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preface From an empirical as well as a personal point of view, risk management in the financial industry has been one of the most exciting and most researched areas over the last decade. Depositors and regulators claim that risk management is necessary, and many banks argue that superior risk management can create (shareholder) value. However, from a theoretical point of view, it is not immediately clear if and how risk management at the corporate level can be useful. Very little research has been conducted as to why there is an economic rationale for risk management at the bank level. This book provides a closer and a more differentiated view on the subject than previous research and is intended to describe both the theory and the practice of corporate risk management in financial institutions. It is different from other works on this subject in the following significant ways. First, it addresses the question of under which circumstances risk management at the corporate level can help to maximize value. These conditions require a deviation from standard neoclassical finance theory because in (risk) efficient markets corporate risk management could destroy value, especially if it comes at a cost, and it is shown that risk management at the bank level is not restricted to hedging activities in such a world. Second, the book agrees in principal with what other publications find are the correct building blocks on which risk-management decisions in banks should be based in such a world, namely economic capital and RAROC (risk-adjusted return on [economic] capital). It also explains, that in the circumstances under which corporate risk management can add value, the conclusions of classical finance theory are not valid in general, and that the Net Present Value (NPV) rule might not always be the correct measure to decide whether a (risk management) transaction adds or destroys value. Third, this book, therefore, develops the foundations for a model that would allow banks to identify comparative advantages that, in turn, would enable them to select those risk-management strategies that really add value. Fourth, the approach presented in this book is able to reconcile the debt holders’ (who are averse to default risk) and the shareholders’ (who prefer more volatility rather than less because they are option holders on the firm’s value) perspectives and to identify those activities that are helpful to all v
vi PREFACE constituents/stakeholders of a financial institution because they avoid the consequences of a bank run. Even though the following Chinese proverb: A smart man learns from his own mistakes, A wise man learns from the mistakes of others, And a fool never learns applies to both risk management and writing a manuscript on this subject, I hope this book will be a valuable contribution to the ongoing discussion. There are undoubtedly errors in the final product both orthographically and conceptually that remain my own responsibility, and certainly further research needs to be done. Thus, I encourage anybody with constructive comments to send them on to me. All views presented in this book represent the author’s views and do not necessarily reflect those of Oliver, Wyman & Company.
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Page 5 and 6: Copyright © 2002 by John Wiley & S
Page 10: acknowledgments No book is solely t
Page 13 and 14: x CONTENTS Goals of Risk Management
Page 15 and 16: xii CONTENTS Definition of RAROC 24
Page 17 and 18: xiv FIGURES Figure 5.5 Figure 5.6 F
Page 19 and 20: symbols ↑ ↓ α β i xvi Increas
Page 21 and 22: xviii SYMBOLS ln Natural logarithm
Page 23 and 24: abbreviations APT BIS bn bps CAPM C
Page 25 and 26: 2 RISK MANAGEMENT AND VALUE CREATIO
Page 32 and 33: CHAPTER 2 Foundations for Determini
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Foundations for Determining the Lin
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100 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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