Banks: whatever you’re doing isn’t clever and isn’t working. Now’s the time to own the balance sheet

There are many considerable challenges currently facing investment banks. Not least the tsunami of regulation (Basel 3, Dodd Frank, EMIR, MIFID I & II, FRTB, IFRS9, BCBS239, BCBS248, CRDIV, AIFMD, BSBC261, Leverage ratio etc), that have arrived since the financial crisis of 2007-2009, or that are due to be implemented over the next four years that are creating massive disruption of traditional business lines in the financial sector. Vickers, Liikanen, Volker and ‘Too Big to Fail’ all insist on ring-fencing of retail banks from more capital intensive enterprises, or a separately capitalised and funded subsidiary / bank branch network. All of which intensify the restrictions to the flow of liquidity.

A direct consequence of liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) has seen the value in short-notice deposits dissipated. A bank’s traditional role of being a provider of liquidity is in effect changing – from a warehousing business to a removals business.

Banks are struggling to keep pace and are lurching from one new regulation to the next, with a limited level of success, often not attempting to address the latest regulation until the deadline is looming, due to their limited resources being severely stretched.

The cumulative effect of enforcement of these regulatory requirements result in a far-from-strategic reaction to cut capital intensive business lines, and a steady (and sometimes not so steady) decline in financial sector share prices. At the time of writing, the entire banking sector is under downward pressure once more, and many firms are not far from their lows of five years ago. Some tier 1 banks have seen their balance sheets reduced by two thirds. Return on equity (ROE) is invariably between 0% and 5%, and the weighted average cost of capital (WACC) is at least 6% for some tier 1 banks, which eats into asset values. Investors are seeking other forms of investment.

We see a shift away from banks, where non-banking competitors in less well-regulated sectors begin to take up the previous core business: peer-to-peer lending and other shadow banking finance activity is stealing market share (and transfers risk into those areas, without the safeguards now deployed through banking regulation).

In a sense the banking sector is suffering a downward spiral of death.

Meanwhile, CEO’s seem to come and go with the change in the weather, and strategic direction is constantly being readjusted – which means these are no longer strategic decisions.

There has to be a better way of dealing with the new environment, which halts the decline in share value and reinvigorates investor confidence in the sector.

Sample bank shares. Historic prices

• Barclays (London)
  172.10 - 10/3/2016
  288.95 - Highest in last year (July 2015)
  144.00 - Lowest in last 5 years (Sept 2011
• Deutsche (London)
  19.47 - 10/3/2016
  36.06 - Highest in last year (April 2015)
  16.89 - Lowest in last 5 years (Feb 2016)
• JP Morgan (NYSE)
  59.92 - 10/3/2016
  70.08 - Highest in last year (July 2015)
  28.48 - Lowest in last 5 years (Nov 2011)
• Citigroup (NYSE)
  42.61 - 10/3/2016
  60.34 - Highest in last year (July 2015)
  23.63 - Lowest in last 5 years (Nov 2011)
• HSBC Holdings (London)
  450.60 - 10/3/2016
  649.30 - Highest in last year (April 2015)
  440.40 - Lowest in last 5 years (Feb 2016)
• Mitsubishi UFJ (NYSE:MTU)
  4.82 - 10/3/2016
  7.60 - Highest in last year (April 2015)
  4.06 - Lowest in last 5 years (Nov 2011)

We suggest a new approach, which is to manage all businesses to balance sheet, rather than the norm, which is that the balance sheet is a reflection of the bank’s activity. If we align to the availability and cost of capital, funding and liquidity, coupled to an understanding of operational costs of a business, and pass those back to the business, we may create a banking sector that will not only survive, but thrive.

The way we manage balance sheet today is silo-based,

• We are unable to fully price xVA[1] and operational risk
• There is a silo’d response to regulatory impact
• Inventory pools aren’t managed centrally, and are therefore managed sub-optimally
• Front office, Risk and Treasury are also silo’d, or at least not co-ordinated. As such…
• …there is no centralised source of Treasury, Risk and Front Office data.

Banks have been struggling to rebuild their balance sheets since the financial crisis, and are currently unable to measure balance sheet in a consistent way across the enterprise. At the same time, buyside firms and shadow banking have become providers and takers of liquidity.

Going forward, we see large investment banks focusing on four asset classes: Fixed Income, FX, Equities and Asset & Liability Management (ALM).

We see a fundamental case for organisational change within the bank, which seek to address these points in the following way:

• Build of a centralised business to manage balance sheet, cost of capital, liquidity, funding and xVA
• Rationalise inventory pools across all business lines within the bank
• Optimise asset usage for financing, collateral and balance sheet management purposes
• Improve the liquidity profile of the bank
• A forward looking approach by categorising and aligning regulatory change to their business lines, well ahead of any deadline.

Banks should be aiming for greater return on equity, aligning capital to the most valuable businesses. To do this they’ll need to assess a cost / income per business line. All costs need to be priced into the transaction, and therefore pre trade costs need to be understood, and aligned to the post trade allocation of those costs back to the trading book. The best way to align those cost calculations is to have them calculated in the same area, by the same desk. Only then will the bank be able to truly manage its businesses to the available and projected availability of capital and liquidity.

We don’t pretend that this is an easy approach to adopt. It will require strong leadership to move to this model and away from a silo’d ownership of risk and balance sheet. Third party vendors and market utilities will need to be assessed in terms of capability to support any such reorganisation. Internal infrastructure will be challenged.

From an organisational perspective a number of process changes will need to be adopted. Systems and platforms will need to be reassessed in terms of capability for each function and appropriate golden sources identified or created for reference and documentation data. Dashboard analytics will need to be designed, and data distribution will need to meet the standards of timely, accurate and complete data sets, including real-time where appropriate. Data delivery to a ‘smart’ application front end will replace traditional dashboards to allow a greater level of interaction and display of immediately created ‘what-if’ scenarios, allowing faster decision making and stressed market management.

GFT believes that the benefits of this approach abound. With RWA levels in excess of $100bn for most tier 1 firms and tier 1 capital ratio’s averaging around 12.8%, any improvements to balance sheet management are likely to reduce capital requirements by $bn’s if not more.

Using an 8% cost of capital estimate, every $bn of capital reduction could potentially reduce the costs of a typical bank by ~$80mn per year. This will go a long way to replenishing ROE, and possibly raising investor confidence…and could be the cleverest decision the banks will ever make!  

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[1] xVA - standard term for a number of Valuation Adjustments for capturing and measuring risks intrinsic in a transaction: Credit Valuation Adjustment, Market Valuation Adjustment, Funding Valuation Adjustment, Tax Valuation Adjustment, Kapital Valuation Adjustment etc