Regardless of the asset size, all successful financial institutions share common factors that play into their success. Recognizing, understanding, and managing each of these factors can aid financial institutions in their strategic planning to reach their financial goals. ALM First has identified six factors, or levers, of high performing institutions: capital, pricing, funding, management, risk, and profit. In this article, we will define each of these levers and their impact on the balance sheet to in order to understand how to strategically push down or pull back combinations of these levers to optimize balance sheet profitability
With increased focus on risk based capital (RBC), financial institutions are faced with balancing regulatory, dual-capital mandates; the efficient allocation of capital becomes a critical part of capital management. Capital must always account for the institution’s allowance for loan loss, but the capital must also suffice in covering any additional expected or unexpected losses. Capital plays a key role in reducing systemic risk and protecting depositors and insurance funds.
With capital such a vital part of the institution’s health, shouldn’t the institution ensure it holds a large amount on the balance sheets? A large holding of capital provides needed protection and supports the strength of the institution. However, holding excess capital can be expensive if it isn’t deployed in a timely, efficient manner. In this position, the institution must take on additional risk in order to match the same return on equity (ROE), all else equal, from the additional deployment of resources.
With this in mind, the institution must wonder: what is our optimal capital position? Like many questions, the answer is ‘it depends’, as this is best determined by the risk on the balance sheet. Higher levels of risk demand higher capital reserves. As such, the goal will be maximizing ROE while efficiently managing risk-based capital (RBC).
Several examples can be helpful. In situation one, loan demand slows leading to a shift in balance sheet allocation from loans into the investment portfolio, but there is no change in net worth. Resultantly, RBC will be higher while ROE will be lower. Instead in scenario two, the institution leverages the balance sheet to fund mortgage loan growth. The net worth ratio and RBC will fall, but ROE will be higher (given beneficial borrowing costs). Combining these ideas can maximize profitability.
Proper pricing is a second lever necessary in constructing a robust balance sheet. Any balance sheet is limited in its capacity to add assets, and, as such, an institution must be smart in allocating capital. Part of the process in choosing allocations is to determine pricing strategies that can maximize value. Another advantage of strategic pricing is that a quantitative ROE approach removes emotion from the decision making process. The following chart shows various loans and their corresponding marginal ROE rankings:
It is uncommon that an institution has full freedom in choosing the quantity of every product type. Therefore, it is imperative not to overcompensate by expanding one loan sector on behalf of other unattainable products. The value of indirect auto loans, for example, due to high dealer fees and market competition, is significantly lower if those loans are not priced appropriately given risks and costs; if the institution cannot obtain appropriate compensation for the associated risks and costs, holding those loans on the balance sheet should be critically considered.
The ability to reduce the cost of funding to the lowest level possible is another defining characteristic of high performing institutions. The typical balance sheet funding sources are core deposits, time deposits, brokered deposits, and borrowings. Exploring alternative opportunities, like dollar rolls, can prove lucrative due to their lower attainable costs. In fact, there have been instances in which the implied financing rate has actually been negative for some dollar roll collateral and coupons. The institution, in other words, was able to borrow funds at a negative rate – a tremendous benefit to the overall cost of funding.
Having a proactive and engaged management team is another defining element for high-performing institutions. Thoughtful management teams encourage new ideas and different approaches, as they are always seeking new opportunities. Evaluating potential scenarios, both low and high risk, is a healthy and encouraged practice for management teams to better recognize opportunities for their inherent risks and probable rewards. Such evaluations require quantitative analyses, pushing aside imbedded biases within the institution. Then, once management reaches a prudent decision, it must be able to design a process with an efficient implementation.
Risk is a factor that shouldn’t be avoided, but it should be strategic in its methods of managing risk. Profitability, after all, almost always requires taking on some degree of risk, whether that be credit, liquidity, interest rate, optionality, or idiosyncratic risk. It is easy for an institution to appropriately avoid one type of risk, unaware that it has added another. The institution must evaluate each type of risk depending on the asset and ensuring it is receiving proper compensation.
Finally, the institution must consider how shifting these levers impacts profits. Profits build capital, establish reserves, and provide value to the institution. The institutions maintain viability by generating value for stakeholders. Net income takes into account both above- and below-the-line items.
In conclusion, it’s imperative that institutions not only identify and understand each lever of a high-performing institution, but also be able to discern which levers should be used together. Maximizing performance is accomplished by evaluating all levers on the balance sheet and knowing when to shift into high gear or pull back.