Journal of APPLIED CORPORATE FINANCE

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1 VOLUME 27 NUMBER 1 WINTER 2015 Journal of APPLIED CORPORATE FINANCE In This Issue: Corporate Risk Management Risk-Taking and Risk Management by Banks 8 René M. Stulz, Ohio State University Risk Management by Commodity Trading Firms: The Case of Trafigura 19 Craig Pirrong, University of Houston How to Strengthen the Regulation of Bank Capital: Theory, Evidence, and A Proposal When One Size Doesn t Fit All: Evolving Directions in the Research and Practice of Enterprise Risk Management 27 Shekhar Aiyar, International Monetary Fund, Charles W. Calomiris, Columbia University, and Tomasz Wieladek, Bank of England 37 Anette Mikes, HEC Lausanne, and Robert S. Kaplan, Harvard Business School Evidence of the Value of Enterprise Risk Management 41 Robert E. Hoyt, University of Georgia, and Andre P. Liebenberg, University of Mississippi Here We Go Again Financial Policies in Volatile Environments: Lessons For and From Energy Firms Corporate Hedging of Price Risks: Minimizing Variance or Eliminating Lower-Tail Outcomes? OTC vs. Exchange Traded Derivatives and Their Impact on Hedging Effectiveness and Corporate Capital Requirements Valuing Emerging Market Equities A Pragmatic Approach Based on the Empirical Evidence A Practical Guide for Non-Financial Companies When Modeling Longer-Term Currency and Commodity Exposures 48 Marc Zenner, Evan Junek, and Ram Chivukula, J.P. Morgan 57 Tom Aabo, Aarhus University, Denmark 63 Ivilina Popova, Texas State University, and Betty Simkins, Oklahoma State University 71 Niso Abuaf, Pace University and Ramirez and Co. 89 Lurion De Mello and Elizabeth Sheedy, Macquarie University, and Sarah Storck, Technical University Munich Renewable Energy with Volatile Prices: Why NPV Fails to Tell the Whole Story 101 Ricardo G. Barcelona, King s College, London and IESE Business School Real Options in Foreign Investment: A South American Case Study 110 Michael J. Naylor, Jianguo Chen and Jeffrey Boardman, Massey University

2 VOLUME 27 NUMBER 1 WINTER 2015 In This Issue: Corporate Risk Management A Message from the Editor 2 Executive Summaries 4 Risk-Taking and Risk Management by Banks 8 René M. Stulz, Ohio State University Risk Management by Commodity Trading Firms: The Case of Trafigura 19 Craig Pirrong, University of Houston How to Strengthen the Regulation of Bank Capital: Theory, Evidence, and A Proposal 27 Shekhar Aiyar, International Monetary Fund, Charles W. Calomiris, Columbia University, and Tomasz Wieladek, Bank of England When One Size Doesn t Fit All: Evolving Directions in the 37 Research and Practice of Enterprise Risk Management Anette Mikes, HEC Lausanne, and Robert S. Kaplan, Harvard Business School Evidence of the Value of Enterprise Risk Management 41 Robert E. Hoyt, University of Georgia, and Andre P. Liebenberg, University of Mississippi Here We Go Again Financial Policies in Volatile Environments: Lessons For and From Energy Firms 48 Marc Zenner, Evan Junek, and Ram Chivukula, J.P. Morgan Corporate Hedging of Price Risks: Minimizing Variance or Eliminating Lower-Tail Outcomes? 57 Tom Aabo, Aarhus University, Denmark OTC vs. Exchange Traded Derivatives and Their Impact on 63 Hedging Effectiveness and Corporate Capital Requirements Proposal Ivilina Popova, Texas State University, and Betty Simkins, Oklahoma State University Valuing Emerging Market Equities A Pragmatic Approach Based on the Empirical Evidence 71 Niso Abuaf, Pace University and Ramirez and Co. A Practical Guide for Non-Financial Companies When Modeling 89 Longer-Term Currency and Commodity Exposures Lurion De Mello and Elizabeth Sheedy, Macquarie University, and Sarah Storck, Technical University Munich Renewable Energy with Volatile Prices: Why NPV Fails to Tell the Whole Story 101 Ricardo G. Barcelona, King s College, London and IESE Business School Real Options in Foreign Investment: A South American Case Study 110 Michael J. Naylor, Jianguo Chen and Jeffrey Boardman, Massey University

3 A Message from the Editor Ten years ago my colleague John McCormack and I organized a roundtable discussion of corporate risk management that was hosted by Morgan Stanley and published in these pages under the title Enterprise Risk Management and Corporate Strategy. One of the main premises of the discussion was that the discipline of corporate risk management had come of age, that it had established itself as a serious branch of financial economics with a set of principles and methods that had been tested and shown their worth. The most compact articulation of this thesis during the roundtable was provided by Bob Anderson, then (and still) the Executive Director of a non-profit called the Committee of Chief Risk Officers, when he made the following observation: One trend I m seeing very clearly is a major expansion of the focus of corporate risk officers beyond the use of derivatives to hedge specific financial risks into something that people are now calling enterprise-wide risk management. [When I was working for BP in the early 90s], risk management was mainly about the use of swaps and options to hedge interest rates and commodity prices. Back then, risk management was thought of as a pretty much decentralized, or compartmentalized, activity that could help the firm mainly by making modest contributions to the P&L. But the purview of today s risk manager is much broader; it encompasses all aspects of the corporation, including investment and operating decisions as well as financing. It s about ensuring the company s access to capital and its ability to carry out its strategic plan and, in this sense, it is a critical part of the business model. Much has happened during the past ten years that could be used to support that statement. As Anette Mikes and Bob Kaplan begin by noting in their assessment of the state of enterprise risk management in this issue, we now have ample regulations and prescriptive frameworks for enlightened risk management, including the risk disclosure recommendations in the UK Turnbull report; the COSO Enterprise Risk Management Framework; and the International Standards Organisation s Risk Management Principles and Guidelines on Implementation. The Toronto Stock Exchange