The Two Headed Coin

CHAPTER 3Which Risks to Keep

More than a decade ago, the Nobel Prize–winning Robert C. Merton made the following observation:

Thanks to the inventiveness of the modern financial markets, managers can, in principle, engineer a company's capital structure so that virtually the only risks its shareholders, debt holders, trade creditors, pensioners, and other liability holders must bear are what I call value-adding risks. Those are the risks associated with positive-net-present-value activities in which the company has a comparative advantage. All other risks can be hedged or insured against through the financial markets.¹

Much of our understanding of the strategic value of risk management stems from this insight. But let's focus on the first key component: risk-based capital is expensive, far more expensive than debt, so it should be used strategically to support increasing shareholder value.² In practical terms, this means transferring risks to someone better able to manage them: take advantage of their competitive advantages so that you can take advantage of yours. Now Merton's observations were written prior to the 2007–2008 financial crisis, so some might be wondering if this still holds true. In the main, we would argue yes, but the crisis did call attention to one of the enduring principles of risk management: risk and uncertainty don't go away. The level of uncertainty that we can survive combined with what investors think about survival will determine the level of capital ...