2. 2
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 bank’s 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 sign-
off 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].
The Capital Optimization drive – Can banks
avoid the capital squeeze?
3. 3
Income ~10%
RoE ~15%
Cost /Income Ratio ~65%
Tier1 Ratio ≥ 10%
Leverage ≤ 25%
PerformanceConstraint
Opportunities for performance uplift
Revenue Growth ~ 8 %
(*)
The industry converges on the performance targets and constraint coefficients. However, there are opportunities to increase the numerator
and reduce the denominator.
(*) Target average figures based on analysis by a pool of banks – Risk Management Research
1. Improve RoE vs RARoC
• Current RoE is under threat for a
number of LoBs (Lines of Businesses)
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
Figure 1: Balance Sheet Structure
4. 4
This contribution can be achieved
using three levers (See Figure 2):
Lever 1: Operational
Excellence for RWA
processes
The RWA processes include a number
of processes which have direct and
indirect impact on the RWA of the
bank and cover front, middle and back
office operations:
• Achieve operational excellence
for processes that have a direct
impact on regulatory capital release
such as collateral, hedging, netting,
counterparty limits, client on-boarding
and others
• Improve effectiveness in line with
risk mitigation and business strategy
• Improve accuracy of RWAs, as
regulators will recognize and reward
operational risk management of risk
mitigation processes and risk oversight
including CVA monitoring, wrong way,
and risk concentrations
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.
Lever 2: Cost-of-Capital
to pricing strategy
The pricing strategy of a bank is
intricately dependent on having a
holistic understanding of the
Cost-of-Capital for serving a client’s
needs:
• Manage counterparty risk
performance
• Increase product/asset return
(Return on Asset/Return on Equity)
• 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.
Lever 3: Operational
Realignment – Efficient
Processes
The operational costs of a bank can
have a major negative impact on
the profitability and capital reserve
demands:
• Improve operational efficiency to
reach C/I Ratios of around 40%
• Improve data quality on front-to-
back processes for calculating market
and credit risk, which will lead to RWA
reduction
(*) Target average figures based on analysis by a pool of banks – Risk Management Research
Linking
Cost-of-Capital to
Customer Pricing
Operational
Realignment for
Efficient Processes
Operational
Excellence on
RWA Processes
Leverage ≤ 25%
Income ~10%
Revenue Growth ~ 8 %
RoE ~15%
Cost/Income Ratio ~65%
Tier1 Ratio ≥10%
PerformanceConstraint
(*)
Balance Sheet Structure
Figure 2: Capital Optimization and Three Lever Framework
6. 6
The proposed approach provides
enough flexibility for banks to tailor
the elements to their own environment
and select the levers that will deliver
maximum return given the current
state of their organization.
Lever 1: Operational
Excellence for RWA
processes
Analysis of the effectiveness of the
processes involved in the calculation
and management of RWAs shows
that in most organizations, processes
are disconnected and important risk
measures are lost during the RWA
calculation and attribution, creating
a type of data leakage. The problem
becomes more acute in reviewing
certain asset types (such as OTC
products and collateralized portfolios)
and when specific risk mitigation
strategies are applied.
There are a number of processes which
can help release RWA Capital and
which play a direct or indirect role in
RWA measurement.
Within the wide range of RWA
processes we believe financial
institutions should concentrate on
those processes which are associated
with RWA intensive assets (such as
OTC products) and place particular
emphasis on the way collateral
strategy, growth and volatility are
executed throughout the organization.
This will help establish the linkage of
collateral processes to operating risk.
Figure 3: RWA Process “Heat Map”,
identifies the processes and associated
services requiring operational
excellence.
Another area of RWA improvement
is the processes associated with
market risk and the contribution of
CVA. The seamless integration and
high business performance of front
office (CVA pricing, wrong way risk)
and middle office are critical in
delivering improved RWA ratios. This
operational excellence performance
should be assessed via a number of key
performance indicators, such as the
percentage of term sheets generated
after execution, the percentage of
trades or transactions not booked on
trade date, and the number of trades
which have been amended, among
others.
Basel III provides an additional
incentive to reach the point at which
regulatory capital can be released by
improving operational performance in
areas such as margining management,
back-testing, and stress testing.
This provides further input into
the process areas and the needs of
financial institution to enhance their
capabilities and performance. This
performance uplift may include: flow
product confirmations issued by T+2,
structured products confirmations
issued by T+4, the provision of cash
forecasts to treasury by the agreed
cut off, queues that impact posting
to books and records cleared on T0,
margining and collateral principle
timely drawn, Sign off Trading
Balance Sheet on T+1 and Backtesting
completed T+1.
An opportunity exists for financial
institutions to improve their RWA
efficiency by focusing on the weak
link processes in the RWA calculation.
Evaluating current operating models
in the aforementioned areas can
provide an RWA boost to help counter
forthcoming regulatory demand for
higher levels of capital.
Lever 2: Cost-of-Capital
to pricing strategy
An analysis of client performance
against product profitability and risk
contribution will highlight areas of
RWA performance to be addressed.
