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The Capital Optimization drive Can banks avoid the capital squeeze?
Banks are experiencing unprecedented pressure: from earnings erosion, on one hand, to rising operating costs on the other. This pressure is increased by the raft of new regulations, spearheaded by Basel III, which will increase requirements for both regulatory and economic capital and drive up capital costs. Current turbulence in the markets has led to higher operating costs and in turn to changes in the overall business strategy, to protect shareholder value and improve business performance. Capital is now a precious resource, critical to the survival and growth of banks. A banks balance sheet provides the best place to see how capital is utilized. The balance sheet illustrates the income flows generated, the assets that generate the income, and the liabilities that provide the funding for the bank. In the process of delivering shareholder value (equity) the bank must provide sufficient loss absorption. The Tier 1 Capital Ratio, which captures and measures the threats to the potential income flows of the bank, completes the picture of the way the bank is geared to meet its strategic objectives. The performance of most banks on most components of the balance sheet is compressing into a fairly narrow range, but there are a number of opportunities for banks to achieve competitive differentiation through their capital structure and utilization (see Figure 1). Under the new regulations such as Basel III, capital requirements will increase significantly for market risk, reflecting Credit Valuation Adjustments (CVA) for all global banks and changes in risk weighting for certain securitizations. The average Risk Weighted Assets (RWAs) increase for Basel III is estimated to be up to 40% before mitigation measures [Source: J.P. Morgan Research - Global Investment Banks: Investment Banking wallet outlook - all eyes on equity derivatives, Global Equity Research 08, September 2010]. We recognise that financial institutions need to achieve the right balance between performance and risk in the post credit crunch environment by adopting new strategies, such as short deleveraging (reducing risky assets) followed by a return to a leveraging phase and a race to take on risk; or a securitization exit strategy; and /or restrained growth, meaning that financial institutions could limit their balance sheet size and curb leverage. Regardless of the strategy each financial institution follows, we believe banks can protect their capital from further regulatory demands by improving the operational performance on all business processes involved in managing RWAs. Banks face an equally challenging task in defining a new capital supply strategy, as they face demands from the regulators for adequate funding planning and as the markets increase the cost of funding. Banks senior management and boards have initiated changes designed to maintain oversight over the liquidity position of the bank and the signoff of regulatory reports. However, challenges still persist in establishing a forward-looking, firm-wide liquidity risk appetite and aggregated liquidity position for the bank. One of the innovative ways financial institutions can contribute to managing the regulatory capital demand and protect shareholder value is to develop and implement a capital optimization strategy by identifying and redesigning inefficient activities within the capital management process. We estimate an average bank could increase its Return on Equity (RoE) to a range of 17 to 20 percent (a three to five percentage point uplift) and a front office to back office risk management operational efficiency target of Cost-to-Income Ratio (C/I Ratio) of less than 60 percent [Source: Based upon research work and analysis completed by Accenture Risk Management in 2010 using publically available analyst information].
Revenue Growth
~8%
(*)
Opportunities for performance uplift 1. Improve RoE vs RARoC Current RoE is under threat for a number of LoBs (Lines of Businesses)
Income Performance
~10%
2. Improve C/I ratio on revenue path processes Potential to improve C/I Ratio to 60% for client capture & risk management processes Potential to improve C/I Ratio by process realignment and integration Potential to improve C/I by IT infrastructure refresh 3. Reduce / Contain Tier 1 Capital Reduce Tier 1 Capital by improving Credit Risk RWA (process/data) Redefine core and optimize non-core activities Further reduce RWA Capital by driving operational excellence optimum business control framework
RoE
~15%
~65%
Constraint
Tier1 Ratio
10%
Leverage
25%
(*) Target average figures based on analysis by a pool of banks Risk Management Research
This contribution can be achieved using three levers (See Figure 2):
Operational excellence in these areas creates a risk management environment which enables the financial organization to reduce its RWA by containing any capital increase due to CVAs and from changes in the risk weighting for certain securitizations, while aligning the organization to its business strategy, for instance by readjusting its securitization strategy and repositioning itself for the development and launch of new products.
Lower cost of execution and servicing a deal These initiatives help provide an efficient and effective client management workflow, delivering consistent global pricing for clients and truly reflecting the Cost-of-Capital in each transaction.
Constraint
10% 25%
4. Client Analytics
5. Client Services
11. Market Making & Quote Management 14. Trade Capture & Amend
Product Data
Market Data
Process realignment in areas such as product control, operations, finance, risk, treasury, compliance and technology will also yield higher profitability for banks. Key focus areas may include late trade booking percentages, OTC trade ISDA (International Swaps and Derivatives Association) orphans, and the daily dollar amounts of disputed margin calls. Finally, moving the business validation rules for downstream finance and risk processes to the upstream trade booking process will enable straight through processing. This can eliminate additional operational activities due to trade errors or operational inefficiencies which may result in lower operational costs and improved effectiveness in the RWA performance. Establishing a clear view into the cost of servicing a client and understanding the performance of organizations and processes involved in client management and deal servicing can yield a significant return on investment, which in turn can play an important role in developing strategy for a bank or other financial service organization.
Processes
We have discussed a number of processes which play an important role in both reducing RWA and increasing client profitability. Developing a cross-asset operation strategy is critical in achieving these goals. Other opportunities, however, may be available to pursue further improvement in the RWAs and client profitability value chains, including improving the operating model by redistributing skill sets, reengineering business processes, changing workforce locations and strengthening IT infrastructure. Although it will be difficult to provide a standard template for achieving operational efficiency for all organisations, it is possible to identify underperforming business units in relatively short order.
Takis Sironis
Takis Sironis is a senior manager Accenture Risk Management. Based in London, Takis brings over 18 years of deep experience in business and IT transformation in the risk management space for investment and retail banking. His extensive knowledge and technical skills in risk management processes and methodologies and risk technologies helps Takis drive and implement risk programs, align risk functions to business strategy and bring to market new operating models and risk architectures. With his current focus on Capital Optimization, Stress Testing and Risk Transformation, Takis guides organizations on their journey to high performance.
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About Accenture
Accenture is a global management consulting, technology services and outsourcing company, with approximately 211,000 people serving clients in more than 120 countries. Combining unparalleled experience, comprehensive capabilities across all industries and business functions, and extensive research on the worlds most successful companies, Accenture collaborates with clients to help them become high-performance businesses and governments. The company generated net revenues of US$21.6 billion for the fiscal year ended August 31, 2010. Its home page is www.accenture.com.
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ACC11-0675 / 11-2979