requires the establishment and disclosure of a company s risk management function, and the Dodd- Frank Wall Street Reform and Consumer Protection Act requires large publicly traded financial firms to have a separate board risk committee composed of independent directors. Credit rating agencies now evaluate how firms manage risks, with Moody s and Standard & Poor s (S&P) having an explicit focus on ERM in the energy, financial services, and insurance industries. But as Mikes and Kaplan go on to say, there have clearly also been disappointments and considerable skepticism about the claims for ERM as a mature discipline with proven concepts and tools. Much of that skepticism can of course be traced to the recent global financial crisis, and to the massive failures of risk management at banks and other financial institutions that are still viewed by many as a major (if not the main) contributor to the crisis. In our lead article, Risk-Taking and Risk Management by Banks, Ohio State professor René Stulz suggests that this view of both ERM s promise and its failure to live up to it have been exaggerated by misconceptions about the role and capabilities of the corporate risk management function. Perhaps most important, the goal of corporate risk management for publicly traded companies, as Stulz begins by pointing out, is not to reduce or minimize risk, but to ensure that the firm takes the optimal, or value-maximizing, level of risk. And the value-maximizing level of risk, as prescribed by standard finance theory, is the one that allows the company to carry out all its positive-npv investments and activities while ensuring, under most circumstances, continuous access to the funding needed to carry out those investments and activities. But as Stulz also points out, such decisions about how much risk to take or what is often referred to as the firm s risk appetite are generally not made by the Chief Risk Officer, but rather by the CEO and his senior management team. Today s CROs, to be sure, are typically part of that team, and presumably given some say in corporate investment, operating, and financing decisions. But the job of the CRO is a more limited one: given the firm s business model and risk appetite, the main tasks of risk managers are to measure (to the extent possible) and monitor the risks actually being taken by the firm and, in some cases, to advise the firm s risk takers when structuring transactions to help ensure that the probability of financial failure stays within acceptable levels. This limitation of the CRO s authority, when combined with other realities of risk management inside large organizations, creates some major challenges when applying this value-maximizing risk management framework to the case of banks. For what the research has shown including several studies by Stulz 2 Journal of Applied Corporate Finance Volume 27 Number 1 Winter 2015

4 himself with coauthors is that the banks with the most sophisticated risk management systems and shareholder-friendly governance structures (including large equity ownership by top management) also showed the greatest propensity to fail during the recent crisis. Why did this happen? Encouraged by federal deposit guarantees and other subsidies that had the effect of reducing their cost of capital and with the backing of the large, well-known institutional investors who loaded up on their shares commercial (and investment) banks with arguably state-of-the-art risk management systems were emboldened by them to take ever larger risks during the mid-2000s. And in this sense, the fundamental cause of the wave of bank failures was the investment and financing decisions of banks top management decisions to take on excessive concentrations of risky assets (mortgages) and support them (often using short-term debt) with equity bases that, although meeting the regulatory standards of the time, proved to be too small. What can be done to reduce the probability and severity of the next wave of bank failures? Part of the answer will involve the new restrictions of banks risk-taking activities now being implemented under the Volcker Act. But as Stulz s argument suggests, excessive regulatory intervention in the investment and operating decision-making of U.S. banks runs the risk of destroying much of the value of the U.S. financial sector. And achieving the right social balance of regulatory constraints and preservation of market forces will require careful deliberation, further negotiation between regulators and market participants, and probably some experimentation. Take the case of corporate hedging with OTC derivatives. The benefits of such hedging described by Betty Simkins and Ivilina Popova in this issue provide a nice illustration of the value that would likely have been lost by mandating the use of exchange-traded derivatives, as proposed in an earlier version of Dodd-Frank. To the extent there are scale economies and synergies from combining depositgathering, lending, market-making, and other activities that make up today s largest financial institutions, such regulatory prohibitions can be expected to reduce the value and global competitiveness of those firms. And mainly for that reason, the best way for regulators to limit systemic risk to acceptable levels is through the continued imposition of bank capital requirements that are not only higher, but reworked in other ways designed to (1) make it easier for regulators to monitor compliance and (2) give bank managers stronger incentives to manage risk more effectively in other ways. Such a proposal is provided in this issue by Columbia University s Charles Calomiris in collaboration with economists Shekhar Aiyar of the IMF and Tomasz Wieladek of the Bank of England. Calomiris et al. recommend that today s higher equity capital requirements be supplemented by two additional requirements: (1) minimal holdings of cash as a percentage of total assets; and (2) mandatory issuance of convertible contingent securities (or CoCos ). Having dwelled on the alleged failures of risk management, let s now turn to our main risk management success story. Another critical part of effective risk management also emphasized by Stulz is an organizational design that achieves the right