Capital Management for Banking: Dawn of a New Era

Abstract

The current regulatory environment requires banks to hold capital not just on the current portfolio; they’re also required to plan capital for the next three years. Banks carefully identify the way their businesses, projected revenues, losses, reserves and capital levels will evolve under adverse macroeconomic scenarios. The quantum of capital needed will be progressively increased from 8 percent in 2013 to 10.5 percent in 2019. To ensure maximum loss absorbency of capital during times of stress, the level of Core Tier 1 equity capital is raised to 4.5 percent out of 8 percent minimum capital. Banks will face much pressure to sustain return on equity targets as the level of capital needed substantially increases and as curbs are placed on the activities a bank can engage in (for example, rules that separate traditional commercial banking from investment banking, private equity and proprietary trading). In response, banks will need to efficiently plan and deploy capital and funds to achieve the profitability targets. This paper provides banks with an approach to managing capital that will enable them to proactively steer the vital components of the strategic plan – product mix evolution, revenue growth and risk appetite. It postulates that banks must manage the strategic planning life cycles in tandem with risk appetite and forward capital position. Forward capital position should not create a huge capital surplus or a deficit. This paper illustrates ways to make capital management – that is, forward-looking planning and short- to mid-term utilization – more efficient and more oriented to risk-adjusted performance measures.