On Risk & Capital Allocation In Commercial Banking

Most people have little notion of how capital is treated inside a commercial bank. While regulators and those concerned with systemic risk want banks to hold as much capital as possible, those inside the bank want to operate on as little capital, especially equity, as possible.

Like every other business, banks are sensitive to the costs of capital, and, following basic economics, which is about rationing scarce resources, their managements want to use the absolute minimum to do their business.

Back in the late 1980s, RAROC (Risk Adjusted Return On Capital) was developed at Bankers Trust's. It is, or was, the original risk management tool for bank capital allocation. From it, and its design team, flowed many of the modern variants of VAR-style risk metric systems in financial services firms.


While working on resource allocation and productivity at Chase Manhattan, it was necessary to address risk capital. Thus, I retained the developer of Bankers Trust's famous RAROC model, Philippe Geneste, as a consultant to assist us in introducing the concepts into resource allocation at Chase, as well as to better understand its likely ramifications on business unit operating decisions and overall bank profitability.


There were, and are, fundamentally two methods to internally adjust for risk. One is to raise required rates of return for businesses, on notionally-allocated capital. The other is to use some variance-based approach to allocate more capital to riskier businesses, where risk is defined by greater variances in returns, or losses, of the business.


When dealing with risk, internal capital and allocation, one rapidly runs into a conundrum. It was on display yesterday morning on CNBC, where a guest, no less than Bill Gross of PIMCO, was opining on the need to make banks carry as much capital as possible to mitigate risk.


Here's the problem.


Internally, business units decline to accept capital allocations. They will claim to not need as much as is allocated. But, from a corporate viewpoint, the regulatory-mandated capital has to be allocated. Otherwise, one is in the position of having unallocated, in effect fallow capital. Capital that has been raised and is being paid for, whether through interest or implied total return to shareholders.


In the normal course of business, probably 95% of the time, that added regulatory capital buffer is unnecessary. It constitutes a drag on bank earnings and returns to shareholders.


Of course, in rare circumstances, like those of late 2008, losses in various units of a bank can skyrocket. But, when those so-called black swans appear, even the excess regulatorily-mandated capital levels are unlikely to be sufficient to absorb the losses.

If you look closely at a commercial bank, such as Chase, you'll see that even today, it's common equity/total assets ratio is only about 8%. An incredibly thin wedge of pure equity is in that ratio, as preferred equity outweighs common by about 10:1.

It doesn't take a genius to see how fast a commercial bank can lose substantial equity and become insolvent from a particularly big valuation hit in one or two businesses.

Yet, if regulators force a commercial bank to carry more equity, they inevitably depress profitability and returns. Bank CEOs want to believe their institutions can offer total returns which are competitive with industrial firms. But, if regulators have their way, this can't and won't be true.

Like it or not, fractional reserve banking systems and commercial banks' participation in modern capital markets as publicly-owned entities virtually guarantees that big risk mistakes on their part will quickly lead to insolvency. The banks won't carry more capital than they are forced to, yet, given the risks they take, they are occasionally going to burn through that thin wedge of equity.

Debating about a few percentage points of capital won't really change that.