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Published: November 22, 2011
 / Winter 2011 / Issue 65

 
 

The Right Side of Financial Services

Recognizing the opportunity, Silicon Valley Bank implemented a client-centric strategy in which specialized sales and product teams pursued venture capital customers for both cash management and loan activity. The goal was to develop broader product development capabilities to serve both sides of the venture capital firms’ balance sheets, as opposed to merely trying to provide credit to them. By doing this, Silicon Valley Bank was able to fund its loans to venture capital customers with extremely low-cost and low-risk deposits from other venture capital outfits. In choosing this client-centric strategy, the bank put itself in a strong position with stable, low-cost funding (two-thirds of its deposits are non-interest-bearing) and balanced growth in client assets and liabilities.

This approach is also applicable to large, diversified financial firms, as long as they are willing to develop the appropriate new product and organizational capabilities. A good example of a major company that has begun to adopt a client-centric model in parts of its business is American Express. Long focused primarily on developing new charge and credit card products for its members, in recent years American Express has promoted a new brand called Open, which offers small businesses a wide range of services from credit cards to payments to social networking. By continuing to broaden its suite of offerings to small businesses, American Express may soon be in a position to access new pools of liquidity (for example, small-business deposit accounts) and greatly alter the corporation’s funding profile, perhaps relying less on capital markets.

Rethinking Risk and Capital

Observers outside the financial-services industry have long believed that banks and financial institutions were experts at managing risk and capital; it was generally accepted that their business model was driven by those skill sets. However, the credit collapse revealed that this was not the case. In the decade preceding the global crisis, risk and capital management had become more disconnected at many large banks and financial companies. Chief risk officers and their teams focused on managing risk exposures with little regard for the bank’s capital structure. Meanwhile, the chief financial officers and their teams exploited loopholes in regulatory capital frameworks to continually lower the cost of capital on hand and boost returns while largely ignoring increases in risk.

A framework did (and does) in fact exist for tying risk closely to capital, but its importance was largely ignored. It is a concept known in the financial-services industry as economic capital. This set of algorithms and practices is used to translate a firm’s multiple risk exposures into the amount of equity capital that it needs to protect shareholders against insolvency.

To minimize the chances of another financial-services meltdown — raising the specter of dozens of additional failed banks, big and small — boards and management teams must take the lead and create a new risk culture in which economic capital is the organization’s currency of risk, right- and left-side capital strategies are tightly integrated, and the responsibility for managing risk and capital is broadly shared within the firm. For this to become a reality, several things need to happen: Boards and senior management must become more knowledgeable about right-side strategies and economic capital; economic capital algorithms and systems need to be upgraded to account for new sources of risk; economic capital must be an essential data point in all pricing and investment decisions at all levels of the organization; and performance assessments must factor in the cost of economic capital usage, not just profits. For many banks, this represents a difficult path; it entails a significant upgrade in their risk and capital management capabilities.

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. They have clearly demonstrated that financial institutions can ignore right-side strategies only at their peril. The opposite is true as well. Banks that capably and actively manage both sides of the balance sheet will no doubt be the survivors — the industry leaders — well past the next global financial debacle.

 
 
 
 
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