Risk Management Second Revised and Enlarged Edition Michael Frenkel ´ Ulrich Hommel Markus Rudolf (Editors) Risk Management Challenge and Opportunity Second Revised and Enlarged Edition With 100 Figures and 125 Tables 12 Professor Dr. Michael Frenkel Professor Dr. Markus Rudolf WHU Otto Beisheim Graduate School of Management Burgplatz 2 56179 Vallendar mfrenkel@whu.edu mrudolf@whu.edu Professor Dr. Ulrich Hommel EUROPEAN BUSINESS SCHOOL International University Stiftungslehrstuhl Unternehmensfinanzierung und Kapitalmårkte Schloss Reichartshausen 65375 Oestrich-Winkel ulrich.hommel@ebs.de Cataloging-in-Publication Data Library of Congress Control Number: 2004114544 ISBN 3-540-22682-6 Springer Berlin Heidelberg New York ISBN 3-540-67134-X 1st edition Springer Berlin Heidelberg New York This work is subject to copyright. 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Hardcover-Design: Erich Kirchner, Heidelberg SPIN 11308300 43/3130-5 4 3 2 1 0 ± Printed on acid-free paper #9QTFQH)TGGVKPI In my "Word of Greeting" of the first edition of this book which was dedicated to Günter Dufey, I pointed out that I appreciate Günter Dufey as someone who builds bridges between Germany and the United States. Meanwhile, almost 5 years have gone by. Günter Dufey's significance as an academic intermediary between the continents has even increased since then. Due to his efforts, the cooperation be- tween high ranked U.S. business schools and the WHU - Otto Beisheim Hochschule in Germany have been intensified. The joint summer MBA program on the WHU campus is attended by 45 U.S. students every year. This number is still growing. Moreover, since the issue of the first edition, Günter Dufey has enlarged his activity spectrum also to Asia. In 2002 until 2003 Günter Dufey joined the Singapore Office of the firm as Senior Advisor, supporting the Corpo- rate Governance Practice of the firm in the Region. Since then he was appointed as Professor of Banking and Finance at the Nanyang Business School - Nanyang Technological University and as Principal of the Pacific International Business Associates. Last but not least, he is now an ordinary member of the Singapore In- stitute of Directors. It is impressive to see the energy and the enthusiasm with which Günter Dufey travels restlessly around the world, once eastwards, another time westwards. Without any doubt, it is quite unusual that a Festschrift sells out. The first edition of this book has been written by a global selection of financial experts. They wanted to act as a sign of friendship by honoring Günter Dufey's 60th birthday. I am very happy, that the first edition was so successful because this indicates also the importance of the book' content. Much has been changed in the field of risk management since then. Probably most significantly, there has been an intensive discussion between financial insti- tutions dealing with modified rules of determining the adequate amount of equity capital for risks. The committee of banking supervision located at the Bank of In- ternational Settlement in Basel, Switzerland, has initiated several proposals known under the short form "Basel II". One of the core questions in the context of these capital adequacy rules is the capital requirement for credit risks. According to Basel II, in the future this will be closer related to the rating of transaction coun- terparties enhancing the role of the rating process and the rating industry. Another important risk category which is addressed by Basel II for the first time is opera- tive risk. The terror attack on the World Trade Center on 11 September 2001 showed drastically how significant external and unpredictable events can be on the operations of any company, particularly of banks. Moreover, risks form internal processes, people, or systems contribute to the success or to the failure of the business. All these risks are summarized as new risk type in Basel II, namely as VI A Word of Greeting operative risk. Operative risk is much more difficult to measure than credit and market risks. But they nevertheless affect the performance of financial institutions. The deadline for implementing Basel II in national laws is year-end 2006. It is obvious that this development is intensively covered in the second edition of the book. I hope that this book will help