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72 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
Fifth, since risk management in this world only redistributes risk across
market participants, who charge the same price for bearing it, 88 all banks,
for example, would offer similar products at the same price, and their current
portfolio constitution would not influence the pricing decision.
Sixth, decisions on capital budgeting, capital structure, and risk management
can therefore be determined separately in the neoclassical world, 89
because all market participants face the same price/cost for their actions and
are thus able to replicate any of the decisions taken by the firm.
Last but not least, even though risk management is irrelevant for value
creation, that is, a NPV = 0 proposition, it could still be useful to ensure and
signal a certain company risk profile and hence a certain M&M risk class
to the outside world. Therefore, risk management is not per se redundant in
the neoclassical theory.
The neoclassical world does not build a sound foundation for an economic
rationale for using risk management to create value. However, as soon
as we relax one or more of the rigid assumptions, risk management could
potentially increase value and there would be an economic rationale for
conducting risk management even at the corporate level. As we will see in
the following section, many of the assumptions of the neoclassical world
appear to be unrealistic because we can observe wide discrepancies between
what the neoclassical theory predicts and what we can observe in practice.
Therefore, we will analyze the results of relaxing some of the assumptions
in the subsequent sections.
Discrepancies Between Neoclassical Theory and Practice
The neoclassical theory predicts that neither banks nor any other (financial)
intermediaries would exist, 90 because all market players would contract
directly with each other in complete and perfect (financial) markets. And
even if banks existed, they would not be able to add value through
the provision of their services, since prices are determined in efficient markets
and are the same for all participants, irrespective of their preexisting
portfolios.
However, what we can observe in reality is that banks do exist and that
they offer a variety of different financial products and services that are utilized
by investors who are willing to pay a premium for them. One of the
reasons that could explain this fact is that there is empirical evidence that
investors do not hold diversified portfolios and that there is only limited
88 See Stulz (2000), p. 2-41.
89 See, for example, Mason (1995), p. 29.
90 However, the existence of firms is consistent with the neoclassical world. See Mason
(1995), p. 27.