mix of decentralized risk-taking with centralized oversight and that, partly as a result, succeeds in creating a corporate culture in which managers and employees routinely consider the effects of their actions of the overall risk of their institutions. In the article that follows Stulz s, the University of Houston s Craig Pirrong shows how a highly successful commodity trading firm called Trafigura has used its extensive risk management capability to increase the long-run value and staying power of its trading operations. One of the most important lessons from the firm s success has to do with which risks the firm chooses to take. As a matter of strict policy, Trafigura takes no flat price risk ; that is, all oil sales or purchases are immediately hedged by a centralized risk management function, and thus the firm never takes a long or short position in a commodity. This decision reflects the firm s understanding of its comparative advantage, which does not include bearing oil price risk. Where the firm does have such an advantage is in managing basis risks exploiting differences in prices among comparable commodities that arise from differences in quality, location, and timing. In addition to hedging its flat price risk, Trafigura also devotes considerable effort to limiting its counterparty credit and liquidity risks effort that helped ensure that, unlike most U.S. banks, the firm came through the financial crisis of with flying colors. The next four issues will be devoted to (1) corporate sustainability and shareholder value; (2) activist investors and corporate governance; (3) German capital markets and corporate governance; and (4) enterprise risk management once more. Manuscripts should be sent to me at don.chewnyc@gmail.com. Journal of Applied Corporate Finance Volume 27 Number 1 Winter

5 Executive Summaries Risk-Taking and Risk Management by Banks René M. Stulz A well-governed bank takes the amount of risk that is expected to maximize its shareholder wealth, subject to the constraints imposed by laws and regulators. The role of risk management in such banks is not to minimize or reduce the banks total risk. It is rather to identify and measure the risks the banks are taking, aggregate these risks into a measure of the banks total risk, enable the banks to avoid or eliminate bad risks, and ensure that the banks level of risk is consistent with their risk appetites. Organizing the risk management function to play such a role is challenging not only because of the difficulty of measuring risk with precision, but also because the use of more detailed rules, although potentially effective in preventing destructive risk-taking, limits the flexibility of an institution to take advantage of opportunities that increase firm value. The limitations of risk measurement together with the decentralization of risk-taking in most large financial institutions mean that setting appropriate incentives for risk-takers and promoting the development of an appropriate risk culture are essential to the success of risk management in performing its function. Risk Management by Commodity Trading Firms: The Case of Trafigura Craig Pirrong Commodity trading firms like Trafigura assume little, if any, flat price risk; that is, they are never simply long or short a commodity. In accordance with a firm-wide policy, any purchases or sales of physical commodities at Trafigura are accompanied by flat-price hedging that is accomplished through a central execution desk. But in so doing, the firm does assume basis risks, which arise from differences in the quality, location, and timing of commodity purchases and sales and of the instruments used to hedge them. Such basis risks are the primary risks borne by the firm, which views itself as having a comparative advantage in actively managing them. Risk management at Trafigura is highly centralized and involves continuous quantitative analysis of various risk exposures. The firm s process is highly dependent on the collection, analysis, and distribution of information about risks and involves large investment in systems and databases. The firm calculates its VaR and CVaR every day using Monte Carlo simulation and assuming heavy-tailed probability distributions that are more realistic than those provided by conventional statistical methods and assumptions. In constructing its hedges, Trafigura assumes counterparty credit risk, although the credit risks the firm takes are small in comparison with those routinely assumed by banks and other financial institutions. The firm sets risk limits for counterparties, imposes margin requirements on some counterparties, uses the Moody KMV model to measure risk, and transfers credit risks to banks when the firm s exposure reaches a certain size. The firm also assumes some operational risks relating to the transportation, refining, storing, and distribution of commodities. Central to Trafigura s approach and methods is the recognition that the attempt to eliminate some kinds of risk almost invariably involves the assumption of some other type of risk. As already noted, a hedge that eliminates flat price risk creates counterparty credit risk. Moving a trade from OTC to a futures exchange reduces counterparty credit risk but creates liquidity risk the risk that the firm is unable to borrow enough cash to continue operations. Trafigura manages this risk as it did successfully during the global financial crisis by establishing credit lines with many different banks that are well in excess of their current requirements. How to Strengthen the Regulation of Bank Capital: Theory, Evidence, and A Proposal Shekhar Aiyar, Charles W. Calomiris, and Tomasz Wieladek The authors argue that the need for equity capital ratio regulation arises because bank managers may choose not to maintain socially optimal levels of equity capital, most obviously because banks, in the presence of government protection of deposits, no longer face the discipline of depositors when their default risk rises. At the same time, the authors also maintain that there are significant costs as well as benefits associated with raising minimum equity capital ratio requirements and that, in theory, there is an optimal capital ratio for banks that is mainly a function of the risk of an individual bank s assets and activities. The empirical evidence reveals that the costs of requiring additional capital can be large, both for banks and for their borrowers, not only because such capital can be expensive to raise, but also because banks tend to contract lending significantly in response to higher minimum capital requirements. In light of these considerations, the article assesses the adequacy of current 4 Journal of Applied Corporate Finance Volume 27 Number 1 Winter 2015

