The linkage between capital, risk and strategy and its implications for decision-making at global banks

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Banks are working hard to improve their methods and processes for evaluating the risk and returns that lie at the heart of their businesses. For now, capital decisions seem relatively straight-forward: more capital and more high quality capital.

But as economic and monetary conditions begin to return to normalcy, capital decision-making becomes more difficult. Capital management is inherently linked to a bank’s risk appetite so consequently it is tied to bank strategy at the highest level.

Risk appetite determines growth strategy
A bank’s risk appetite depends on many factors, including its competitive landscape, existing businesses, geographic footprint and growth aspirations. When banks consider areas in which they want to grow, they must determine their risk appetite for each area.

Capital metrics demonstrate success to investors
The global financial crisis snapped investors’ attention to the quality and size of capital buffers by exposing the fragility of highly leveraged banks. At least for now, the experience seems to have turned the dial downward on acceptable returns. Even though the focus on return-on-equity never really went away, in the depths of the crisis, safety through strong capitalization was the bias.

While the markets give swift feedback on a bank’s capital management, their judgments by necessity are made in comparison to other banks’ performance. Capital decision-making unfolds in the larger competitive landscape, and capital metrics are fundamental to demonstrating the success of a given strategy to investors and to the public at large.

Impact of capital requirements on business models
The ties between capital and strategy give good reason to predict that changes in capital requirements will eventually lead banks to change their businesses in response, adapting their business models to optimize what they see as the risk/reward characteristics.

But even when the regulatory landscape changes, many forces combine to preclude immediate action on a large scale. The executives interviewed for this report point out that it’s much easier for managers to influence growth through capital allocation (by directing additional capital to businesses they wish to promote) than it is to withdraw funding from a mature business.

Lingering uncertainty regarding regulatory capital and liquidity requirements will also prevent most banks from returning funds to shareholders for some time to come. Uncertainty is also leading most banks to take a wait-and-see stance to market entry and exit decisions, at least for now. And market conditions are less than ideal for divestitures in any case, our sources observe.

That said, the scale and potential influence of coming reforms are already leading banks to begin evaluating their current strategies and making plans for large-scale changes. In many cases, these plans seem to involve coming home to core competencies and familiar ground.

NextThe current state of financial reform and changing capital requirements 

Download the CFO report “Capital management in banking: senior executives on capital, risk, and strategy” for complete findings.