Forbes.com

The future of banks hangs in their balance sheets

Leading banks are improving balance sheet management capabilities throughout the organization.

By Mike Baxter and Thomas Olsen

Published on May 16, 2012
min read


This article originally appeared on Forbes.com Since the global financial crash, banks have traveled a hard road of bad debt, volatile funding markets and an uncertain economy. Now, as tough new rules under Basel III and a host of local regulations require banks to increase capital and threaten to put a big dent in their returns on equity, it’s clear that many banks will need a new roadmap. To navigate the difficult journey ahead, industry leading banks are implanting better balance sheet management capabilities throughout the organization. A comprehensive analysis by Bain & Company of approximately 200 banks around the world and interviews with more than 50 senior executives revealed that the leaders recognize that the ability to fully account for risk, capital and liquidity in their strategic and daily business decisions will be a source of competitive advantage. Our investigation suggests that views are coalescing around new ways to think about running the bank with greater heed to the consequences of decisions on the balance sheet. They are best captured in a comprehensive approach for incorporating risk and capital in critical decisions. Called RaCAD^TM (for “risk and capital-adjusted decision making”), it translates the bank’s overall strategy into discrete objectives, governance and processes for managing risk, capital and liquidity in an integrated way at the level of each of its businesses (see figure). The new orientation marks a welcome shift in bankers’ strategic mindset from a drive to maximize short-term returns to a commitment to create sustainable, more valuable institutions. But as they wrestle with how best to implement these new competitive disciplines, bankers told us that they were struggling to reconcile four fundamental dilemmas. What is the “right” level of capital? Bank leaders recognize that more capital is required, of course, but the critical point of debate going on around boardroom tables centers on what level of capital is consistent with the bank’s risk appetite and commercial objectives. The ultimate choice is to target the level of risk-adjusted capital the bank needs to hold in order to maintain market, regulatory and political confidence in the institution’s ability to withstand stress robustly and to pay dividends over time. Once the bank has settled on the target capital level, it needs to communicate its rationale clearly, and often, to all stakeholders. Internally, business unit managers need to understand how the amount of capital they are allocated reflects the risk of their business. Shareholders, debt holders and regulators need to be able to size up the amount of capital the bank is targeting, how this compares to the minimum and how much capital is currently available on the balance sheet. Which metrics best support decision making? Banks have typically gauged their performance primarily by the easily understood yardstick of return on equity (ROE). But as a single-period measure, ROE falls short as a reliable indicator of returns across the ups and downs of the business cycle. Leading banks are responding by applying a suite of metrics to get a 360-degree view of the impact of competitive challenges on their balance sheet. The choice of a predominant measure of capital that best suits a bank’s needs depends on the type of bank it is and its risk-return objectives. As the metric that best captures how much capital is needed to support commercial planning and pricing decisions at the granular level of customer segments, products or accounts, economic capital remains an indispensable tool for most. Many of the bankers with whom we spoke reported that their banks are measuring and allocating both economic and regulatory capital across their businesses. They report that economic capital often becomes the basis for determining how to allocate regulatory capital (the real constraint) with finer attention to product and customer segments. How to make decisions that account for risk when competitors do not always do the same? Disciplines that put risk at the center of a bank’s decision-making process support better decisions. But if its rivals are not following a similar approach, the bank faces real commercial pressures to chase business that could lose money or market share. Leading banks recognize that they need to move away from thinking that is fixated on gaining market share, increasing revenues or building volume. Instead, their growth objectives concentrate on achieving sustainable competitive advantage and increasing the bank’s share of economic profits in the markets where it competes. The choice of whether to accept a lower return on risk in order to remain competitive is a strategic judgment about whether the bank can earn an appropriate risk- and capital-adjusted return in a given market, customer segment, product niche or area of expertise. What are the right investments to make in capital-management capabilities? Most banks we surveyed are shoring up their technical risk-management capabilities. However, banks also need to invest to deepen the awareness of risk, capital and liquidity disciplines in how operating managers think about their businesses. Nearly all of the senior bank executives we interviewed mentioned how important their people and culture were to their success. But only a few forward-thinking banks truly help their line managers to better understand the interactions between the balance sheet and their commercial goals and behaviors. These banks are reinforcing those essential capabilities through communication and training and by sharpening the effectiveness of their decision making. Banks that embrace this new way of thinking about risk and capital face major cultural and behavioral challenges. For some, it means rediscovering disciplines that were lost in the heady days of the past decade. For others, it requires starting afresh and building new muscles. How any individual bank tackles its capital management challenges depends on its business model, its strategic objectives and its unique starting point; but its future success will hinge on whether it is able to sustain these new disciplines once they have been developed. Mike Baxter is a partner with Bain & Company based in New York. Thomas Olsen is a partner in Bain’s Sao Paulo office. Both are members of the firm’s Global Financial Services practice.

