Risk Management and Value Creation in Financial Institutions / Edition 1 available in Hardcover
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An analysis of the links between risk management and value creation
Risk Management and Value Creation in Financial Institutions explores a variety of methods that can be utilized to create economic value at financial institutions. This invaluable resource shows how banks can use risk management to create value for shareholders, addresses the advantages of risk-adjusted return on capital (RAROC) measures, and develops the foundations for a model to identify comparative advantages that emerge as a result of risk-management decisions. It is the only book needed for banking executives interested in the relationship between risk management and value creation.
About the Author
GERHARD SCHRoECK has been a senior management consultant with Oliver, Wyman & Company in Frankfurt and London since 1997, where his specialty is to advise financial institutions on risk management issues and value creation. He received his PhD in finance and his MA in business administration from the University of Augsburg, Germany, and an MBA from the Joseph M. Katz Graduate School of Business at the University of Pittsburgh.
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Risk Management and Value Creation in Financial Institutions
By Gerhard Schroeck
John & Wiley SonsISBN: 0-471-25476-2
Increased (global) competition among banks and the threat of (hostile) takeovers, as well as the increased pressure from shareholders for superior returns has forced banks-like many other companies-to focus on managing their value. It is now universally accepted that a bank's ultimate objective function is value maximization. In general, banks can achieve this either by restructuring from the inside, by divesting genuinely value-destroying businesses, or by being forced into a restructuring from the outside.
The approach typically applied to decide whether a firm creates value is a variant of the traditional discounted cash flow (DCF) analysis of financial theory, with which the value of any asset can be determined. In principle, this multiperiod valuation framework estimates a firm's (free) cash flows and discounts them at the appropriate rate of return to determine the overall firm value from a purely economic perspective. However, since a bank's liability management does not only have a simple financing function -as in industrial corporations-but is rather a part of a bank's business operations, it can create value by itself. Therefore, the common valuation framework is slightly adjusted for banks. It estimates the bank's (free) cash flows to its shareholders and then discounts these at the cost of equity capital, to derive thepresent value (PV) of the bank's equity-which should equal (ideally) the capitalization of its equity in the stock market.
This valuation approach is based on neoclassical finance theory and, therefore, on very restrictive assumptions. Taken to the extreme, in this world-since only the covariance (i.e., so-called systematic) risk with a broad market portfolio counts-the value of a (new) transaction or business line would be the same for all banks, and the capital-budgeting decision could be made independently from the capital-structure decision. Additionally, any risk-management action at the bank level would be irrelevant for value creation, because it could be replicated/reversed by the investors in efficient and perfect markets at the same terms and, therefore, would have no impact on the bank's value.
However, in practice, broadly categorized, banks do two things:
* They offer (financial) products and provide services to their clients.
* They engage in financial intermediation and the management of risk.
Therefore, a bank's economic performance, and hence value, depends on the quality of the provided services and the "efficiency" of its risk management. However, even when offering products and services, banks deal in financial assets and are, therefore, by definition in the financial risk business.
Additionally, risk management is also perceived in practice to be necessary and critically important to ensure the long-term survival of banks. Not only is a regulatory minimum capital-structure and risk-management approach required, but also the customers, who are also liability holders, should and want to be protected against default risk, because they deposit substantial stakes of their personal wealth, for the most part with only one bank. The same argument is used from an economy-wide perspective to avoid bank runs and systemic repercussions of a globally intertwined and fragile banking system.
Therefore, we find plenty of evidence that banks do run sophisticated risk-management functions in practice (positive theory for risk management). They perceive risk management to be a critical (success) factor that is both used with the intention to create value and because of the bank's concern with "lower tail outcomes", that is, the concern with bankruptcy risk.
Moreover, banks evaluate (new) transactions and projects in the light of their existing portfolio rather than (only) in the light of the covariance risk with an overall market portfolio. In practice, banks care about the contribution of these transactions to the total risk of the bank when they make capital-budgeting decisions, because of their concern with lower tail outcomes. Additionally, we can also observe in practice that banks do care about their capital structure-when making capital-budgeting and risk-management decisions-and that they perceive holding capital as both costly and a substitute for conducting risk management.
Therefore, banks do not (completely) separate risk-management, capital-budgeting, and capital-structure decisions, but rather determine the three components jointly and endogenously (as depicted in Figure 1.1).
