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Chapter 1
Capital Management as a Means to Create Value
The core message of this book is that capital management is a means to create value. In order to manage capital so that value is actually being created, one needs to have an understanding of many different topics. However, when these topics are discussed in isolation, it might not always be clear how each relates to capital management, let alone understand the role each plays in the value creating function of capital management. This chapter summarizes the main objectives of capital management and how the activities to realize these objectives fit into the broader management context of financial institutions. The chapter should also help the reader to place the topics that are discussed throughout this book in a broader capital management context. Because this chapter is conclusive in nature it might be that the reader is not familiar with all the terminology and concepts that are used. If this is the case, do not be deterred as the concepts and terminology are explained in subsequent chapters.
1.1 THE PRIMARY OBJECTIVES OF CAPITAL MANAGEMENT
Capital management has two primary objectives:
1. Optimize capital structure. This is an objective that capital management has to fulfil almost entirely by itself and evolves around the financing of business operations.1 The activities that capital management undertakes to achieve this objective should ultimately result in an optimal cost of capital.
1. Optimize performance. The activities that need to be employed to fulfil this objective lie partly with the individual businesses and risk management. Even though, in order to optimize performance, capital management is dependent on other areas within a financial institution, it should act as the owner of this optimization process. In this role, it should oversee and manage this process. Apart from developing a corporate strategy,2 the activities to pursue this objective are similar to the activities of the strategy, risk, and capital management cycle as described in Chapter 19. If successful, these activities should lead to an optimal return on capital.
Figure 1.1 displays the main activities necessary to fulfil the two primary objectives of capital management. Both objectives need to be achieved in order to create maximum value. The next two sections explain each of the two primary objectives of capital management in more detail.
1.2 OPTIMIZATION OF CAPITAL STRUCTURE
Figure 1.1 shows the four main responsibilities of capital management in order to optimize the capital structure. When performed well, this should result in an optimal cost of capital. The four main responsibilities of this optimization process are discussed throughout the book, for which capital management is almost solely responsible. To summarize, these responsibilities are:
1. Fulfil regulatory requirements. This is a conditio sine qua non and means, among other things, that a financial institution’s available capital should exceed required capital. Hence, capital management should always check whether its optimal capital structure fulfils regulatory requirements. If it does not, capital management needs to continue its optimization loops until regulatory requirements are fulfilled. Because there is some leeway in how to fulfil these regulatory requirements, it does not need to be imposed as a single condition in the optimization process. However, capital management does need to “tweak” its optimization until the requirements are fulfilled.
Some people would argue that the regulator is a stakeholder that needs to be satisfied. This book treats fulfilling of regulatory requirements as a separate responsibility, because of their transparency and mandatory nature. Part II explains what capital management needs to do in order to fulfil regulatory requirements.
2. Satisfy stakeholder expectations. In contrast to regulatory requirements, which are to a great extent transparent, it is hard to understand the exact expectations of different stakeholders. In general, a financial institution only gets signals if it is not satisfying certain stakeholder expectations. If this happens, it is already too late, because the financial institution needs to bear the negative consequences of the irrational behaviour of these unsatisfied stakeholders. It is crucial that a financial institution never finds itself in this situation. Capital management is therefore responsible for conducting careful stakeholder analyses, and ensuring that the expectations of relevant stakeholders are met at all times. Or at least, if capital management chooses not to satisfy a certain stakeholder, it should be absolutely sure that the financial institution is able to withstand the potentially negative consequences. Satisfying stakeholder expectations is dubbed the soft side of capital management in section 17.3.
Capital management should go through optimization loops until the expectations of all relevant stakeholders are satisfied.
3. Determine optimal level of debt financing. This lies at the core of the cost of the capital optimization process. The main constraints for this optimization are stakeholder expectations and regulatory requirements. How to determine the optimal level of debt financing is discussed in section 20.3.
4. Make optimal corporate finance decisions. These are the more ad hoc type of decisions, such as acquisitions, but it is crucial to carefully think these decisions over as they can heavily impact the capital structure and therefore the cost of capital. How this is done in practice is explained in Chapter 20.