This article originally appeared on Forbes.com

Since the global financial crash, banks have traveled a hard road of bad debt, volatile funding markets and an uncertain economy. Now, as tough new rules under Basel III and a host of local regulations require banks to increase capital and threaten to put a big dent in their returns on equity, it’s clear that many banks will need a new roadmap.

To navigate the difficult journey ahead, industry leading banks are implanting better balance sheet management capabilities throughout the organization. A comprehensive analysis by Bain & Company of approximately 200 banks around the world and interviews with more than 50 senior executives revealed that the leaders recognize that the ability to fully account for risk, capital and liquidity in their strategic and daily business decisions will be a source of competitive advantage.

Our investigation suggests that views are coalescing around new ways to think about running the bank with greater heed to the consequences of decisions on the balance sheet. They are best captured in a comprehensive approach for incorporating risk and capital in critical decisions. Called RaCAD^TM (for “risk and capital-adjusted decision making”), it translates the bank’s overall strategy into discrete objectives, governance and processes for managing risk, capital and liquidity in an integrated way at the level of each of its businesses (see figure).

The new orientation marks a welcome shift in bankers’ strategic mindset from a drive to maximize short-term returns to a commitment to create sustainable, more valuable institutions. But as they wrestle with how best to implement these new competitive disciplines, bankers told us that they were struggling to reconcile four fundamental dilemmas.

managing-risk-and-capital-fig-01_embed

What is the “right” level of capital? Bank leaders recognize that more capital is required, of course, but the critical point of debate going on around boardroom tables centers on what level of capital is consistent with the bank’s risk appetite and commercial objectives. The ultimate choice is to target the level of risk-adjusted capital the bank needs to hold in order to maintain market, regulatory and political confidence in the institution’s ability to withstand stress robustly and to pay dividends over time.

Once the bank has settled on the target capital level, it needs to communicate its rationale clearly, and often, to all stakeholders. Internally, business unit managers need to understand how the amount of capital they are allocated reflects the risk of their business. Shareholders, debt holders and regulators need to be able to size up the amount of capital the bank is targeting, how this compares to the minimum and how much capital is currently available on the balance sheet.

Which metrics best support decision making? Banks have typically gauged their performance primarily by the easily understood yardstick of return on equity (ROE). But as a single-period measure, ROE falls short as a reliable indicator of returns across the ups and downs of the business cycle. Leading banks are responding by applying a suite of metrics to get a 360-degree view of the impact of competitive challenges on their balance sheet.

The choice of a predominant measure of capital that best suits a bank’s needs depends on the type of bank it is and its risk-return objectives. As the metric that best captures how much capital is needed to support commercial planning and pricing decisions at the granular level of customer segments, products or accounts, economic capital remains an indispensable tool for most. Many of the bankers with whom we spoke reported that their banks are measuring and allocating both economic and regulatory capital across their businesses. They report that economic capital often becomes the basis for determining how to allocate regulatory capital (the real constraint) with finer attention to product and customer segments.

How to make decisions that account for risk when competitors do not always do the same? Disciplines that put risk at the center of a bank’s decision-making process support better decisions. But if its rivals are not following a similar approach, the bank faces real commercial pressures to chase business that could lose money or market share.

Leading banks recognize that they need to move away from thinking that is fixated on gaining market share, increasing revenues or building volume. Instead, their growth objectives concentrate on achieving sustainable competitive advantage and increasing the bank’s share of economic profits in the markets where it competes. The choice of whether to accept a lower return on risk in order to remain competitive is a strategic judgment about whether the bank can earn an appropriate risk- and capital-adjusted return in a given market, customer segment, product niche or area of expertise.

What are the right investments to make in capital-management capabilities? Most banks we surveyed are shoring up their technical risk-management capabilities. However, banks also need to invest to deepen the awareness of risk, capital and liquidity disciplines in how operating managers think about their businesses. Nearly all of the senior bank executives we interviewed mentioned how important their people and culture were to their success. But only a few forward-thinking banks truly help their line managers to better understand the interactions between the balance sheet and their commercial goals and behaviors. These banks are reinforcing those essential capabilities through communication and training and by sharpening the effectiveness of their decision making.

Banks that embrace this new way of thinking about risk and capital face major cultural and behavioral challenges. For some, it means rediscovering disciplines that were lost in the heady days of the past decade. For others, it requires starting afresh and building new muscles. How any individual bank tackles its capital management challenges depends on its business model, its strategic objectives and its unique starting point; but its future success will hinge on whether it is able to sustain these new disciplines once they have been developed.

Mike Baxter is a partner with Bain & Company based in New York. Thomas Olsen is a partner in Bain’s Sao Paulo office. Both are members of the firm’s Global Financial Services practice.