2. Restoring
Profitability while
Rebuilding Capital
Operating and competing with
a more restricted balance sheet
In response, universal banks need to find
ways to mitigate the costs of regulatory
developments - particularly on their non-ring-
fenced operations - while also identifying
opportunities to restore profitability by
increasing existing revenue streams or
generating new ones. In our view, the optimal
approach will involve understanding the cost
of capital accurately to serve clients and price
correctly, managing risk-weighted assets
(RWAs) to maximise risk-adjusted returns, and
ensuring an efficient cost base to underpin
operations. Banks that take these steps at an
early stage will be well positioned to achieve
high performance in the capital-constrained
post-ICB world.
The Independent Commission on Banking’s proposals on loss
absorbency will intensify the already strong regulatory pressures on
banks’ capital, liquidity, funding and leverage. And the introduction
of ring-fencing will make the task of managing these pressures
more complex, by requiring universal banks to address them
separately for their ring-fenced and non-ring-fenced operations.
The overall impact will be to raise the costs of doing business still
further, while simultaneously restricting banks’ opportunities to
pursue revenue growth.
Restoring Profitability while Rebuilding CapitalRestoring Profitability while Rebuilding Capital
3. Tightening risk and capital standards
The years since the global financial crisis have
seen the emergence of a complex web of new
bank solvency regulations, as global regulators
seek to reduce risk in the banking system by
improving banks’ ability to absorb losses and
curbing incentives for excessive risk taking.
In combination, these measures are reducing
banks’ ability to generate profits, by requiring
them to hold more capital, maintain greater
liquidity, reduce leverage, and seek longer-term
(and therefore more costly) funding.
The ICB’s recommendations on loss absorbency
will increase these pressures, while the
introduction of ring-fencing will mean banks
have to tackle them separately on each side
of their chosen ring-fence location. The ICB’s
detailed provisions have been widely reported
and their key impacts will include increasing
the required primary loss-absorbing capacity
to 17% of risk-weighted assets for some
global systemically important banks (G-SIBs);
lifting the equity-to-RWA ratio requirement
for larger ring-fenced banks in the UK to 10%;
and raising the minimum leverage ratio for
the same banks to 4.06%, well above the 3%
imposed under Basel III.
In combination, it is estimated that the capital
impacts of the ICB’s proposals may be to raise
equity by 0.5% and total capital by 0.5%. As
Figure 1 shows, on the current implementation
timetable these effects will step up from 2015
before accelerating strongly in 2019.
The final category is ‘ancillary’ services relating
to the delivery of non-prohibited services -
such as internal hedging activities and treasury
- which are also allowed within the ring-fence.
Immediate priorities in four areas
As banks look to prepare for these changes by
building the right level of capital adequacy and
optimise their ring-fences, they are likely to
have four immediate priorities.
First, in terms of raising capital, while in the
past the Treasury used the other group divisions
to raise capital, it will now be more difficult
to achieve. Furthermore, the current market
conditions are hardly conducive to raising
equity, meaning that more innovative forms of
capital such as bail-in bonds will probably be
needed. However, these are likely to be more
expensive than standard debt. Asset sales may
also be useful for raising capital.
Second, to retain earnings, the options include
paying lower (or no) dividends, reducing
operational costs, and generating higher
revenues by boosting sales and/or prices.
Cutting bonuses is also an option, and is the
focus of increasing attention from politicians,
regulators and activist investors.
Third, in order to cut down risk, banks may
identify core assets and sell off others, reducing
the size of the balance sheet. They may also
decide to reduce the trading book and improve
the balance of lending, while reinforcing their
Pillar II models.
Fourth, and most radically, banks can change
their business model by identifying the loss
absorbency implications on both sides of
ring-fence. This involves looking at how
the balance sheet is currently structured,
and working out how to minimise capital
requirements across the ring-fence, as well
as its implications for funding and for the
bank’s products and services.