to understand the complex and new aspects of risk management better. And I am happy that such an instructional content is asso- ciated to the name of my former student in Würzburg, Günter Dufey. Otmar Issing 2TGHCEG Michael Frenkel, Ulrich Hommel, Markus Rudolf The success of the first edition of this book encouraged us to update and extend this volume in order to provide an up-to-date and comprehensive survey of the major areas of risk management issues. Since the first edition of this book, a num- ber of changes in the area of risk management took place. Some of them are re- flected in the discussions on the “Basel II” rules. The new edition takes these new developments into account. Given the wider scope of the new edition, we decided to structure the book according to the type of risk management the various aspects are most narrowly related to. More specifically, we distinguish four broader top- ics. Part 1 focuses on bank risk management, part 2 on insurance risk manage- ment, part 3 on corporate risk management, and part 4 on systemic issues of risk management. In the following, a very brief outline of the papers is presented. Part 1 begins with the analysis by Thomas Hartmann-Wendels, Peter Grundke and Wolfgang Spörk of the Basel II rules and their consequences on bank lending. Then, Ingo Walter looks at conflicts of interest involving financial services firms. He shows the conditions that can cause or limit exploitation of conflicts of interest and argues that external regulation and market discipline can be both complements and substitutes. A normative theory or risk management in banks is the subject of the contribution of Gerhard Schröck and Manfred Steiner. Then, Claudia Holtorf, Matthias Muck and Markus Rudolf present a case study that analyses the new Basel capital accord requirements by applying the RiskMetricsTM. Value at Risk is the core of several papers in part 1. Alois Paul Knobloch surveys applications of this concept for risk measurement purposes; John Bilson uses to concept to review fixed income portfolios, Robert Härtl and Lutz Johanning examine risk budgeting, and Jack Wahl and Udo Broll examine the implications of Value at Risk for the optimum equity level of a bank. Wolfgang Drobetz and Daniel Hoechle compare alternative estimates of conditional return expectations. Subsequently, Ludger Overbeck surveys modelling of credit risk portfolios. A critical evaluation of credit risk models is the topic of the paper by Hergen Frerichs and Mark Wahren- burg. Related to this type of risk is the analysis of Stefan Huschens, Konstantin Vogl, and Robet Wania, who look at possibilities to estimate default probabilities and default correlations. The subsequent two papers examine operational risk in the context of Basel II. While Carol Alexander gives an overview of the different dimensions of this risk type, Wilhelm Kross addresses practical issues for man- agement dealing with such risk. In the last paper of this part, Christoph Kaserer, Niklas Wagner and Ann-Kristin Achleitner investigate possibilities to measure private equity returns under conditions of illiquidity. Part 2 focuses on insurance risk management. Martin Nell and Andreas Richter discuss three issues related to the management of catastrophic risk which stem from the terror attacks of September 11, 2001. Subsequently, Christopher Culp surveys products and solutions that represent the convergence or integration of VIII Preface capital markets and traditional insurance. Such products are referred to as alterna- tive risk transfer. Ulrich Hommel and Mischa Ritter address a similar area of risk management. They analyze the main forces behind the securitization of catastro- phic insurance risk and derive conclusions as to how other forms of insurance can be transferred to financial markets. In recent years, demographic changes in a number of advanced economies have been discussed intensely. The paper of Petra Riemer-Hommel and Thomas Trauth addresses this issue by analyzing possibili- ties of managing longevity risk associated with pension, annuity and long-term care products. Particularly in the German market, another problem of life insur- ance companies generate from unknown capital market developments and the si- multaneously issued interest rate guarantees of traditional life insurance