Right-Side Strategies in Financial Services Revisiting the Balance Sheet

Transcription

1 Perspective Gauthier Vincent Right-Side Strategies in Financial Services Revisiting the Balance Sheet

2 Contact Information Amsterdam David Wyatt Beirut Peter Vayanos Frankfurt Peter Gassmann London Alan Gemes Senior Milan Vincenzo Bafunno Mumbai Jai Sinha Munich Dr. Johannes Bussmann New York Paul Hyde Ken Favaro John Plansky Gauthier Vincent Senior Executive Advisor São Paulo Roberto Marchi Shanghai Andrew Cainey Sydney Vanessa Wallace Senior Tokyo Takeshi Fukushima Principal Zurich Carlos Ammann

3 EXECUTIVE SUMMARY The credit crisis has exposed a number of shortcomings and vulnerabilities in the financial services industry. One involves the long-neglected idea that the right side of the balance sheet matters. For a number of years, many financial services firms ignored the importance of right-side strategies, including funding and capital strategies, but in truth they are absolutely critical to the long-term success of a financial franchise. In fact, they are as important as left-side, asset growth strategies. The funding of asset growth with a core of stable client liabilities does not just happen. It is most often the result of both deliberate portfolio choices at the corporate level and client-centric, integrated asset and liability strategies at the business unit level. Similarly, capital strategies must be purposeful, focusing on economic capital that is, how much long-term capital is required to protect shareholders, rather than merely optimize the use and cost of regulatory capital. 1

4 REVIVAL OF THE RIGHT SIDE The recent financial collapse and meltdown of financial stocks unmasked a truth that too many management teams at banks and financial companies had lost sight of: Both sides of the balance sheet matter. Sustainable shareholder value creation has as much to do with funding and capital (right-side) strategies as with asset growth (left-side) strategies. Consider the events of late 2007 through much of 2008: A sharp devaluation of mortgage-related and other financial assets on banks balance sheets led to a sudden drying up of funding sources such as interbank lending and debt issuances. In turn, the share prices of banks and financial companies tumbled. Within months some Wall Street mainstays, such as Lehman Brothers and Bear Stearns, were out of business; others, like AIG and Citigroup, were bailed out by the U.S. government or, like CIT, forced into bankruptcy. Yet, in the midst of all these failures, some financial companies endured. The difference between the survivors and the losers came down to the strength of their balance sheets not just the credit quality of their loan assets and securities on the left side but also, and more important, their mix of client deposits and other liabilities on the right side, the stability of these liabilities, and the depth of their capital reserves. For much of the previous decade, diversified financial institutions had often emphasized asset growth to the detriment of the right side of the balance sheet. Citigroup is an apt illustration. By the time the crisis hit, the company had acquired asset-rich consumer finance businesses, stocked up on corporate loans, and greatly expanded the reach of its trading operations. As a result, in 2008, Citigroup found itself structurally underfunded in core client liabilities. 2

5 It soon started to hemorrhage even the retail and commercial deposits that it had. Furthermore, many of the tactics that the firm, like most other large financial companies, had used to lower its capital requirements, including off-balance-sheet vehicles, had proven illusory. The government had to step in quickly, guarantee the company s deposits, and bring in fresh capital. The lesson? Right-side strategies matter. And had financial institutions not forgotten that, they would have avoided much of the damage done to their businesses, their investors, and their customers. In fact, funding and capital considerations must be central to the enterprise s strategy. These activities cannot simply be delegated to the chief financial officer anymore but should be squarely on the CEO s agenda. As this report will show, financial companies that have fared relatively well through this crisis exemplify the way boards and management teams can develop rightside strategies that create long-term shareholder value. These stories teach the following lessons: An advantaged funding position is often the result of both corporate portfolio strategy and business unit strategy, not just corporate strategy. Capital strategies must emphasize growth in economic capital and regulatory capital, not just regulatory capital. Funding and capital considerations cannot simply be delegated to the chief financial officer anymore but should be squarely on the CEO s agenda. 3

6 FUNDING AS CORPORATE PORTFOLIO STRATEGY Through the 1990s, Capital One aggressively grew its base of credit card assets on the back of superior credit and segmentation capabilities. By the early 2000s, the company was leveraging these capabilities across new asset classes such as auto loans. Capital One s funding strategy was simple: Rely primarily on bond issuances through capital markets to match its asset growth. But in 2003, Capital One s strategy came under attack as concerns suddenly surfaced about the credit quality of its assets. Almost overnight the company faced resistance to rolling over its debt in capital markets. Its share price fell abruptly by nearly 50 percent as many investors feared that the company could not survive much longer as a stand-alone entity. It turned out that this near-death experience, several years ahead of the credit and funding crisis of , was a blessing in disguise. It forced Capital One s senior management to view funding as a critical element of enterprise strategy. In the wake of this reappraisal, Capital One acquired two retail banks: Hibernia and North Fork (in 2005 and 2006, respectively). The company sought these deals to change its mix of liabilities and to back its credit card assets with a core of relatively stable retail deposits. Although the value of operating cost savings did not justify the acquisition premium paid by Capital One, capital markets reacted positively to the transactions. Specifically, the deals substantially reduced Capital One s funding risk, which investors had priced as a premium of 150 to 200 basis points on the company s cost of equity. Just a few years earlier, few would have thought that Capital One could withstand a credit crisis of the magnitude of the current collapse. Yet not only has the company held its own throughout this difficult period, but in the last two years its share price has outperformed the financial sector index by 20 percent. Capital One s experience illustrates that funding considerations must be front and center on the corporate strategy agenda. Relying on wholesale markets and brokered deposits for funding is no longer a solution for many consumer or commercial banking businesses. Instead, accessing low-cost, stable funding, such as retail or commercial deposits or even pools of insurance premiums, is essential to the long-term viability of these firms. Corporate portfolio strategies must strike the appropriate balance between client asset rich and client liability rich businesses. 4