Figure 1: The ICB’s projected capital impacts
Restoring Profitability while Rebuilding Capital Restoring Profitability while Rebuilding Capital
25
20
15
10
5
0
Basel II 2011 2012 2013 2014 2015 2016 2017 2018 2019 ICB RFB ICB GSI
RFB
ICB GSI
NRFB
PLAC Additional Resolution Buffer
PLAC Additional Buffer
Tier 2
Additional Tier 1
CCB Counter Cyclical Buffer
CCB RFB or GSIB
Capital Conservation Buffer minimum
Minimum Common Equity
ICB RFB= ICB non Globally Systemically Important (GSI) ring-fenced
bank with 3% RWAs / GDP
ICB GSI RFB = GSI ring-fenced bank with 3% RWAs / GDP
ICB GSI NRFB= GSI non-ring-fenced bank with maximum GSIFI
surcharge
Bail in Bonds
Non-Equity Capital
Hard Equity Minimum
Equity Capital Conservation
Buffer (CCB) Components
2.0
2.02.5
2.5
2.5 2.5
2.5 2.5 2.5
2.5
2.5 2.5
2.5
1.5
1.5
1.5
0.6 1.3 1.9
1.5
1.5
1.5
1.5 1.5
1.5
2.0
2.0
2.0
2.0
2.0 2.0
2.0
3.5
3.5
4.0
3.0 3.0
3.0 3.0 3.0
1.0
1.0 1.0 1.5
4.5 4.5 4.5 4.5 4.5 4.5 4.5 4.5
Pre-ICB Universal Bank
4. Restoring Profitability while Rebuilding Capital Restoring Profitability while Rebuilding Capital
Key strategic challenges
Our view is that the location of the ring-fence
will be driven as much by existing internal
business considerations - such as balance sheet
structure and the funding mix - as by market-
facing factors. However, banks need to keep
in mind the implications for their competitive
positioning, culture and operations.
In practice, many banks may adopt a ‘tactical’
short-term ring-fence location aligned with
their existing business structure until the
regulations have fully evolved and the future
market trends are clearer. Once any clear
trends have emerged, banks may drop this
interim approach and move their activities to
long-term ‘strategic’ positions in relation to
the ring-fence.
Given this likelihood, and the fact that the
optimal ring-fencing structure will vary for
every bank, there is no ‘one-size-fits-all’
solution. However, we believe there are four
key factors that every bank should take into
consideration in locating its ring-fence:
capital constraints, funding, customer impact,
and operational impact.
Managing these impacts raises four strategic
challenges for banks, as shown in Figure 2.
1. Managing RWAs
Banks need to work out the optimal approach
for managing business with clients that
attract a higher risk-weighting; how to
withstand additional capital charges from
elements such as the Credit Valuation
Adjustment charge (CVA); and how to take
advantage of capital reductions from Expected
Positive Exposures (EPEs).
2. Optimising Capital
Although the timetable for meeting the ICB
capital requirements is likely to be in line
with Basel III (i.e. extending to 2019), markets
are looking favourably on those banks
planning to meet the new requirements well
in advance of that date. This means banks are
incentivised to move early to consider their
options for improving the quality and quantity
of their capital, and for optimising collateral
to reduce the impact of regulatory pressures
on profitability.
3. Allocating Capital
Internal allocation of capital needs to align
with a principle of rewarding businesses on a
‘par’ basis, considering new measures for risk-
adjusted return on equity (RoE). Alongside this
is the challenge of managing one of the most
controversial aspects of the financial crisis:
appropriate compensation of staff. Regulatory
limits on bonuses have encouraged higher
base salaries, which have ultimately reduced
flexibility in the cost base thus creating another
challenge in addressing profitability pressures.
4. Changing the Business Model
Finally, banks need to think through the
restructuring needed in response to new
capital and liquidity constraints, including
the implications of the ring-fence, and where
certain businesses sit and their impact on
balance sheet management. The ring-fence
proposals demand tough choices around
how to manage and source support services
whether shared or dedicated and therefore
what operational efficiencies can be exploited.
Figure 2: Four strategic challenges
Manage RWAs Organise Capital
Bank
Allocate Capital Change the Business Model
Manage clients with high risk
weightings
Withstand additional capital
charges
Take advantage of CVA
capital reductions
Improve the quantity and
quality of capital
Optimise collateral
Reward businesses on
a ‘par’ basis
Compensate staff effectively
Understand new capital and
liquidity constraints
Identity core shared services
5. Achieving and sustaining success in the
new capital constrained environment
In Accenture’s view, the keys to reducing the
cost implications of the ICB’s proposals lie in
understanding the cost of capital for serving
clients and pricing correctly, managing RWAs
to maximise risk adjusted returns, and ensuring
that operations are underpinned by an efficient
cost base. As Figure 3 shows, these objectives
can be achieved through four steps:
1. Analyse the implications of the ring-fence
to determine the new business model, products
and services: Understanding the capital
implications of the ring-fence enables the bank
to determine its shape and location, and drive
the types of products and services offered to
clients and customers from ring-fenced and
non-ring-fenced entities.