products. Peter Albrecht and Carsten Weber investigate the implications of this constellation on the asset allocation decision. Part 3 includes papers that discuss a variety of issues of corporate risk manage- ment. In the first paper, Fred Kaen addresses the relationship between risk man- agement and corporate governance and makes the point that risk management not only helps a firm to survive but also serves broader policy objectives. In the next paper, Christian Laux examines how corporate risk management can be integrated into the objective of maximizing firm value. Subsequently, Ulrich Hommel inves- tigates the more fundamental question why the management of corporate risk should be managed at all and why it should be managed on the firm rather than the investor level. Focusing on a German regulation requiring firms to implement risk management systems, Jürgen Weber and Arnim Liekweg discuss critical imple- mentation issues for non-financial firms. How risk analysis and risk aggregation enters value-based corporate risk management is the topic of the paper by Werner Gleißner. A more macroeconomic focus of risk is presented by Lars Oxelheim and Clas Wihlborg who emphasize the importance of exchange rates, interest rates and inflation rates in estimating corporate risk. This issue is taken one step further in the paper of Matthias Much and Markus Rudolf as they include international is- sues of corporate risk management. They use the case study of three airlines to emphasize commodity and exchange rate risk and show the effects on corporate risk by applying the “Earnings at Risk” concept. A consequence of corporate risk is the use of financial derivatives in risk management. In this context, real options represent alternatives to financial hedging. The paper of Alexander Triantis uses a specific example to discuss the implications of these alternatives. Operational and managerial flexibility in international supply chains also contribute to real options. Arnd Huchzermeier uses a case study to illustrate the value of such flexibility for risk management. In the international context, exchange rate exposure represents a major risk, when cross-border acquisitions are considered. Stefan Hloch, Ulrich Hommel, and Karoline Jung-Senssfelder show that this risk stems from consider- able time lags between the acquisition decision and its implementation due to, e.g., the process of regulatory clearance by the antitrust authorities. In the following paper, Christian Geyer and Werner Seifert describe electricity derivatives as new risk classes to organized exchanges and explain why the German Stock Exchange (Deutsche Börse) intends to establish an exchange for energy derivatives. Foreign exchange risk is more closely examined in two contributions. While Martin Glaum Preface IX presents an empirical study on the measuring and management of foreign ex- change risk in large German non-financial corporations, Kathryn Dewenter, Robert Higgins and Timothy Simin show that, contrary to many studies presented earlier in the literature, there is a negative influence of the value of the dollar and stock returns of U.S. multinational firms. The subsequent paper by Wolfgang Breuer and Olaf Stotz addresses the problem of securing the real value rather than the nominal value of assets in risk management. The last paper of part 3 focuses on capacity options. Stefan Spinler and Arnd Huchzermeier explain how options on capacity can be used in capital intensive industries for risk management. Part 4 focuses on more systemic risk aspects with which firms have to deal in the national and the international environment. Adrian Tschoegl argues in his con- tribution that financial debacles in the mid-1990s are the result of management failures and suggests that risk management has to take into account that such er- rors are the result of human nature. While this emphasizes a microeconomic ele- ment of risk management, Michael Frenkel and Paul McCracken show that a cur- rency union as represented by the European Monetary Union exerts several additional risks which firms operating in this area have to recognize. Whether risk management itself makes financial markets riskier is discussed in the paper by Ian Harper, Joachim Keller and Christian Pfeil. The authors argue that both on theo- retical and