Risk Management and Financial Institutions. Hull John C.

risks should not be considered when accept/reject decisions on new projects are taken. In practice, companies are concerned about nonsystematic as well as systematic risks. For example, most companies insure themselves against the risk of their buildings being burned down – even though this risk is entirely nonsystematic and can be diversified away by their shareholders. They try to avoid taking high risks and often hedge their exposures to exchange rates, interest rates, commodity prices, and other market variables.

      Earnings stability and the survival of the company are often important managerial objectives. Companies do try and ensure that their expected returns on new ventures are consistent with the risk-return trade-offs of their shareholders. But there is an overriding constraint that the total risks taken should not be allowed to get too large.

      Many investors are also concerned about the overall risk of the companies they invest in. They do not like surprises and prefer to invest in companies that show solid growth and meet earnings forecasts. They like companies to manage risks carefully and limit the overall amount of risk – both systematic and nonsystematic – they are taking.

      The theoretical arguments we presented in Sections 1.1 to 1.4 suggest that investors should not behave in this way. They should hold a well-diversified portfolio and encourage the companies they invest in to make high risk investments when the combination of expected return and systematic risk is favorable. Some of the companies in a shareholder's portfolio will go bankrupt, but others will do very well. The result should be an overall return to the shareholder that is satisfactory.

      Are investors behaving suboptimally? Would their interests be better served if companies took more nonsystematic risks? There is an important argument to suggest that this is not necessarily the case. This argument is usually referred to as the “bankruptcy costs” argument. It is often used to explain why a company should restrict the amount of debt it takes on, but it can be extended to apply to a wider range of risk management decisions than this.

      Bankruptcy Costs

      In a perfect world, bankruptcy would be a fast affair where the company's assets (tangible and intangible) are sold at their fair market value and the proceeds are distributed to the company's creditors using well-defined rules. If we lived in such a perfect world, the bankruptcy process itself would not destroy value for stakeholders. Unfortunately, the real world is far from perfect. By the time a company reaches the point of bankruptcy, it is likely that its assets have lost some value. The bankruptcy process itself invariably reduces the value of its assets further. This further reduction in value is referred to as bankruptcy costs.

      What is the nature of bankruptcy costs? Once a bankruptcy has happened, customers and suppliers become less inclined to do business with the company; assets sometimes have to be sold quickly at prices well below those that would be realized in an orderly sale; the value of important intangible assets, such as the company's brand name and its reputation in the market, are often destroyed; the company is no longer run in the best interests of shareholders; large fees are often paid to accountants and lawyers; and so on. The story in Business Snapshot 1.1 is representative of what often happens in practice. It illustrates how, when a high risk decision works out badly, there can be disastrous bankruptcy costs.

      BUSINESS SNAPSHOT 1.1

      The Hidden Costs of Bankruptcy

      Several years ago, a company had a market capitalization of $2 billion and $500 million of debt. The CEO decided to acquire a company in a related industry for $1 billion in cash. The cash was raised using a mixture of bank debt and bond issues. The price paid for the company was justified on the basis of potential synergies, but key threats to the profitability of the company were overlooked.

      Many of the anticipated synergies were not realized. Furthermore, the company that was acquired was not profitable and proved to be a cash drain on the parent company. After three years the CEO resigned. The new CEO sold the acquisition for $100 million (10 % of the price paid) and announced that the company would focus on its original core business. However, by then the company was highly leveraged. A temporary economic downturn made it impossible for the company to service its debt and it declared bankruptcy.

      The offices of the company were soon filled with accountants and lawyers representing the interests of the various parties (banks, different categories of bondholders, equity holders, the company, and the board of directors). These people directly or indirectly billed the company about $10 million per month in fees. The company lost sales that it would normally have made because nobody wants to do business with a bankrupt company. Key senior executives left. The company experienced a dramatic reduction in its market share.

      After two years and three reorganization attempts, an agreement was reached between the various parties and a new company with a market capitalization of $700,000 was incorporated to continue the remaining profitable parts of the business. The shares in the new company were entirely owned by the banks and the bondholders. The shareholders got nothing.

      The largest bankruptcy in U.S. history was that of Lehman Brothers on September 15, 2008. 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