2. Understand cost-of-capital to develop a
profitable pricing strategy: A bank’s pricing
strategy is intrinsically dependent on a holistic
understanding of the cost-of-capital for serving
a client’s needs, to:
• Manage counterparty risk performance
• Increase product/asset return (Return on
asset/ROE)
• Lower the cost of execution and deal
servicing.
In combination, these steps help to ensure
an efficient and effective client management
workflow, delivering consistent global pricing
for clients and truly reflecting the cost-
of-capital in each transaction to support
competitive yet profitable business.
3. Focus on efficiency: Manage RWAs to
mitigate capital costs where possible, and drive
operational realignment to reduce operating
costs in two key ways.
a) Operational excellence for RWA processes
RWA management includes a number of
processes that have direct and indirect impacts
on the bank’s RWA and cover front, middle and
back office operations. The aims should be to:
• Achieve operational excellence for processes
that have a direct impact on regulatory
capital release, such as collateral, hedging,
netting, counterparty limits, client on-
boarding
• Improve effectiveness, in line with the bank’s
risk mitigation and business strategy
• Improve the accuracy of RWAs, as regulators
will recognise and reward good operational
management of risk mitigation processes and
risk oversight, including CVA monitoring and
risk concentrations.
Operational excellence in these areas
helps to creates a fit-for-purpose risk
management environment. This will enable
the bank 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.
Examples include readjusting its securitisation
strategy and repositioning itself for the
development and launch of new products.
b) Operational realignment efficient
processes
A bank’s operational costs can have a major
negative impact on its profitability and capital
reserve demands. So it should aim to:
• Improve operational efficiency to reach cost/
income ratios of around 40% for the retail
business and 60% for the capital markets
business
• Improve data quality in the front-to-back
processes for calculating market and credit
risk, helping to achieve reduced RWA.
Restoring Profitability while Rebuilding Capital Restoring Profitability while Rebuilding Capital
Figure 3: The four steps to success in a capital-constrained world
4. Identify growth opportunities: To identify and
seize opportunities for growth, the bank needs
to understand the core and non-core business
in which it will be able to compete in the long
term. Achieving the optimal mix of clients,
products and markets is critical, and raises
questions in four key areas:
a) Identify geographical markets: What
geographies are most advantageous to work in?
Do regulatory factors mean the bank should
restrict its business in some geographies more
than others?
b) Identify business markets: What business
segments can the bank compete in most
effectively? This is a particular challenge for
the capital markets business. Not everyone
can compete profitably in every segment⎯and
experience suggests one particular business
segment can only accommodate four or five
‘flow monsters’.
c) Identify Products: What products and
services will differentiate between that bank
and its competitors? If a bank’s trading in
certain products is not profitable, it should
consider exiting those product lines.
d) Identify Clients: Which customers are most
profitable? Customer segmentation is key
for reducing the cost of serving unprofitable
customers.
1. Analyse ring-fence implications to
determine products and services
2. Develop profitable pricing strategy
3. Focus on efficiency
4. Identify growth
opportunities
Successinanewcapitalconstrainedenvironment
6. Restoring Profitability while Rebuilding Capital
Accenture Contacts
David Parker
Senior Executive
Financial Services UK
+44 20 7844 3216
david.m.parker@accenture.com
Takis Sironis
Senior Manager
Financial Services UK
+44 20 3335 0457
takis.sironis@accenture.com
Karl Meekings
Manager, Banking Research
Financial Services UK
+44 20 7844 5530
karl.meeking@accenture.com
Building future differentiation
In the post-ICB world, the established drivers
of high performance in banking – including
outstanding management of risk and capital,
efficient and effective capital allocation,
smart and responsive pricing, and deep
understanding of the strategic and operational
impacts of regulation – will if anything be
even more important than they are today.
With implementation scheduled for 2019,
the ICB’s proposed regime may appear some
way off. But the changes it envisages are so
profound and pervasive that banks should
start considering their impacts as a matter of
urgency. Those that hit the ground running
now will have a head start in the future race
for differentiation in an even more constrained
capital environment.