6 capital requirements, and argues that the high bank failure risk observed in recent decades demonstrates that capital ratios have been too low. The authors also identify the pitfalls of relying on book equity requirements as a regulatory tool, and discuss how to avoid those pitfalls by combining minimum book equity ratio requirements with other prudential regulations, including requirements for both contingent capital (CoCos) and cash reserves. When One Size Doesn t Fit All: Evolving Directions in the Research and Practice of Enterprise Risk Management Anette Mikes and Robert S. Kaplan Academics are increasingly examining the adoption and impact of ERM, but the authors argue that the studies are inconsistent and inconclusive because of their inability to specify how ERM is used in practice. Based on a ten-year field project and over 250 interviews with senior risk officers, the authors present a contingency theory of ERM that identifies potential design parameters that can be used to explain observable variation in the ERM mix adopted by organizations. In so doing, the authors also contribute a new contingent variable: the type of risk that a specific ERM practice addresses. With the help of this variable, the authors aim to provide a minimum necessary contingency framework that is sufficiently nuanced, while still empirically observable, to enable empirical researchers to hypothesize about (and then test) the fit between contingent variables, such as risk types and the ERM mix, as well as about outcomes such as organizational effectiveness. Evidence of the Value of Enterprise Risk Management Robert E. Hoyt and Andre P. Liebenberg Enterprise risk management (ERM) aims to manage a wide array of risks in an integrated, enterprise-wide fashion. Until recently, however, there has not been much empirical evidence on whether and how ERM programs affect corporate values. With the aim of making a clear and quantifiable business case for ERM, the authors published a study four years ago of publicly listed U.S. insurance companies that found a strong positive correlation between ERM adoptions and a measure of corporate value added called Tobin s Q, after controlling for a number of factors associated with both higher values and ERM adoptions. After summarizing the findings of their study, the authors point to a number of successes at insurance companies; and after noting the adoption of ERM requirements by both the ratings agencies and a growing number of stock exchanges, the authors go on to cite the widespread adoption by state insurance regulators of ORSA standards for disclosure of risk management policies and procedures that are set to become effective this year. Here We Go Again Financial Policies in Volatile Environments: Lessons For and From Energy Firms Marc Zenner, Evan Junek, and Ram Chivukula The 50% drop in oil prices between the middle of 2014 and the start of 2015 is part of a long history of oil price volatility. Since 1983, oil prices have dropped by more than 40% seven times. In response to such volatility, energy firms tend to be conservatively capitalized, and rating agencies perform through-cycle analyses that assume high oil price volatility. The authors also report that the weighted average cost of capital for most E&P companies is likely to be minimized by maintaining a BBB rating through the cycle; at the same time, they note that maintaining such a rating requires relatively more equity and a more conservative distribution policy than for BBB-rated firms in other sectors. During downturns, energy companies follow a well-established pecking order of tools when raising cash. Such companies typically begin by cutting share buybacks, dividends, and discretionary spending, especially capital expenditures, even if this means forgoing some positive-npv investments. Next, energy firms are likely to consider liquidating in-the-money hedges, particularly if management believes prices will recover quickly. And after such steps, the firms might consider raising additional capital and selling non-core assets. Alternatively, some management teams might decide to merge with or acquire another firm for scale benefits and a better credit rating, in part to avoid having to issue equity. Such decisions usually reflect assumptions about whether the recovery will be V-shaped (fast) or U-shaped (slow), with expectations for a slow recovery leading to more conservative financial policies. After noting their uncertainty about the kind of recovery lies ahead, the authors stress the importance of laying out the optimal financial policies under different scenarios to help companies make better decisions. Journal of Applied Corporate Finance Volume 27 Number 1 Winter

7 Executive Summaries Continued Corporate Hedging of Price Risks: Minimizing Variance or Eliminating Lower-Tail Outcomes? Tom Aabo Reducing the expected costs of financial trouble is one of the most important ways that hedging financial risks can increase firm value. But current finance theory does not provide much guidance on how much of a company s exposures to hedge. Most of the early academic work on hedging focused on its role in reducing or minimizing the volatility or variance of cash flows. More recent work, however, has shifted the focus of corporate risk management to the elimination of lowertail outcomes. But what is the practical difference between the two approaches? Doesn t a policy that reduces variance also reduce the probability of lower-tail outcomes (the worst case scenarios), and vice versa? Making use of an analogy with a dice game, the author begins by showing that the optimal hedge ratios for the two strategies are different, and then goes on to demonstrate that a policy of