An understandable and flexible approach supported by top executives brought business leaders on board.
Extensive analysis showed a large regional bank’s share price is highly correlated to consistent return on equity (ROE) performance, prompting its treasury team to set about developing a process to ensure the appropriate ‘E’ was assigned to business units. The treasurer described the bank’s “hybrid” capital allocation approach to peers in a recent meeting.
- Three “guiding principles” to developing the approach were making sure the aggregated allocated equity is close to what appears in corporate financial statements; holding a minimum amount of capital in each business unit no matter the type of asset or risk; attributing additional capital for risks assumed in each line of business.
Peanut butter. The bank’s hybrid approach is broken down into two parts.
- The first spreads or “peanut butters” the same percentage of capital across all its lines of businesses—essentially representing the regulatory capital minimum.
- It then employs an economic capital metric for risk in each business unit—a good measure of risk if not actual capital. Most capital is for credit risk, but it can also include operational risk, liquidity risk, model risk, etc.
- To determine the capital attribution for different risk assets, it adds up two numbers and if the sum is less or more than the bank’s common equity target, it scales the economic capital portion up or down.
- “So the scaling really happens in the risk adjusted portion of that metric,” the member said.
The biggest challenge. Persuading the business lines to accept their capital attribution, especially if it changed significantly, required some serious politicking.
- Support from the CEO and CFO was critical.
- Clearly explaining the rationale eventually got everybody on board, the member said, adding, “Everyone saw the math worked and was correct.”
- The benefit of applying an established process was the ability to gauge the adjusted returns more accurately. “It allowed us to say, this is how your business is performing,” the member said.
And then the pandemic hit. The new approach was highly beneficial in terms of more efficiently attributing capital, but the arrival of Covid-19 threw businesses’ performances out of whack.
- One lesson learned was that capital allocation targets can’t be rigid, the member said, adding that flexibility in managing the portfolio generates buy-in from the business.
- “It’s not just a mathematical exercise, but you’re working with the lines of business and walking them through this,” the member said.
- The process requires cognizance of the economic environment and the need to measure performance over longer periods.
Spreading the word. A peer from another bank that had grown rapidly in recent years was seeking a more robust profitability measurement system and sought insights from the large regional bank’s treasurer.
- “They were very generous and let me pick their brains,” the peer said, adding that his bank adopted the economic capital allocation model to replace its traditional risk weighting approach, which didn’t differentiate between types of products and risks.
- The approach, anticipated to begin use early next year, leans on the economic capital model rather than taking the hybrid approach, attributing capital by product and risk at the individual account level.
- Interestingly, it indicates that higher or lower allocations of capital can exist for different components of retail and commercial sectors.
Accountability. Both treasurers agreed that holding businesses accountable for achieving ROE targets on their capital allocations was the next step, and signals are clearly positive so far at the bank using the hybrid model.
- The head of institutional banking consulted with the treasurer on the appropriateness of pursuing a deal providing a certain ROE on a blended basis, reaffirming that business unit’s buy-in to the process.
- “That’s half the battle,” he said. “If I can get everybody thinking in those terms for every piece of marginal business they do, then we did our job.”
- Incorporating these metrics in incentive systems will also increase accountability.