empirical grounds there are indications that this is indeed possible. In the same direction, Torben Lütje and Lukas Menkhoff analyze risk management of institutional investors may lead to the behaviour of rational herding. A final look at systemic risk aspects is presented by Mitsuru Misawa. He looks at the Japanese experience in the 1990s when financial markets suffered significant damage due to the burst of the asset price bubble and evaluates Japan’s big bang financial reform. Although this book covers a variety of diverse aspects of risk management, no book on this broad and complex issue can cover all aspects. Therefore, we were forced to be selective in certain areas. In addition, new topics may come up in the future, as further risk categories may continue to evolve and both risk manage- ment and policies will also further develop. Such a volume cannot be completed without the help of many individuals. We thank all authors and those that have given us suggestions for the new edition. We are very grateful to Kerstin Frank who showed enormous commitment and pa- tience in preparing the manuscript. We are also thankful to Gudrun Fehler for proofreading a number of papers of this volume and to Martina Bihn representing the publisher for her support and patience in making this new edition possible. $TKGH6CDNGQH%QPVGPVU A Word of Greeting V Preface VII Part 1: Bank Risk Management Basel II and the Effects on the Banking Sector 3 Thomas Hartmann-Wendels, Peter Grundke and Wolfgang Spörk Conflicts of Interest and Market Discipline in Financial Services Firms 25 Ingo Walter Risk Management and Value Creation in Banks 53 Gerhard Schröck and Manfred Steiner The New Basel Capital Accord 79 Claudia Holtorf, Matthias Muck, and Markus Rudolf Value at Risk: Regulatory and Other Applications, Methods, and Criticism 99 Alois Paul Knobloch Parsimonious Value at Risk for Fixed Income Portfolios 125 John F. O. Bilson Risk Budgeting with Value at Risk Limits 143 Robert Härtl and Lutz Johanning Value at Risk, Bank Equity and Credit Risk 159 Jack E. Wahl and Udo Broll Parametric and Nonparametric Estimation of Conditional Return Expectations 169 Wolfgang Drobetz and Daniel Hoechle Credit Risk Portfolio Modeling: An Overview 197 Ludger Overbeck Evaluating Credit Risk Models 219 Hergen Frerichs and Mark Wahrenburg Estimation of Default Probabilities and Default Correlations 239 Stefan Huschens, Konstantin Vogl, and Robert Wania Managing Investment Risks of Institutional Private Equity Investors – The Challenge of Illiquidity 259 Christoph Kaserer, Niklas Wagner and Ann-Kristin Achleitner XII Brief Table of Contents Assessment of Operational Risk Capital 279 Carol Alexander Operational Risk: The Management Perspective 303 Wilhelm Kross Part 2: Insurance Risk Management Catastrophic Events as Threats to Society: Private and Public Risk Management Strategies 321 Martin Nell and Andreas Richter New Approaches to Managing Catastrophic Insurance Risk 341 Ulrich Hommel and Mischa Ritter Alternative Risk Transfer 369 Christopher L. Culp The Challenge of Managing Longevity Risk 391 Petra Riemer-Hommel and Thomas Trauth Asset/Liability Management of German Life Insurance Companies: A Value-at-Risk Approach in the Presence of Interest Rate Guarantees 407 Peter Albrecht and Carsten Weber Part 3: Corporate Risk Management Risk Management, Corporate Governance and the Public Corporation 423 Fred R. Kaen Integrating Corporate Risk Management 437 Christian Laux Value-Based Motives for Corporate Risk Management 455 Ulrich Hommel Value-based Corporate Risk Management 479 Werner Gleißner Statutory Regulation of the Risk Management Function in Germany: Implementation Issues for the Non-Financial Sector 495 Jürgen Weber and Arnim Liekweg A Comprehensive Approach to the Measurement of Macroeconomic Exposure 513 Lars Oxelheim and Clas Wihlborg Foreign-Exchange-Risk Management in German Non-Financial Corporations: An Empirical Analysis 537 Martin Glaum [...]