1.3 OPTIMIZATION OF PERFORMANCE
With respect to optimization of performance, capital management relies heavily on the individual businesses and risk management. Although optimization of (commercial) performance is primarily a responsibility of the individual businesses, capital management should drive this process in order to achieve an optimal return on capital on a consolidated basis. Nevertheless, the actual performance improvements need to be established by the businesses with the ‘aid’ of risk management. Capital management can influence this process by reallocating capital from businesses that perform relatively poorly to businesses that perform well. The main activities in order to achieve an optimal return on capital are discussed in Part III and can be summarized as:
1. Translate strategy into capital allocation. Once a corporate strategy has been formulated, available capital needs to be allocated in line with this strategy. However, this requires significant fine-tuning with the different businesses in terms of how and when this capital is actually allocated. Indeed, the allocated capital has to be in line with the size of the business. Even if the strategy is to expand a certain business, this does not happen overnight. Hence, capital needs to be allocated over time, in line with the strategies of the individual businesses.
2. Optimize economic profit per business line. Once capital is allocated, the individual businesses and business risk management are responsible for getting the most out of this capital. In other words, the individual businesses need to continually improve their economic profit. Risk management challenges the individual businesses on the business they undertake and sets guidelines within which these businesses need to operate. Optimization of economic profit per business line is not a responsibility of capital management, but rather of the business and business risk management. This is discussed in Chapters 18 and 19.
3. Evaluate performance per business line. Performance evaluation is again a responsibility of capital management. As part of this activity, capital management evaluates how well businesses are performing and challenges them on how these individual businesses can improve their performance. Part of this performance evaluation is to compare RAROC (risk-adjusted return on capital) and economic profit growth potential. How this works exactly is discussed in Chapters 18 and 19.
4. Optimize capital allocation. Based on the performance evaluation, capital management should optimize its available capital allocation. This could mean that it has to reallocate capital from poorly performing businesses, or businesses with little growth expectations, to well-performing and high-growth businesses. This is also discussed in Chapters 18 and 19.
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Part I
Accounting Perspective
One needs to be able to read a balance sheet in order to understand the dynamics of a financial institution. A balance sheet displays information that is valuable from a corporate finance, capital management, and risk perspective. In turn, one can only read a balance sheet if one understands the underlying business. This enables one to fully grasp what is driving the balance sheet. Hence, Chapter 2 first discusses the bank and insurance business models. Chapter 3 subsequently shows how these business models are reflected in the balance sheet and provides an in-depth overview of the balance sheet structure of a bank and insurance company, respectively. Part I then goes on to provide an overview of the differences between banking and insurance. Even though bank and insurance business models are converging, some inherent differences will always remain. Chapter 5 discusses the concept of economic capital, which is a concept that defines capital in an economic way, and is mainly used by risk and capital managers. The reason that it is discussed in Part I is because it aids readers to understand the subsequent chapters that build on the concept of economic capital (e.g. Chapter 7 on capital requirements). Chapter 6 goes into the details of balance sheet management. Lastly, Chapter 7 presents the necessary accounting concepts in order to understand the interaction between capital regulation and accounting. Although slightly technical, Chapter 7 is meant to jump-start the reader into Part II.
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Chapter 2
Bank and Insurance Business Model
Banks and insurance companies are both in the business of attracting money from customers. In doing so they fulfil a very important social function. A bank focuses on managing customers’ monies and subsequently relocating these monies (e.g. through lending) in an opportune manner to other parts of society. This process is called financial intermediation, which goes hand in hand with maturity transformation. Maturity transformation means that banks transform the maturity of money. They do this by giving customers who store money with them the option of withdrawing money on demand (short-term money), and by lending this money to customers on a long-term basis through, for example, mortgages (long-term money).
An insurance company exists by virtue of the inherent risk averseness of society and adds value by pooling these risks. In sections 2.1 and 2.2, bank and insurance business models are discussed, respectively.
2.1 BANK BUSINESS MODEL
Several types of bank companies can be distinguished. Hence, it is hard to talk about the business model for banks. This section introduces four different bank concept...
