März 2007 - No.

46 BANK-FORUM
100 per cent equity
allocation for the treasury?
At present, equity allocation is mostly determined by the credit business, with
the logical consequences for corporate banking. This article asks whether it
wouldn‘t be more appropriate to allocate the entire risk-indexed equity – for
that read the entire economic and statutory equity – to the treasury. Ultima-
tely, the question is: are banks being managed properly today?
BY HANNES ENTHOFER

The status quo
in bank management
Banks are managed diffe-
rently to other companies.
While “normal” enterprises set
their own “right” level of
equity, banks are prescribed a
risk-based equity requirement
by the regulator. These legal
requirements are economical-
ly motivated: banks are sup-
posed to align their internal
management and hence their
(economic) equity require-
ments with the inherent risk
level of their business. In short,
a bank needs equity because
of the banking risks.
Today, banks usually aim to
maximise earnings after tax
(see also the article “Is value-
based management a must?”
in Bank-Forum 44). Divided by
equity (usually tier 1) this
yields the return on equity
(RoE). A high RoE is conside-
red a success; banks‘ and bank
managers’ performance is mea-
sured by this yardstick and the
share price of a bank is massi-
vely influenced by it.
As a consequence, a bank’s
management will steer all bu-
siness activities accordingly.
Equity requirements are de-
termined by the banking risk
incurred by a business unit.
For the corporate, retail and
treasury units equity require-
ments are set according to
their earnings expectations
and thus are limited (accor-
ding to the Basel II and ICAAP
rules). Under IFRS (Internal Fi-
nancial Reporting Standards)
the unit results are matched
up with the equity require-
ments and a unit-specific RoE
is calculated. Maximising this
RoE is the main goal of line
managers.
To be continued on Page 2

Legal Framework
Total Bank
Management
Return

optimal RORAC

Risk

Retail and Risk Business

Corporate Business TRANSFER PRICES Management
Management

Market Risk

Credit Risk
GOAL : GOAL :
Return from Return from
optimally meeting Liquidity Risk limited market
customer requirements and credit risk
 Continuation from Page 1
Discerning questions
Retail banking seems a lot
more attractive than corpora-
te banking these days. Retail
banks enjoy high market capi-
talisations, they are popular
takeover targets, their RoE is
much better than that of
banks with a corporate busi-
ness emphasis. Our current Re-
gionalBANKINGStudy shows
an average RoE of 17.45 per
cent for retail banks while cor-
porate banks achieve a mere
11.45 per cent. The likely re-
ason for this is that the classic
deposit business carries neit-
her credit nor market and li-
quidity risk. The same goes for
the commission business (se-
curities, payment transactions
and services). Only the over-
draft, consumer and mortga-
ge businesses require equity.
- This poses the question:
Is it appropriate that only a
part of the retail business is
allocated equity while ALL re-
turns count towards the RoE?
The corporate business, on
the other hand, largely con-
sists of lending, with credit
risk being the main draw on
equity. Therefore, it is only lo-
gical that the corporate busi-
ness would have low RoEs.
However, there are exceptions
to this rule: “large corporates”
yield a very high RoE.
This is due to the fact that
these customers have little
need for borrowing (instead
securing funding by issuing
their own bonds) while doing
lots of derivative business
(which requires little equity)
for risk management purpo-
ses.
- This avoidance of “balance
sheet lending” leads to a good
RoE, raising the question:
Should a bank really have to
avoid credit business in order
to achieve a good RoE?
Consistent
implementation
of the current
management concept
Transfer prices are at the
heart of bank management.
Via transfer prices banking
risks are bundled and handed
over to the treasury for hed-
ging or managing. This system
works well in the mature inte-
rest markets where there are
reference rates for hedging
the interest rate risk of all cus-
tomer business. Via these refe-
rence rates all interest rate
risks of the market units are
bundled in the banking or tra-
ding book and managed cen-
trally by the treasury.
This methodology, however,
is NOT used in the credit busi-
ness. The credit and hence the
equity risk remains in the cre-
dit unit; the treasury is only
responsible for those credit
risks that it “purchased” itself.
Logically it would follow to
pass these standard risk costs
(more precisely: the credit
spread) on to the treasury
while simultaneously alloca-
ting the loan defaults to the
treasury as well. Credit risk can
only be managed when subsu-
med in a portfolio. After all,
remedial action should be ta-
ken as soon as the prognosis
worsens rather than after the
loss event has occurred. This
means that all risks should be
bundled and managed by the
treasury, or:
100 per cent equity for the
treasury.
The consequences
If this is so obvious, how
come it hasn‘t been imple-
mented yet? The pragmatic
answer is that in the past, cre-
dit risk was to a large extent
unmanageable. To be precise,
credit risk could not be traded
in the secondary market, it
was not fungible. This is chan-
ging rapidly though: more
transparency in the credit mar-
ket, Basel II, securitisation tech-
niques and credit derivatives
are making credit risk increa-
singly manageable.
We recommend that the en-
tire credit business be alloca-
ted to the treasury via transfer
prices (and where not fully
fungible to asset & liability ma-
nagement). The unmanageab-
le parts should then be restric-
ted by means of portfolio
limits.
The consequences of this ap-
proach are manifold. The
banks’ pricing is based on the
market (transfer prices are by
definition market prices), so
no new, non-hedgeable busi-
ness gets into the books. The
bank starts out with hedging
and securitisations which,
while falling short of being
perfect, will make the loan
portfolio more aligned with
the market. This process will
be similar to the interest rate
hedging practised in the 80s.
Loan business, then, is not au-
tomatically linked to increased
equity allocation since the en-
tire credit risk resides in the
treasury. Banks such as CC
Bank or FinConsum Bank al-
ready achieve outstanding
RoEs by securitising the grea-
ter part of their loan portfo-
lio.
We therefore believe there
will be a renaissance of corpo-
rate business in the medium-
term.
Banks with a focus on SME
clients will need to endorse
this idea of a credit treasury
particularly vigorously since
this is the only way they will
be able to make themselves as
attractive as banks with a re-
tail or large corporate business
focus.
How then to manage
the retail business
of a bank?
After dropping the equity al-
location the retail business is
left without a management
approach linking its results di-
rectly to the use of equity.
What is needed, then, are risk
drivers that result in an alloca-
tion of equity to the retail
business. One cannot manage
a retail bank, for instance, wit-
hout equity, even if the risks
have been hedged using trans-
fer prices.
Our suggestion is to use the
concept of “invested capital”
derived from non-banking
companies: investments are
partially funded with equity
while this equity is allocated
to the business unit as a basis
for calculating the RoE. This
will result in consistent bank
management that allocates
the entire risk business to the
treasury (whose task is to ge-
nerate returns on this equity
within the set risk limits) and
makes the retail business com-
parable with its non-bank
competitors using an RoI ap-
proach. Investment and global
banks are already pursuing
this approach, as can be glea-
ned from the pricing beha-
viour of the markets.
Note
Treasury here is equivalent to
the terms money and capital
market, capital markets, glo-
bal markets, credits and mar-
kets, markets and investment
banking used elsewhere.
This article provides a rough
outline only; more precise in-
formation for translation into
everyday practice is given in
our seminars Risk*Bank and
Banking*College.