variance minimization has the potential to produce larger (that is, more destructive) lower-tail outcomes than not only tail-elimination strategies, but also even policies that forgo hedging altogether. The underlying intuition is that companies that pursue variance-minimizing hedge strategies are vulnerable to losses not only on their operations, but also on the hedges themselves. To the extent that hedges turn out to be speculative in their own right that is, not offset by business exposures because the underlying business rationale fails to materialize they can end up imposing risk on the firm. For this reason, corporate managers whose primary concern is the variability of cash flows or accounting earnings should center their hedging decisions on their best guess of future sales and cash flows (the budget), while managers whose main goal is providing protection against worst cases should hedge only the lowest possible estimate of sales and cash flows. OTC vs. Exchange Traded Derivatives and Their Impact on Hedging Effectiveness and Corporate Capital Requirements Ivilina Popova and Betty Simkins Many observers have blamed OTC derivatives, particularly because of their complexity and lack of regulation, as a major contributor to the financial crisis. Calls for stricter regulation, margin requirements, mandated clearing, and forcing derivatives onto exchanges have all been proposed. In this paper, the authors illustrate some of the important benefits of OTC derivatives by showing the costs that would otherwise be borne by corporate hedgers if the use of OTC derivatives were banned and nonfinancial companies were forced to hedge using exchange traded derivatives only. Using three case studies of actual corporate hedges, the authors analyze the negative impact of exchange-traded derivatives on corporate hedging effectiveness as well as on capital requirements and corporate liquidity. Valuing Emerging Market Equities A Pragmatic Approach Based on the Empirical Evidence Niso Abuaf Combining the theory with empirical evidence, the author proposes a pragmatic approach to estimating the cost of equity for industry groups operating in African, Asian, and Latin American emerging-markets, and in high-risk European markets as well. The author s approach has two building blocks: (1) use of the U.S.-based Capital Asset Pricing Model (CAPM) with a beta that is designed to represent industry (instead of individual company) risk; and (2) an adjustment of the U.S.-based CAPM that involves assigning a certain proportion from as little as 35% to as much as 100% of a given country s political risk to a specific industry. The author s empirical work shows that the returns on emerging market are strongly correlated with two main variables: (1) S&P 500 returns (the beta of the ADR is virtually the same (statistically speaking) as the U.S.-based average industry beta); and (2) changes in the emerging market country s CDS spreads (which the author finds a reliable proxy for capture country risk). The author also reports that changes in the CDS spread are strongly negatively correlated with the ADR s P/E multiple, which suggests that certain industries are more exposed to political risk than others. Using this approach, the author distinguishes between industries with low (consumer discretionary and staples) and moderate (health care, industrials, information technology, materials, telecommunications, and utilities) levels of exposure to political risk, and those with the greatest exposure categories (energy 6 Journal of Applied Corporate Finance Volume 27 Number 1 Winter 2015

8 and financials). With the help of these results, the author provides estimates of the cost of equity for individual emerging-market companies that reflect the following variables: (1) their industry beta, (2) the country s CDS spread, and (3) the industry s country-risk exposure. To cite two examples, whereas a utility operating in South Korea might have a cost of equity of less than 8%, an energy company in Russia is likely to have a cost of equity of more than 16%. A Practical Guide for Non-Financial Companies When Modeling Commodity and Currency Risk for Longer Horizons Lurion De Mello, Elizabeth Sheedy and Sarah Storck Previous research on risk modeling has focused on short-term horizons for trading portfolios, typically one to five trading days. But for non-financial corporations, the risk horizon is much longer, and tends to be measured in months and years rather than days. The authors report the findings of their empirical study of the most reliable models for the distribution of commodity prices and currencies for horizons of one, three, and twelve months. The most popular random walk model performs poorly for risk horizons greater than one month due to a persistent tendency to overstate the probability of extreme market movements. This finding contrasts with the risk modeling literature relating to short horizons, which reports that the random walk model understates the probability of extreme market movements. The danger for those implementing the random walk model is that if risks are overstated, companies may mistakenly reject projects exposed to currency and commodity price risk. For modeling commodity price risks, the authors recommend the use of either GARCH or mean reversion models. For modeling currency price risks, they recommend only GARCH models. Renewable Energy with Volatile Prices: Why NPV Fails to Tell the Whole Story Ricardo Barcelona Net Present Value (NPV) calculations are a standard part of corporate investment decisions. There is a sound economic logic behind the concept and it has the important practical advantage of having very few variables. The problem with this approach, however, is that it misses critical elements of risk and return. The best portfolio of energy assets is likely to involve a variety of generating technologies, including renewable energy sources. The value of such a portfolio comes mainly from the real options provided by different assets. The existence and value of such options become evident only within a framework that recognizes the value of managerial flexibility and the reality that various inputs and outputs are likely to vary significantly over the lives of