lost, and the main reason for the losses. explains why risk management matters for firms, because modern financial theory does not imply that firms should manage their risks at the corporate level (normative theory). Following the arguments of Modigliani and Miller (M&M), it can be shown that—under certain conditions—investors will not reward firms for changing their leverage, paying dividends, or managing and reducing their risks. Because investors can replicate or reverse all of these actions by themselves, 14 they have no impact on the overall value of the firm and are therefore irrelevant. There are—by relaxing these conditions—a number of theoretical arguments that can explain why risk management can be useful at the firm level. On the other hand, testing these concepts empirically shows—as we have 14 See Fenn et al. (1997), p. 13.
58 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS seen previously—only weak or inconclusive evidence. 15 In particular, there is only very limited confirmation that risk management creates (shareholder) value. 16 However, the major challenge for researchers is the fact that data limitations make it very difficult to obtain such evidence. 17 This section examines risk management in the light of whether it can meet the sufficient condition mentioned above, that is, whether it can be used as a device to increase value (in banks). In discussing the theoretical foundations for the rationale of risk management at the firm level, we will derive the circumstances under which risk management can help to create value. RISK MANAGEMENT AND VALUE CREATION IN THE NEOCLASSICAL FINANCE THEORY In this section we investigate if and how risk management at the corporate level can help to create value under the strict assumptions of the neoclassical finance theory. The Neoclassical Finance Theory Risk management at the level of individual investors is well established in modern finance theory. However, this neoclassical world is based on rigid assumptions that capital markets are perfect and complete. The details of such markets are defined in the following lists. Financial markets are perfect, if: 18 ■ ■ ■ ■ ■ ■ There are no taxes. There are no transaction costs (i.e., markets are frictionless, and information is available free of charge). There are no costs for writing and enforcing contracts. There are no restrictions on investments in securities (no regulation, no limitations on short-selling). There are no differences in information across investors (i.e., markets are efficient, and information is simultaneously available to all market players). All market players are price takers (i.e., price is a given and is the same for buyers and sellers). 15 For a summary of empirical studies on risk management and value creation see, for example, Fenn et al. (1997) and the “Empirical Evidence” section of Chapter 2. 16 See Fenn et al. (1997), pp. 14 and 25. 17 See for example, Fenn et al. (1997), p. 28, and Tufano (1996), pp. 1097–1098. 18 See for example, Stulz (2000), p. 2-4, Schmidt and Terberger (1997), p. 56.
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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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4 RISK MANAGEMENT AND VALUE CREATIO
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108 RISK MANAGEMENT AND VALUE CREAT
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eferences Aguais, Scott D., and Ant
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References 295 Blanden, Michael (19
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References 297 and Abuses,” Journ
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References 299 Froot, Kenneth A., a
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References 301 risiken aus Handelsg
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References 303 Investments in Stock
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References 305 Institute of Technol
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References 307 Sharpe, William F. (
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References 309 Wall, L.D., and John
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312 INDEX Approach (continued) top-
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314 INDEX Capital: Tier-1, 139, 146
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316 INDEX Credit: derivatives, 178,
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318 INDEX Expectations: homogeneous
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320 INDEX Incentive(s), 22, 33, 45,
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322 INDEX Managers, poorly diversif
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324 INDEX Overinvestment, 75, 79, 8
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326 INDEX Reserve(s) (continued) lo
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328 INDEX Risk, liquidity, 3, 165 R
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330 INDEX Sharpe ratio, 244, 252 Sh
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332 INDEX Value at risk (VaR) (cont
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