Introduction 1
CHAPTER 2
Foundations for Determining the Link between Risk Management
and Value Creation in Banks 9
Value Maximization in Banks 10
Value Maximization as the Firm’s Objective 10
Valuation Framework for Banks 14
Problems with the Valuation Framework for Banks 16
Empirical Conundrum 16
Other Stakeholders’ Interests in Banks 21
Risk Management in Banks 23
Definition of Risk 24
Definition of Risk Management 25
Role and Importance of Risk and Its Management in Banks 28
Link between Risk Management and Value Creation in Banks 30
ix
Goals of Risk Management in Banks 31
Choice of the Goal Variable 31
Choice of the Stakeholder Perspective 33
Choice of the Risk Dimension 34
Choice of the Risk-Management Strategy 38
Ways to Conduct Risk Management in Banks 39
Eliminate/Avoid 40
Transfer 41
Absorb/Manage 41
Empirical Evidence 43
Summary 48
Appendix 48
Part A: Bank Performance 48
Part B: Systematic versus Specific Risk 49
CHAPTER 3
Rationales for Risk Management in Banks 55
Risk Management and Value Creation in
the Neoclassical Finance Theory 58
The Neoclassical Finance Theory 58
Corollaries from the Neoclassical Finance Theory
with Regard to Risk Management 61
The Risk Management Irrelevance Proposition 64
Summary and Implications 70
Discrepancies Between Neoclassical Theory and Practice 72
Risk Management and Value Creation in
the Neoinstitutional Finance Theory 74
Classification of the Relaxation of the Assumptions
of the Neoclassical World 75
The Central Role of the Likelihood of Default 80
Agency Costs as Rationale for Risk Management 81
Agency Costs of Equity as a Rationale for Risk Management 82
Agency Costs of Debt as a Rationale for Risk Management 91
Coordination of Investment and Financing 97
Transaction Costs as a Rationale for Risk Management 105
The Costs of Financial Distress 105
The Costs of Implementing Risk Management 113
The Costs of Issuance 114
The Costs of a Stable Risk Profile 114
Taxes and Other Market Imperfections as Rationales
for Risk Management 116
Taxes 116
x CONTENTS
Other Market Imperfections 121
Additional Rationales for Risk Management in Banks 122
Summary and Conclusions 123
Appendix 127
CHAPTER 4
Implications of the Previous Theoretical Discussion for This Book 129
CHAPTER 5
Capital Structure in Banks 137
The Role of Capital in Banks 138
Capital as a Means for Achieving the Optimal Capital Structure 138
Capital as Substitute for Risk Management to
Ensure Bank Safety 140
The Various Stakeholders’ Interests in Bank Safety 141
Available Capital 145
Required Capital from an Economic Perspective 150
Determining Capital Adequacy in the Economic Perspective 160
Summary and Consequences 162
Derivation of Economic Capital 164
Types of Risk 164
Economic Capital as an Adequate Risk Measure for Banks 166
Ways to Determine Economic Capital for
Various Risk Types in Banks (Bottom-Up) 170
Credit Risk 170
Market Risk 186
Operational Risk 196
Aggregation of Economic Capital across Risk Types 210
Concerns with the Suggested Bottom-Up Approach 212
Suggestion of an Approach to Determine Economic
Capital from the Top Down 219
Theoretical Foundations 221
Suggested Top-Down Approach 225
Assessment of the Suggested Approach 235
Evaluation of Using Economic Capital 236
Summary 237
CHAPTER 6
Capital Budgeting in Banks 239
Evolution of Capital-Budgeting Tools in Banks 239
RAROC as a Capital-Budgeting Tool in Banks 242
Contents xi
Definition of RAROC 242
Advantages of RAROC 245
Assumptions of RAROC 247
Deficiencies of RAROC 253
Deficiencies of the Generic RAROC Model 253
Modifying RAROC to Address Its Pitfalls 259
Fundamental Problems of RAROC 261
Evaluation of RAROC as a Single-Factor Model
for Capital Budgeting in Banks 267
New Approaches to Capital Budgeting in Banks 268
Overview of the New Approaches 269
Evaluation of RAROC in the Light of the New Approaches 272
Implications of the New Approaches to Risk Management
and Value Creation in Banks 273
Implications for Risk-Management Decisions 274
Implications for Capital-Budgeting Decisions 279
Implications for Capital-Structure Decisions 279
New Approaches as Foundations for a Normative
Theory of Risk Management in Banks 280
Areas for Further Research 282
Summary 285
CHAPTER 7
Conclusion 287