Regulators are not the only ones who are concerned about banks’ capitalisation; management and shareholders also want to ensure the level of capital is sufficient to meet shareholder goals. But the relationship between the groups results in the need for a fine balancing act, write Hassan Filali and Joe Rizzi.
Capital management involves balancing potentially conflicting bank stakeholders (see diagram). The first group, the risk stakeholders, includes regulators and rating agencies, which view capital relative to risk protection. The second group is the return stakeholders, such as shareholders and management, who view capital relative to growth and returns.
The link between the various stakeholders is capital, and the balance between risk and return among the stakeholders is capital management. As noted by former US Federal Reserve Board chairman Alan Greenspan: “Determining appropriate capital levels is not just a regulatory concern. Increasingly, bankers are treating the determination of proper capital levels as integral to meeting shareholder goals. Shareholder value is maximised when long-run adjusted return on equity is maximised.”
The essential value-creating relationship is maximising risk-adjusted return on equity relative to the cost of equity. This is accomplished on the left hand side of the balance sheet by increasing asset returns through a combination of higher margins and higher asset turnover. Alternatively, capital costs can be reduced by improving capital management on the right hand side of the balance sheet through the optimisation of the capital structure. This entails actively managing both sides of the balance sheet.
Capital management framework
Managing capital involves comparing capital availability against capital requirements. Capital availability is defined by the following:
- book capital: assets less liabilities
- regulatory capital: certain assets (for example, excluding goodwill) less certain liabilities
- rating agency capital: related to regulatory capital with some adjustments
- shareholder capital: related to market value of book capital.
Typically, the most constraining definitions are ratings and regulatory related. Capital has both a stock and a flow component. The stock component represents external cash investments. The flow component concerns capital generated through retained earnings and capital distributions through dividends. The capital instruments through which external capital is raised reflect differences in priority concerning liquidation and distribution rights. This includes:
- equity: paid in capital and retained earnings (core Tier I)
- hybrids: perpetual fixed income obligations with loss absorption features (Tier I)
- subordinated debt: Tier II capital.
The drivers of capital needs include the risk exposure of the bank, which translates into the amount of economic capital needed to provide a cushion against extraordinary losses beyond expected loss, with a high degree of certainty (99.95% confidence level). Economic capital is there to ensure the bank remains solvent in case of tail-end risk (defined as extraordinary loss on business risks, credit risks, operational risks, country risks, interest rate risks and market risks). Thus, economic capital is a true economic measure of how much capital, in addition to the recurring income, a bank needs to remain solvent with a very high confidence level, given the risks it is taking.
However, the risks the bank takes also translate into a different capital requirement to satisfy the bank’s obligation towards its regulator. Although an amount of economic capital is allocated to each separate asset on the bank’s balance sheet, regulators classify assets into four risk categories and assign a risk weight to each category. Thus, the amount of risk the bank takes translates into an aggregate amount of regulatory capital that is different from the aggregate amount of economic capital.
These two measures of capital requirement can translate into a paradox that banks have to manage until regulators set up capital requirements in line with economic risk (Basel II). A bank can have an amount of recurring income and capital that could sustain a higher risk appetite. However, such a level of risk would require a much higher amount of regulatory capital than the bank currently has.
Most institutions hold more than the regulatory minimum to reduce distress costs and maximise flexibility. For example, larger institutions will seek total Tier I and total BIS (Bank of International Settlement) capital ratios of 6% and 10% respectively to achieve “well capitalised” status.
Rating agencies tend to focus on capital levels and capital generation relative to peers for a given rating level. For example, to achieve AA/Aa ratings, most institutions need core Tier I, total Tier I and total capital ratios in the range of 6%, 8% and 11% respectively. Falling below these thresholds is usually only tolerated on a temporary basis and requires a credible capital replenishment plan to avoid a downgrade.
In summary, a bank manages its business based on economic capital, but its capital requirement is driven by the minimum regulatory capital to be considered “well capitalised” and the need to maintain or improve its rating.
The difference, if any, between capital availability and requirements represents the institution’s capital buffer. The buffer increases the institution’s risk absorption capacity and flexibility, but is costly. Capital management can be seen as a strategy to manage the capital buffer in a cost-effective manner.
Capital buffer management
When a bank has more capital available than it needs to cover (with a very high degree of confidence) all its economic risk, to be considered “well capitalised” by the regulator and to maintain its rating, it might be considered as having excess capital. Capital buffer management is a dynamic process of balancing the reduction of expensive excess capital against maintaining the flexibility provided to the management to grow the business.
The primary tools used in this balancing process include:
- capital allocation, which affects the size and risk level through the CEO-directed strategic capital budgeting process. It is influenced by risk appetite, minimum return requirements, market opportunities and management strategy.
- capital securities, which are part of the Tier I composition, consisting of fixed income securities (hybrid securities). Payments on these securities are tax deductible, hence they represent the cheapest form of capital that a bank has. However, the percentage of such capital that a bank can hold is capped by the regulator and the rating agencies. Optimal use of hybrid capital helps the bank to reach its capital ratio targets, while reducing the average cost of capital.
- distribution, which involves both dividends and share repurchases. Any distribution beyond the dividend expected by shareholders needs to be justified. Capital management requires an assessment of the best use for the additional capital, whether using the additional capital for growth improves the bank’s overall return on capital or not.
The primary capital buffer management tool is the capital plan. The capital plan incorporates various sources and uses of capital under alternative scenarios from which appropriate responses can be evaluated.
Setting the capital structure
The capital structure should be a consequence of the firm’s strategy. Once the funding implications of the strategy and a target debt rating are known, it can begin to develop a capital structure. The process involves the following considerations:
- ensuring coverage of economic or risk capital requirements;
- satisfying regulatory capital targets;
- matching against similarly rated peers as a reality check;
- comparing to rating agency requirements;
- being consistent with announced shareholder dividend and repurchase announcements.
Institutions can then alter the mix of securities consistent with regulatory and rating agency guidelines to lower the cost of capital. This is accomplished by substituting lower cost hybrid instruments for high cost equity.
The right balance
The importance of capital management cannot be overemphasised. A Risk Capital 2006 Survey by the International Centre for Business Information indicates that more than 75% of those surveyed ranked capital management as high in importance.
Shareholders’ concerns over banks losing their capital discipline at this point in the cycle are increasing. Consequently, many institutions are returning more funds to them through increased dividends and repurchases. Regulators and rating agencies have expressed concern over whether capital levels are at a sufficient level to withstand shocks if and when the credit cycle turns. Striking the right balance between these concerns has never been more important.
Hassan Filali is senior vice-president, group asset liability management, ABN AMRO and Joe Rizzi is executive vice-president, capital management group, ABN AMRO. CAPITAL STAKEHOLDERS:
