Two years later on September 14, 2010, the Financial Times reported that the legal and accounting fees in the United States and Europe relating to the bankruptcy of all the subsidiaries of the Lehman holding company had almost reached $2 billion, even though some of the services had been provided at discounted rates.
We mentioned earlier that corporate survival is an important managerial objective and that shareholders like companies to avoid excessive risks. We now understand one reason why this is so. Bankruptcy laws vary widely from country to country, but they all have the effect of destroying value as lenders and other creditors vie with each other to get paid. If a company chooses projects with very high risks (but sufficiently high expected returns to be above the efficient frontier in Figure 1.4), the probability of bankruptcy will be quite high. Lenders will recognize that expected bankruptcy costs are high and charge very high interest rates. The equity holders will therefore bear the high expected bankruptcy costs in the form of higher interest charges. To limit the extent to which this happens, managers try to keep the bankruptcy probability low.
When a major new investment is being contemplated, it is important to consider how well it fits in with other risks taken by the company. Relatively small investments can often have the effect of reducing the overall risks taken because of their diversification benefits. However, a large investment can dramatically increase these risks. Many spectacular corporate failures (such as the one in Business Snapshot 1.1) can be traced to CEOs who made large acquisitions (often highly leveraged) that did not work out.
Financial Institutions
One can argue about how important bankruptcy costs are for the decision making of a non-financial company, but there can be no question that it is crucially important for a financial institution such as a bank to keep its probability of bankruptcy very low. Large banks rely on wholesale deposits and instruments such as commercial paper for their funding. Confidence is the key to their survival. If the risk of default is perceived by the market to be other than very low, there will be a lack of confidence and sources of funding will dry up. The bank will be then be forced into liquidation–even if it is solvent in the sense of having positive equity. Lehman Brothers was the largest bankruptcy in U.S. history. Northern Rock was a large failure of a financial institution in the United Kingdom. In both cases, the failure was because there was a lack of confidence and traditional sources of funding dried up.
Regulation
Even if, in spite of the arguments we have just given, the managers of a bank wanted to take huge risks, they would not be allowed to do so. Unlike other companies, many financial institutions are heavily regulated. Governments throughout the world want a stable financial sector. It is important that companies and private individuals have confidence in banks and insurance companies when they transact business. The regulations are designed to ensure that the probability of a large bank or an insurance company experiencing severe financial difficulties is low. The bail-outs of financial institutions in 2008 during the subprime crisis illustrate the reluctance of governments to let large financial institutions fail. Regulated financial institutions are forced to consider total risks (systematic plus nonsystematic).
Bankruptcy often arises from losses being incurred. Regulators try to ensure that the capital held by a bank is sufficient to provide a cushion to absorb the losses with a high probability. Suppose, for example, that there is considered to be only a 0.1 % probability that a financial institution will experience a loss of $2 billion or more in a year. Regulators might require the bank to hold equity capital equal to $2 billion. This would ensure that there is a 99.9 % probability that the equity capital is sufficient to absorb the losses. The models used by regulators are discussed in more detail in later chapters.
The key point here is that regulators are concerned with total risks, not just systematic risks. Their goal is to make bankruptcy a highly unlikely event.
1.6 RISK MANAGEMENT BY FINANCIAL INSTITUTIONS
There are two broad risk management strategies open to a financial institution (or any other organization). One approach is to identify risks one by one and handle each one separately. This is sometimes referred to as risk decomposition. The other is to reduce risks by being well diversified. This is sometimes referred to as risk aggregation. Both approaches are typically used by financial institutions.
Consider, for example, the market risks incurred by the trading room of a bank. These risks depend on the future movements in a multitude of market variables (exchange rates, interest rates, stock prices, and so on). To implement the risk decomposition approach, the trading room is organized so that a trader is responsible for trades related to just one market variable (or perhaps a small group of market variables). For example, there could be one trader who is responsible for all trades involving the dollar-yen exchange rate. At the end of each day, the trader is required to ensure that certain risk measures are kept within limits specified by the bank. If the end of the day is approached and it looks as though one or more of the risk measures will be outside the specified limits, the trader must either get special permission to maintain the position or execute new hedging trades so that the limits are adhered to. (The risk measures and the way they are used are discussed in Chapter 8.)
The risk managers, working in what is termed the middle office of a bank, implement the risk aggregation approach for the market risks being taken. This involves calculating at the end of each day the total risk faced by the bank from movements in all market variables. Hopefully, the bank is well diversified so that its overall exposure to market movements is fairly small. If risks are unacceptably high, then the reasons must be determined and corrective action taken. The models used for the aggregation of market risks are given in Chapters 12, 13, and 14.
Risk aggregation is a key tool for insurance companies. Consider automobile insurance. The insurance company's payout on one particular automobile insurance policy is quite uncertain. However, the payout from 100,000 similar insurance policies can be predicted with reasonable accuracy.
Credit risks are also traditionally managed using risk aggregation. It is important for a financial institution to be well diversified. If, for example, a bank lends 40 % of its available funds to a single borrower, it is not well diversified and likely to be subject to unacceptable risks. If the borrower runs into financial difficulties and is unable to make interest and principal payments, the bank could become insolvent.
If the bank adopts a more diversified strategy of lending 0.01 % of its available funds to each of 10,000 different borrowers, it is in a much safer position. Suppose that the probability of any one borrower defaulting is 1 %. We can expect that close to 100 borrowers will default in the year and the losses on these borrowers will be more than offset by the profits earned on the 99 % of loans that perform well. To maximize the benefits of diversification, borrowers should be in different geographical regions and different industries. A large international bank with different types of borrowers all over the world is likely to be much better diversified than a small bank in Texas that lends entirely to oil companies.
But, however well diversified a bank is, it is still exposed to systematic risk, which creates variations in the probability of default for all borrowers from year to year. Suppose that the probability of default for borrowers in an average year is 1 %. When the economy is doing well, the probability of default is less than this and when there is an economic downturn it is liable to be considerably more than this. Models for capturing this exposure are discussed in later chapters.
Since the late 1990s, we have seen the emergence of an active market for credit derivatives. Credit derivatives allow banks to handle credit risks one by one (risk decomposition) rather than relying solely on risk diversification. They also allow banks to buy protection against the overall level of defaults in the economy. However, for every buyer of credit protection there must be a seller. Many sellers of credit protection, whether on individual companies or on portfolios of companies, took huge losses during the