However, this integrated decision-making process in banks is not reflected in the traditional valuation framework as determined by the restrictive assumptions of the neoclassical world. And therefore it appears that some fundamental links to and concerns about value creation in banks are neglected.
Apparently, banks have already recognized this deficiency. Because the traditional valuation framework is also often cumbersome to apply in a banking context, many institutions employ a return on equity (ROE) measure (based on book or regulatory capital) instead. However, banks have also realized that such ROE numbers do not have the economic focus of a valuation framework for judging whether a transaction or the bank as a whole contributes to value creation. They are too accounting-driven, the capital requirement is not closely enough linked to the actual riskiness of the institution, and, additionally, they do not adequately reflect the linkage between capital-budgeting, capital-structure, and risk-management decisions.
To fill this gap, some of the leading banks have developed a set of practical heuristics called Risk-Adjusted Performance Measures (RAPM) or also better known, named after their most famous representative, as RAROC (risk-adjusted return on capital). These measures can be viewed as modified return on equity ratios and take a purely economic perspective. Since banks are concerned about unexpected losses and how they will affect their own credit rating, they estimate the required amount of (economic or) risk capital that they optimally need to hold and that is commensurate with the (overall) riskiness of their (risk) positions. To do that, banks employ a risk measure called value at risk (VaR), which has evolved as the industry's standard measure for lower tail outcomes (by choice or by regulation). VaR measures the (unexpected) risk contribution of a transaction to the total risk of a bank's existing portfolio. The numerator of this modified ROE ratio is also based on economic rather than accounting numbers and is, therefore, adjusted, for example, for provisions made for credit losses (so-called expected losses). Consequently, "normal" credit losses do not affect a bank's "performance," whereas unexpected credit losses do.
In order to judge whether a transaction creates or destroys value for the bank, the current practice is to compare the (single-period) RAPM to a hurdle rate or benchmark return. Following the traditional valuation framework of neoclassical finance theory, this opportunity cost is usually determined by the covariance or systematic risk with a broad market portfolio.
However, the development and usage of RAROC, the practical evidence for the existence of risk management in banks (positive theory), and the fact that risk management is also used with the intention to enhance value are phenomena unexplained by and unconsidered in neoclassical finance theory. It is, therefore, not surprising that there has been little consensus in academia on whether there is also a normative theory for risk management and as to whether risk management is useful for banks, and why and how it can enhance value.
Therefore, the objective of this book is to diminish this discrepancy between theory and practice by:
* Deriving circumstances under which risk management at the corporate level can create value in banks
* Laying the theoretical foundations for a normative approach to risk management in banks
* Evaluating the practical heuristics RAROC and economic capital as they are currently applied in banks in the light of the results of the prior theoretical discussion
* Developing-based on the theoretical foundations and the implications from discussing the practical approaches-more detailed instructions on how to conduct risk management and how to measure value creation in banks in practice
In order to achieve these goals, we will proceed in the following way: We will first lay the foundations for the further investigation of the link between risk management and value creation by defining and discussing value maximization as well as risk and its management in a banking context, and establishing whether there is empirical evidence of a link between the two.
We will then explore both the neoclassical and the neoinstitutional finance theories on whether we can find rationales for risk management at the corporate level in order to create value. Based on the results of this discussion, we will try to deduce general implications for a framework that encompasses both risk management and value maximization in banks.
Using these results, we will outline the fundamentals for an appropriate (total) risk measure that consistently determines the adequate and economically driven capital amount a bank should hold as well as its implications for the real capital structure in banks. We will then discuss and evaluate the currently applied measure economic capital and how it can be consistently determined in the context of a valuation framework for the various types of risk a bank faces.
Subsequently, we will investigate whether RAROC is an adequate capital-budgeting tool to measure the economic performance of and to identify value creation in banks. We do so because, on the one hand, RAROC uses economic capital as the denominator and, on the other hand, it is similar to the traditional valuation framework in that it uses a comparison to a hurdle rate. When exploring RAROC, we take a purely economic view and neglect regulatory restrictions that undeniably have an impact on the economic performance of banks. Moreover, we will focus on the usage of RAPM in the context of value creation. We will not evaluate its appropriateness for other uses such as limit setting and capital allocation.
