The great financial meltdown of 2008 unmasked a truth that management teams at banks and financial institutions had clearly lost sight of: The right side of the balance sheet matters. For many years leading up to the crisis, the financial-services industry by and large dismissed the importance of the right side. This is the part of the ledger that lists customer liabilities (for example, bank deposits and insurance premiums), debt, and capital — the money on hand to fund loans and other assets (the left side). Without the proper blend of liabilities to fund their assets, banks and financial institutions are vulnerable to economic upheavals, during which fearful clients may withdraw their deposits or capital markets may suddenly become unwilling to roll over an institution’s debt — and they risk sharp declines in shareholder value or even total or near collapse. This was the fate of Lehman Brothers, Bear Stearns, AIG, Citigroup, and Bank of America.
Right-side strategies aim to find an effective mix of sources of funding on the right side of the balance sheet, taking into account their cost and duration in good and bad times, to support asset growth on the left side and adequately cover losses in asset values. Through much of the past couple of decades, financial-services firms tended to ignore the right side because they were under pressure both to aggressively grow assets to drive improvements in revenue and earnings and to release “excess” equity to boost returns and enhance valuations. Moreover, the lack of transparency in the valuation of certain complex financial instruments (such as mortgage-backed securities and derivatives) along with loopholes in regulatory capital frameworks — for example, in the treatment of off-balance-sheet exposures — made it easier to neglect right-side strategies. Over time, this approach created elevated risk levels at some firms. In today’s financial-services environment, it is clear that sustainable shareholder value creation (and protection) has as much to do with the right side as with the left side of the balance sheet. In short, right-side strategies matter more now than they ever have mattered before.
To be fair, since the onset of the recession and the subsequent bank bailouts, the financial-services industry has made progress in recalibrating the importance of the right side of the balance sheet. Overall, industry capital ratios have improved. Some firms have reduced their reliance on more unstable sources of funding and increased the stability and duration of their borrowings. Moreover, lending business models that depended almost exclusively on capital markets for funding have all but disappeared.
But most of those changes came in the immediate wake of the worst of the great financial meltdown; the urgency to craft long-term right-side strategies has begun to recede in recent months. And as the crisis mentality wanes and short memories take over, one thing is becoming more and more apparent: If there is another dramatic shock to the financial system, the outcome is likely to be just as devastating to the industry as it was in 2008.
Financial-services firms should consider three types of right-side strategies. They are built, respectively, on changing the company’s portfolio, becoming more client-centric, and using economic capital to help rethink risk and capital strategies.
Shifting the Portfolio
A portfolio strategy involves changing the blend of the company’s holdings through acquisitions and divestitures, or through other types of organic growth across the company’s businesses. When there is a right-side focus, this means increasing the influence of businesses that are rich in client liabilities or that require less capital, as well as shrinking businesses that mostly generate assets and drive up capital requirements.