Better Investment Performance for Public Pension Funds
The Hunt for Revenue: To secure future growth, banks must fundamentally transform their economics, businesses, and cultures.
November 2011 | by David Delaney
Banks are trying madly to raise it, investors are wary of giving it, and lenders seem keener than ever to hang on to it. Strange, then, that we hear so little about how to manage the scarce resource of the day: capital. One reason for the lack of discussion is the sorry current state of the art of capital management. In the run-up to Basel II, banks treated the subject with appropriate energy. But as the global expansion after 2001 turned into a full-fledged boom, capital was plentiful and cheap, and a strategy to manage it was not only unnecessary but even, arguably, counterproductive. According to some, banks that worried about improving their capital usage were thinking too small and missing much bigger opportunities in rapidly expanding businesses. Whatever their view, most banks paid only scant attention to the husbanding of their capital.
Now, at a time when regulators, investors, and rating agencies, in various ways, are forcing banks to deleverage and increase capital ratios, the focus is on finding more of it—that is, on recapitalization. Of late, however, the search has yielded very little. Capital, when it can be found, is extremely expensive. Effective capital management is no longer just a nice, if somewhat obscure, skill to have; for some banks, it is a question of survival. While a comprehensive capital-management program includes seven elements, two of these—reducing capital “wastage” and developing “capital light” business models—are essential for boosting capital adequacy ratios. Many institutions squander their capital by allocating more of it to a business than is required. This can happen through inefficiencies in business and credit processes and poor data, and through poor choices in the risk-modeling approach.
They can achieve even more if they also successfully implement capital-light business models—that is, if they adopt smart credit-management principles in their day-to-day business and help frontline lenders and sellers internalize these principles. Typically, banks that both reduce waste and put in place capital-efficient business models can achieve a reduction of fifteen percent to twenty percent in risk-weighted assets (RWAs). Further, some banks also see revenue increases of eight percent to twelve percent. These improvements result in additional economic value—for one bank, about twenty percent in two years. Seventy percent of impact is typically achieved within a year of launch.
Reducing capital wastage and implementing a capital-light business model are not only the cheapest ways to improve capital ratios—much cheaper than appealing to once-bitten, twice-shy investors—they can also inform the bank if it has any true additional capital needs. And if banks do instead resort to capital injections, they will not only pay dearly in the short term but also lock in their capital inefficiencies for the foreseeable future. At a time when the need to rebuild return on equity is paramount, capital inefficiency is like a weight around the neck—a burden that will keep the bank uncompetitive but that when removed will result in a powerful uplift to performance.