We close by evaluating the derived results with respect to their ability to provide more detailed answers on whether and where banks should restructure, concentrate on their competitive advantages or divest, and whether they provide more detailed instructions on why and when banks should conduct risk management from a value creation perspective (normative theory).
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Table of Contents
FOUNDATIONS FOR DETERMINING THE LINK BETWEEN RISK MANAGEMENT AND VALUE CREATION IN BANKS.
Value Maximization in Banks.
Value Maximization as the Firm's Objective.
Valuation Framework for Banks.
Problems with the Valuation Framework for Banks.
Other Stakeholders' Interests in Banks.
Risk Management in Banks.
Definition of Risk.
Definition of Risk Management.
Role and Importance of Risk and Its Management in Banks.
Link between Risk Management and Value Creation in Banks.
Goals of Risk Management in Banks.
Choice of the Goal Variable.
Choice of the Stakeholder Perspective.
Choice of the Risk Dimension.
Choice of the Risk-Management Strategy.
Ways to Conduct Risk Management in Banks.
Part A: Bank Performance.
Part B: Systematic versus Specific Risk.
RATIONALES FOR RISK MANAGEMENT IN BANKS.
Risk Management and Value Creation in the Neoclassical Finance Theory.
The Neoclassical Finance Theory.
Corollaries from the Neoclassical Finance Theory with Regard to Risk Management.
The Risk Management Irrelevance Proposition.
Summary and Implications.
Discrepancies Between Neoclassical Theory and Practice.
Risk Management and Value Creation in the Neoinstitutional Finance Theory.
Classification of the Relaxation of the Assumptions of the Neoclassical World.
The Central Role of the Likelihood of Default.
Agency Costs as Rationale for Risk Management.
Agency Costs of Equity as a Rationale for Risk Management.
Agency Costs of Debt as a Rationale for Risk Management.
Coordination of Investment and Financing.
Transaction Costs as a Rationale for Risk Management.
The Costs of Financial Distress.
The Costs of Implementing Risk Management.
The Costs of Issuance.
The Costs of a Stable Risk Profile.
Taxes and Other Market Imperfections as Rationales for Risk Management.
Other Market Imperfections.
Additional Rationales for Risk Management in Banks.
Summary and Conclusions.
IMPLICATIONS OF THE PREVIOUS THEORETICAL DISCUSSION FOR THIS BOOK.
CAPITAL STRUCTURE IN BANKS.
The Role of Capital in Banks.
Capital as a Means for Achieving the Optimal Capital Structure.
Capital as Substitute for Risk Management to Ensure Bank Safety.
The Various Stakeholders' Interests in Bank Safety.
Required Capital from an Economic Perspective.
Determining Capital Adequacy in the Economic Perspective.
Summary and Consequences.
Derivation of Economic Capital.
Types of Risk.
Economic Capital as an Adequate Risk Measure for Banks.
Ways to Determine Economic Capital for Various Risk Types in Banks (Bottom-Up).
Aggregation of Economic Capital across Risk Types.
Concerns with the Suggested Bottom-Up Approach.
Suggestion of an Approach to Determine Economic Capital from the Top Down.
Suggested Top-Down Approach.
Assessment of the Suggested Approach.
Evaluation of Using Economic Capital.
CAPITAL BUDGETING IN BANKS.
Evolution of Capital-Budgeting Tools in Banks.
RAROC as a Capital-Budgeting Tool in Banks.
Definition of RAROC.
Advantages of RAROC.
Assumptions of RAROC.
Deficiencies of RAROC.
Deficiencies of the Generic RAROC Model.
Modifying RAROC to Address Its Pitfalls.
Fundamental Problems of RAROC.
Evaluation of RAROC as a Single-Factor Model for Capital Budgeting in Banks.
New Approaches to Capital Budgeting in Banks.
Overview of the New Approaches.
Evaluation of RAROC in the Light of the New Approaches.
Implications of the New Approaches to Risk Management and Value Creation in Banks.
Implications for Risk-Management Decisions.
Implications for Capital-Budgeting Decisions.
Implications for Capital-Structure Decisions.
New Approaches as Foundations for a Normative Theory of Risk Management in Banks.
Areas for Further Research.