A tighter focus on client portfolio
performance with target profitability
will identify the products with the
potential for increased earnings,
leading to the possibility of releasing
more regulatory capital through
improved RoA and RoE. There are
a number of key performance
indicators (KPIs) that can be applied to
operations from customer on-boarding
to customer reporting, and from
trading to counterparty credit risk,
which can clearly mark the path to
releasing more capital. Key indicators
include:
• Percentage of clients not on-boarded
two days prior to trading;
• Percentage of trades booked without
full legal documentation;
• Percentage of trades without valid
counterparty ID at trade execution;
• Percentage of credit approvals not
obtained prior to execution;
• Percentage of term sheets generated
after execution;
• Percentage of trades (or
transactions) not booked on trade
date;
• Percentage of trades which have
been amended; and
• Percentage of proprietary and
relevant client positions not valued at
the end of each day.
The Levers to Unlocking Capital
Optimization
7. 7
Sales & Marketing Services Pre Trade Service
1. Distribution Services 2. Product Sales 3. Client On-boarding
4. Client Analytics 5. Client Services
6. Research & Analystics
7. Connectivity
Reference Data
Services
Counterparty/ Client
Data & Documentation
Product Data
Books / Cost Centres
& Hierarchies
Market Data
Calendar / User
Permissions
Firm Wide Management & Control Ledgers & Stock Record
27. General Ledger
26. Sub-ledgers
25. Stock Records
24. Funding & Financing
22. Consolidated Firm
wide Reporting (Reg / Fin)
21. Collateral & Margin
Management
23. EOD Risk Aggregation
Post Trade Services
17. Lifecycle Event
Management
18. Transaction
Management
19. Clearing &
Settlement
20. Asset Services
Trading & Valuations Services
14. Trade Capture & Amend
11. Market Making & Quote
Management
8. Deal Structuring
15. Position Management
12. Order Management
9. Quote Management
16. Risk Management
13. Execution Services
10. Pricing & Risk Analytics
Figure 3: RWA Process “Heat Map”
8. 8
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.
Lever 3: Operational
Realignment – Efficient
Processes
There are multiple dimensions to each
operation that could be optimized, and
the measure of their performance must
be linked to the KPIs defined through
the bank’s capital optimization
strategy.
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.
Establish Data Integrity
Another set of operations which,
although widely acknowledged, have
not been properly recognized in their
contribution to capital optimization,
are the data management operations
for the previously mentioned areas
such as product control, finance, risk,
treasury, and compliance. Operational
realignment offers the opportunity
to establish a common data sourcing
policy. The target operating model
should adopt common data sourcing
from front-to-back for all high value
processes and functions, such as
trades (pricing, credit terms) and
margin data (collateral pricing, netting
pools, liquidity pools and other items).
A common data sourcing policy should
also establish an integrated framework
for managing market and reference
data for front-to-back operations
for the key business entities. These
include trades (pricing, credit terms)
and margin data (collateral pricing,
netting pools, liquidity pools). The
policy should also establish centralized
quality and validation rules that lead
to improved consistency of analytics
and reporting for activities including
trade hedging, collateral management
and portfolio analysis among others.
Create Shared Calculation
Engines
The deployment of consistent
valuation and risk pricing across the
different business lines is critical to
improving the measurement and usage
of risk capital. We believe that the new
operating model should fully leverage
shared calculation engines, which use
common data stores across market
risk and credit risk. A single engine, for
example, could be used for scenario
generation and for reusing pricing
models to generate scenario results.
Human Capital - Adjusted
Compensation
The importance of the quality of
the professionals employed in the
various functions of the organization
is fully recognized by most financial
institutions. However, the recent bail-
outs have led to increased displeasure
about compensation levels, and to
calls for more regulation of how banks
pay their employees. We suggest that
the new realignment should take the
compensation factor into account and
link it to capital performance.
10. 10
Banks are entering a period of
uncertainty which will become the
normal operating environment for
the future. Although the mission for
banks is still the same – to deliver
shareholder value — the control
mandates, higher operational costs
and environmental uncertainty
create a compelling case for a
transformational approach to the
banking business. Our approach
for achieving capital optimization
employs three levers: Operational
excellence for RWA processes, linking
Cost-of-Capital to pricing strategy,
and realigning processes to improve
C/I performance. We believe that by
following this approach, banks can
resist further RWA increases, which
could lead to RoE increases of between
17 and 20 percent while achieving
operational efficiency of C/I of less
than 60 percent.
Banks that do not transform the
way they do business could face
significant pressure on their share
prices. The estimated extra regulatory
capital burden could reach up to 42
percent [J.P. Morgan Research - Global
Investment Banks: Investment Banking
wallet outlook - all eyes on equity
derivatives, Global Equity Research
08, September 2010]. The choices for
financial institutions are to strengthen
Tier 1 Capital with additional equity
capital, along with building up other
components on the liability side of
the balance sheet. In order for the
capital increases not to dilute earnings
of existing shares, — the additional
business generated either through the
existing capital or by the new capital
must have a higher yield or marginal
productivity increases for the coming
years. This is different from the current
norm, meaning that banks need to
realign themselves to the new reality.
Conclusion – Avoiding the Capital Squeeze
Peter Beardshaw
Peter Beardshaw is executive director –
Accenture Risk Management. Based in
London, Peter brings over 15 years of
deep experience in delivering target
operating models and business process
redesign initiatives within the credit
risk and capital management areas.
His broad experience in Investment
Banking program management and
change management, in addition to his
technical experience in multiple asset
classes across front, middle and back
office helps organizations become
high-performance businesses.
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.
About the Authors