powergenerating assets. In such an uncertain environment, managerial flexibility provides a way to seize opportunities or avoid losses. The author uses a real options framework to show how a diversified portfolio of generating assets with a strong base of fossil fueled generation, when complemented with renewable technologies, can provide payoffs with proportionately greater upside than downside. Real Options in Foreign Investment: A South American Case Study Michael J. Naylor, Jianguo Chen and Jeffrey Boardman While the ability to expand globally, especially in emerging markets, is now considered a core corporate skill, the track record in practice has often been dismal. Much of the problem stems from inadequate analytical techniques. Although reliable in many cases, the standard discounted cash flow (DCF) analysis handles high levels of volatility poorly and fails to incorporate the value of choices management may have in the future. Using a case study involving a New Zealand-based company s investment in Argentina during the period , the authors show how the valuation of foreign investment opportunities in emerging markets can be structured as a series of investment options. While FDIs may increase corporate profits, they typically lead to highly variable profits and pose greater bankruptcy risk than domestic investments. Moreover, because of the often large element of learning in FDIs, the full risks and costs of emerging market investments do not become apparent until the investment has been made. By staging FDI investments, companies effectively give themselves the option to re-evaluate the project economics at the end of each stage, and then revise their investments accordingly. The value of this opportunity for learning and revision should be reflected in investment appraisals. Journal of Applied Corporate Finance Volume 27 Number 1 Winter

9 Risk-Taking and Risk Management by Banks by René M. Stulz, Ohio State University* M ost people who do not work in business view risk as a bad thing, the possibility of unwanted outcomes. But risk-taking is of course an essential part of business activity; without a willingness to take risk there is generally very little expected reward. And banks the subject of this article have opportunities to take risks that have a positive expected payoff or reward when the opportunities are viewed on a stand-alone basis. We will refer to such risks throughout this paper as good risks. One might be tempted to conclude that the main job of effective risk management at banks is to limit exposure to risk, and hence to the possibility of bad outcomes. However, such a view of risk management ignores the reality that banks cannot succeed without taking risks but risks that, as already noted, are expected to have a profitable outcome. As a consequence, taking actions that reduce risk can prove costly for shareholders when the lower risk is achieved mainly by avoiding valuable investments and activities with higher risk. Thus, when viewed from the perspective of shareholders, the goal of corporate risk management is not to reduce or minimize risk. But if effective risk management does not mean low risk, then what does it mean? How is it implemented? What are its limitations? And what can be done to make it more effective? In the pages that follow, I provide a framework that can be used by practitioners to understand the role, the organization, and the limitations of risk management in helping banks to increase shareholder value. How Does Risk Management Add Value? In what Merton Miller once called the economist s frictionless dream world of perfect markets, the value of companies would not be affected by corporate efforts to manage financial risks, such as the effects on profitability and value of changes in interest rates or commodity prices. That is to say, given a certain level and stability of operating earnings, whether a company chooses to hedge such financial price exposures should be largely a matter of indifference to investors. But in the real world of taxes and transactions costs, the most compelling argument for managing financial risks is that bad outcomes can lead to financial distress, and financial distress can be very costly (especially for banks, as we shall see). 1 When companies get into financial trouble, they often lose their ability to carry out their strategies effectively and find it more difficult and expensive to conduct their businesses. As a result, the value of a company s equity today is reduced by the present value of the expected future costs of financial distress. And to the extent a company s risk management function succeeds in reducing these expected distress costs (by more than the costs incurred by the function), it increases the value of the firm. Banks are different from most industrial companies in the sense that they typically create value for shareholders through their liabilities as well as their assets. In particular, they attract deposits that, thanks to their liquidity and the federal guarantees behind them, provide most banks with a low-cost source of funding. At least for retail banks, the value of the franchise depends in large part on the bank s success in gathering deposits. And a bank s ability to issue deposits that is, claims that are valued in large part because of their liquidity as well as any supporting federal guarantees depends importantly on the perceived risk of the bank. For this reason alone, risk management is a critical part of the business model of banks in a way that it is not for non-financial firms. 2 But as we have already seen, the goal of risk management for banks is not to eliminate or minimize risk, but rather to determine the optimal level of risk the level that maximizes bank value subject to the constraints imposed by regulators, laws, and regulations. A well-governed bank will have processes in place to identify this optimal amount of risk, and to make sure that its risk does not differ too much from this amount. In theory, the rule that guides a bank s investment and risk-taking decisions should be the same as the one that guides all public companies. That is, like all companies, a * This article is a shorter, less technical version of my article titled Governance, Risk Management, and Risk-Taking in Banks, Economic Policy Review, Federal Reserve Bank of New York. The author is grateful for comments to Rich Apostolik, Brian Baugh, Harry DeAngelo, Rudiger Fahlenbrach, Andrei Goncalves, Ross Levine, Hamid Mehran, Victor Ng, Jill Popadak, Anthony Santomero, Anjan Thakor, and Rohan Williamson. 1. Smith and Stulz (1985). 2. See DeAngelo and Stulz (2015). 8 Journal of Applied Corporate Finance Volume 27 Number 1 Winter 2015