... of Contents Value-based Corporate Risk Management Werner Gleißner 1 Introduction 2 Tasks and Elements of Corporate Risk Management – Overview 2.1 From Risk Management to Value-Based Management and Strategic Management 2.2 Analyzing Risks 2.3 Aggregating Risks: Definition of Total Risk Volume 2.4 Coping with Risks 2.5 Designing Risk Management Systems and Monitoring 3 Risk, Cost of Capital and Shareholder... Borrowing 3 Risks of High Adjustment Costs Stemming from European Labor Markets 4 Risks Associated with EMU Enlargement 5 Risks in EMU Financial Markets 6 Conclusion Does Risk Management Make Financial Markets Riskier? Ian R Harper, Joachim G Keller, and Christian M Pfeil 1 Introduction 1.1 Increased Risk through Risk Management? 2 Market Risk as a Regulatory Concern 3 The Measurement of Market Risk 3.1... the Risk Management Function in Germany: Implementation Issues for the Non-Financial Sector Jürgen Weber and Arnim Liekweg 1 Introduction: Statutory Regulations as Cause of a New German Discussion on Risk Management 2 Entrepreneurial Risk and Risk Management: A Holistic Approach 2.1 Chance, Risk and their Definitions 2.2 Chance, Risk and their Dimensions 2.3 The Process of Entrepreneurial Chance and Risk. .. Standard Model 5 Credit Risk 6 Operational Risk 7 Summary and Outlook 79 81 89 91 94 97 97 Value at Risk: Regulatory and Other Applications, Methods, and Criticism Alois Paul Knobloch 99 1 The Concept of Value at Risk and its Role in Contemporary Risk Management 1.1 Value at Risk: Definition and Risks of Concern 1.2 Applications and Regulatory Background 2 Calculating Value at Risk: Methods and Inherent... Management Stefan Spinler and Arnd Huchzermeier 699 Part 4: Systemic Issues of Risk Management The Key to Risk Management: Management Adrian E Tschoegl 721 Economic Risks of EMU Michael Frenkel and Paul McCracken 741 Does Risk Management Make Financial Markets Riskier? Ian R Harper, Joachim G Keller, and Christian M Pfeil 765 Risk Management, Rational Herding and Institutional Investors: A Macro View... 3 Risk Reduction and Capital Allocation Within a Value at Risk Framework 3.1 Minimizing Value at Risk 3.2 Allocating VaR to Business Units 4 Shortcomings of Value at Risk as a Measure of Risk 5 Conclusion Parsimonious Value at Risk for Fixed Income Portfolios John F O Bilson 1 Introduction 1.1 A Simple Example 1.2 The Key Rate Duration Model 1.3 The Level, Slope, and Curvature (LSC) Model 1.4 LSC Risk. .. Entrepreneurial Chance and Risk Management 2.3.1 The Chance /Risk Strategy 2.3.2 Chance /Risk Identification 2.3.3 The Chance /Risk Analysis 2.3.4 The Chance /Risk Reporting 2.3.5 Chance /Risk Management 2.3.6 Chance /Risk Monitoring 2.4 The Process-External Monitoring and Revision Function 3 Summary: The Critical Factors for the Implementation of the Risk Management Function A Comprehensive Approach to the... Model 4 Income Statements 5 Corporate Risk Drivers 6 Hedging Strategies 7 Simulation Results 8.Conclusion Corporate Risk Management: Real Options and Financial Hedging Alexander J Triantis 1 Identification and Classification of Risks 2 Rationales for Managing Risk 3 Using Derivatives and Other Contracts to Manage Risk 4 Using Real Options to Hedge and Exploit Risk 5 Using Real versus Financial Options... Integrating Corporate Risk Management Christian Laux 1 Introduction 2 How Does Risk Management Add Value? 3 Measuring the Value of Risk Management 4 Identifying a Firm’s Collective Risks 5 Interactions Between Risk Management, Financial Structure, and Operating Decisions 6 Integrated Products 7 Risk Management and Managerial Incentive Problems Value-Based Motives for Corporate Risk Management Ulrich... Out-of-sample Results 5 Conclusion 6 Acknowledgement Credit Risk Portfolio Modeling: An Overview Ludger Overbeck 1 Purpose of Credit Risk Modeling 1.1 Enterprise Risk Management 1.1.1 Economic Capital 1.1.2 Capital Allocation 1.2 Integration of Risk Types 1.3 Loss Distribution 1.4 Risk Measure 1.5 Portfolio Transactions 2 Basic Components of Credit Risk Modeling 2.1 Inputs 2.1.1 Exposure at Default 2.1.2 . of Risk Management The Key to Risk Management: Management 721 Adrian E. Tschoegl Economic Risks of EMU 741 Michael Frenkel and Paul McCracken Does Risk Management Make Financial Markets Riskier?. New German Discussion on Risk Management 495 2. Entrepreneurial Risk and Risk Management: A Holistic Approach 497 2.1 Chance, Risk and their Definitions 497 2.2 Chance, Risk and their Dimensions. Chance and Risk Management 499 2.3.1 The Chance /Risk Strategy 500 2.3.2 Chance /Risk Identification 501 2.3.3 The Chance /Risk Analysis 502 2.3.4 The Chance /Risk Reporting 503 2.3.5 Chance /Risk Management