7 FUNDING AS BUSINESS UNIT STRATEGY At large, diversified financial companies, funding need not only be a corporate concern. Integrated asset and liability strategies at the business unit level can go a long way toward addressing a company s long-term funding needs. Silicon Valley Bank, a midsized commercial banking firm with roots in Silicon Valley and operations on the West Coast and in the northeast U.S., is a good example. Most of the bank s asset growth in the last five to 10 years has come from venture capital clients. Working with these entrepreneurs, the bank discovered that the venture capitalists were often at two distinctly different points in their funding cycles: Some had credit needs, while others were flush with liquidity. Recognizing the opportunity, Silicon Valley Bank implemented a clientcentric strategy approach to serving venture capital clients, striving to meet their needs on both sides of their balance sheets. Thus, the bank s loans to venture capital firms were funded by deposits from other venture capital firms. By pursuing this client-centric strategy, Silicon Valley Bank put itself in a strong position with stable, low-cost funding (two-thirds of its deposits were non-interest-bearing) and balanced growth in client assets and liabilities. As a result, the bank s share price has performed well in the last two years, beating the financials by 40 percent. We are not suggesting that clientcentric strategies will necessarily result in the advantageous balance in assets and liabilities that Silicon Valley Bank enjoys. For instance, some client segments are structurally long in financial assets. However, as a general proposition, client-centric strategies at the business unit level often allow financial companies to access their clients liquidity over time and can drive funding requirements. 5

8 CAPITAL MANAGEMENT In the year leading to the onset of the credit crisis in late 2007, the operating committee of a large, diversified, U.S.-based financial institution repeatedly brainstormed ways to improve top-line performance through greater risk taking and asset growth. However, not once during that period was the subject of economic capital broached. Economic capital is the financial industry s term for how much capital (equity and long-term debt) a bank must hold to protect its shareholders against insolvency, given its mix of assets and liabilities and particular risk tolerance. At this financial institution, as in many others, growth strategies and risk management had become largely disconnected from capital management. In the decade preceding the credit and funding collapse, the focus of capital management at most banks and financial companies was threefold: Meeting minimum regulatory requirements with the lowest level of capital possible Leveraging common shareholders equity with aggressive dividend/ share buy-back policies Lowering the company s cost of capital by optimizing its mix of Tier One and Tier Two qualifying debt and equity instruments The implicit assumption was that financial companies were sufficiently capitalized. Capital management was about optimization, including taking advantage of the limitations of the regulatory capital framework, not about strategy. 6

9 But that approach completely masks what should be the true goal of capital strategies. First and foremost, capital strategies should broaden the company s capital base (equity and long-term debt) to the levels required to protect shareholders. In other words, the purpose of capital strategies should be to address the company s economic capital requirements rather than to optimize the use of regulatory capital. However, most companies had little enthusiasm for such economic capital strategies, in part because they were under relentless pressure to release excess capital to boost returns on equity and enhance short-term valuations. In addition, quantifying economic capital involves complex methodologies and algorithms, and although there have been significant improvements in these metric tools over the last couple of decades, many unresolved issues remain. We believe that the time has come to rehabilitate economic capital and to develop strategies that use it to its best purpose. To achieve that, financial companies need to take four steps: Restore credibility to economic capital systems. This will require letting business judgment prevail over the often arcane analytics of economic capital and, in so doing, addressing limitations in the methodologies (in other words, don t let the Ph.D.s run the show). Make economic capital the currency of risk in the organization. That means that risk management should not merely set limits; more important, it should determine the cost of risk to the firm, with that cost being the economic capital requirements multiplied by the company s cost of capital. This is essential to avoid a repeat of the dangerous decoupling of capital and risk management that was evident at many companies in the years preceding the crisis. Incorporate economic capital into the fabric of the company. Integrate it into pricing decisions; make it one of the standards for strategic development and performance management. At the board and senior management levels, commit to managing the bank s capital position to both economic capital and regulatory requirements, not just regulatory requirements. Capital strategies should broaden the company s capital base (equity and long-term debt) to the levels required to protect shareholders, not just satisfy the regulators. 7

10 Key Highlights For a long time, diversified financial institutions had often emphasized asset growth to the detriment of the right side of the balance sheet. The mix and stability of client deposits, other liabilities, and capital reserves (the right side of the balance sheet) are as crucial to a financial company s long-term success as the quality of its loan assets and portfolio of securities. Funding strategies must be implemented at both the corporate and business unit levels. Capital strategies involving equity and long-term debt must focus on growth in both economic capital and regulatory capital, not just regulatory capital. Conclusion Because financial services is a highly leveraged industry, balance sheet management can never be neglected without dire consequences. The events of the last three years have reminded us that strong funding and capital positions are sources of long-term competitive advantage and value creation. And they have clearly demonstrated that financial institutions can ignore right-side strategies only at their peril. 8

11 About the Author Gauthier Vincent is a senior executive advisor with s financial services practice in New York. He advises senior management at banks and financial companies on corporate strategy, managing for value, and business unit growth strategies. He has 15 years of experience in financial services as a management consultant, an investment banker, and a bank executive. 9

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