10 bank should take any project that is expected to earn more than its cost of capital, while taking into account the costs associated with the impact of the project on the bank s total risk. The problem, however, is that anticipating the effects of new projects on a bank s risk is complicated by the reality that, at least in banks of any size, risk-taking decisions are made throughout the organization that when taken together are capable of increasing the bank s probability of financial distress. As a result, decisions to take on new projects and associated risks cannot be evaluated in isolation; they must be assessed in terms of their impact on the overall risk of the bank. In principle, if there is an optimal level of risk for a bank, the costs associated with taking on a new project or activity that increases the bank s total risk should be traded off against the potential gain from taking the risk. But that said, there are some projects it would never make sense for a bank to take on activities that are clearly negative-npv projects that can be expected to destroy value as stand-alone risks. And let s call such projects bad risks to distinguish them from the other, potentially value-adding activities. Such projects have negative expected outcomes. One example is a trading desk s writing of underpriced, deep-out-of-the-money puts based on traders expectation that if the puts are not exercised and the desk ends up booking the premiums as income, the traders will receive higher bonuses. For the traders themselves (though not the banks they work for), this seems like a can t-lose proposition: after all, if the puts do end up being exercised, the traders would have been unlikely to receive a bonus anyway because asset values would had to have fallen by a lot. But for the bank s shareholders, such a trading strategy is clearly a negative NPV project as a stand-alone project since the bank is selling an asset for less than it is worth. But now let s consider the case of writing puts that traders believe to be overvalued. In that case, the trading strategy would be a positive-npv project on a stand-alone basis, and so a good risk. But whether taking such a risk adds value for the bank as a whole depends on its effect on the overall risk position of the bank. In both cases, the one involving a bad risk and the other a good risk, there is an increase in the bank s total risk. While it is clear that taking the bad risk makes no sense for the bank, whether it makes sense to take the good risk cannot be decided on a stand-alone basis. In evaluating the case for taking on the good risks, a bank s risk managers must try to ensure that the expected gains outweigh the costs associated with the expected increase in the bank s overall risk. And this brings us to another major challenge for risk management in banks: When risk-taking is decentralized as it is bound to be for most organizations for most risk-taking actions the tradeoff between a project s contribution to the bank s risk and its expected return cannot be made in real time. What is needed instead is a short-cut one that enables traders and their supervisors to focus on individual risks separately while at the same time giving the bank s management the means to manage the bank s overall risk. The main challenge in developing and operating such a two-level risk evaluation system is to prevent the oversight function from rejecting projects that are valuable for the institution despite their risk. Thus, there are two fundamentally different ways that risk management can destroy value for a bank. First, it can fail to ensure that the bank has the right amount of risk a failure that can come about in a number of different ways: it can fail to uncover bad risks that should be eliminated; it can mismeasure good risks and end up misclassifying them as bad; or it can fail in its task of measuring the bank s total risk. The second main way that a risk management system can destroy value is by failing to exercise the right amount of flexibility when the circumstances call for it for example, blocking increases in risk that, if allowed, would actually increase the bank s value. For instance, in the fall of 2008, it was not unusual for risk managers to impose blanket restrictions on trading because of the high level of uncertainty. More recently, energy traders at major banks have been sidelined because of concerns about capital requirements. However, such restrictions have meant that traders could not exploit mispricings that were unusually large and would have created value for their banks. As I discuss later, when risk management becomes too inflexible, risk managers come to be viewed within the institution as policemen, obstacles to be circumvented rather than partners in creating value. Striking the right balance between helping the firm take risks efficiently and ensuring that employees don t take risks that destroy value is a critical challenge for risk management in any bank. In the rest of this paper, I start by discussing the determinants of the optimal level of risk for companies in general and then in the case of banks. Next I examine the role of governance and risk management in helping a bank achieve its optimal level of risk. Then I turn to an analysis of the organization of the risk management function. And last, after discussing the proper uses and limitations of risk management tools like value at risk (VaR) that are commonly used in banks, I show how such limitations create an important role for well-designed incentives and an effective corporate culture. Step One: Determining a Bank s Risk Appetite In a market economy, there are compelling reasons for corporations to be run to maximize shareholder wealth. These reasons apply to banks as well. But no corporation maximizes shareholder wealth in a vacuum. In particular, corporations are constrained in their actions by laws and regulations. Laws and regulations play a special role in the case of banks because Journal of Applied Corporate Finance Volume 27 Number 1 Winter

