Risk Management and Value Creation in Financial Institutionsby G. Schroeck1. Introduction


2. 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

Empirical Conundrum

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

Eliminate/Avoid

Transfer

Absorb/Manage

Empirical Evidence

Summary

Appendix

Part A: Bank Performance

Part B: Systematic versus Specific Risk


3. 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

Taxes

Other Market Imperfections

Additional Rationales for Risk Management in Banks

Summary and Conclusions

Appendix


4. Implications of the Previous Theoretical Discussion for This Book


5. 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

Available Capital

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)

Credit Risk

Market Risk

Operational Risk

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

Theoretical Foundations

Suggested Top-Down Approach

Assessment of the Suggested Approach

Evaluation of Using Economic Capital

Summary


6. 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

Summary


7. Conclusion