11 the failures or weaknesses of banks can have damaging effects on the financial system and the economy. But when thinking about the effects of regulation, it s important to recognize that market forces also play a role in causing banks to limit their risks. Indeed, if a bank is managed to maximize shareholder wealth, it will choose a level of risk that is consistent with that objective. As some of the world s largest banks were reminded during the crisis, banks that operate with too much risk cannot conduct their business even if regulators allow them to do so because they find it hard to fund themselves. While deposit insurance guarantees depositors against losses, it does not guarantee their continuous access to their deposits. Further, many short-term liabilities of banks are not insured. To the extent that safe and liquid deposits are a source of value for banks, the market s perception that a bank has too much risk can reduce its value by limiting its ability to attract such deposits. Although some borrowers have no reason to care if the bank they borrow from is too risky, others will care. Borrowers that rely on their relationship with the bank could see that relationship jeopardized or lost if the bank becomes distressed such borrowers may therefore seek to borrow elsewhere rather than deal with a risky bank. 3 If the bank is in the derivatives business, counterparties will be reluctant to deal with it if it is too risky. A bank that is perceived as fragile might also find it difficult or expensive to hire potential employees reluctant to make bank-specific investments in human capital. Other reasons can be cited for how excessive risk can reduce a bank s value in the eyes of its shareholders. Nevertheless, as already noted, a bank that takes no risk whatsoever probably won t be worth much either. As a general rule, banks have to take some risks to create wealth for their shareholders. There are many ways to define risk. For risk to affect the value of a bank to its shareholders, it must affect either the bank s expected future cash flows or the rate at which these cash flows are discounted. And let s start with the effects of risk on a bank s operating cash flow. Just the possibility that an unexpected downturn in a bank s cash flow could lead to its financial distress sometime in the future should reduce the value of the bank today. In other words, the market will adjust its estimate of the bank s going concern value for the probability that the bank will experience financial distress and, as a result, will no longer be able to carry out its strategy and maintain operations as before. Viewed from the perspective of shareholder value, then, the main risk of a bank that has to be managed is the risk of financial distress. But how do we evaluate and measure such risk? Let s begin by assuming that the bank s risk of financial distress is reflected with reasonable accuracy by its credit rating (if it has one). For reasons we ve already discussed, the optimal rating of a bank is unlikely to be the highest rating, which is AAA. For almost all public corporations, industrial companies as well as banks, achieving a AAA rating would require the sacrifice of too many valuable risky projects. No U.S. bank holding company today has an AAA rating, and only a handful outside the U.S. do. But let s suppose that the value of a specific bank is expected to be the highest when operating with an A rating. The first point to keep in mind here is that an A rating, although several notches below AAA, is still consistent with a very low probability of default. From 1981 to 2011, the annual average default rate for A-rated credits was 0.08%, according to Standard & Poor s. 4 And this means that by targeting a certain credit rating, a bank s management is also targeting a specific probability of default and, along with it, the bank s desired level of risk. For that institution, a rating higher than A will necessarily limit its activities, possibly forcing it to give up some existing operations as well as planned projects. At the same time, a rating lower than A could make it difficult or impossible for the bank to continue some value-creating activities. For example, banks with significant derivatives operations generally maintain at least an A rating to address their customers concerns about counterparty risk. Moreover, as a general rule, banks with larger deposit franchises and relationship lending operations tend to have higher credit ratings than institutions that rely mainly on fee-based, transactional activities. And so banks with very different strategies, or liability and asset structures, could well end up having very different credit ratings, and different attitudes toward risk. To help make this point, Figure 1 shows the relation between credit ratings and bank value for two different kinds of banks and let s call them Bank Safe and Bank Risky. In both cases, the relation between ratings and bank value is concave, which means that there is a single value-maximizing credit rating or risk posture. In the case of Bank Safe, the value of the bank falls sharply if it turns out to be riskier whether because of a shift in management strategy or a change in external circumstances than its target rating. Banks with large amounts of non-insured deposits tend to look like Bank Safe. Bank Risky has a very different relation between its value and its rating. Its target rating is BBB, and its value increases substantially as it increases its risk towards its target and falls sharply when it exceeds it. For both banks, having too much risk is extremely costly in terms of their value. But, for Bank Safe having too little risk appears to have little cost while for Bank Risky it has a large cost. 3. See, for instance, Poloncheck, Slovin, and Sushka (1993) for evidence that corporate borrowers are affected adversely when their relationship bank becomes distressed etid= Journal of Applied Corporate Finance Volume 27 Number 1 Winter 2015