Delivering shareholder value amid complex regulatory and supervisory landscapes
By Mohamed Azzim Gulamhussen, Professor of Financial Institutions at Vlerick Business School
In the aftermath of the financial turmoil, banks have been facing significant challenges to accommodate the increasing complexity of regulation and supervision, and at the same time create shareholder value. These external pressures from regulators, supervisors and shareholders will have a critical influence on the way in which boardrooms define their strategies and bank managers transform these strategies into effective business models. Ultimately, banks will need to remain competitive in the market whilst being responsive to regulatory, supervisory, and shareholder pressures.
In the years to come, regulators will be looking to ensure the stability of financial systems through complex demands on capital and liquidity, and supervisors will strive to promptly predict any eventual breach in the implementation of such demands.
The introduction of heightened requirements for capital (stress tests, changes in the standardization of risk-weights, limits on the use of internal models, implementation of leverage ratios, and countercyclical and systemic capital buffers) and liquidity (implementation of the coverage and net stable funding ratios) is intended to safeguard the stability of the financial system from future financial turmoil.
This complex set of regulatory and supervisory mechanisms implies a potential higher cost of capital compared to the return on equity, and thus challenges the creation of shareholder value and the attraction of capital.
Shareholders will be looking for returns that are proportionate to the level of risk of their investment in a setting in which regulatory mechanisms (capital buffers and stress tests) may also limit dividend distribution and share repurchases; and resolution mechanisms (capital buffer for bail-in and simplification of bank structures) no longer guarantee minimum payoff for their equity. Moreover, the complex set of regulatory and supervisory mechanisms being put into place may have unintended consequences on the functioning of capital markets, for example, they may limit banks from using dividends and share repurchases as signaling and agency cost reduction instruments and thereby reduce the potential to attract external financing in the form of debt and equity.
It is in the midst of this complexity that shareholders will be demanding both that boardrooms define strategies and managers implement business models that will ultimately deliver value that is proportionate to the level of risk of their investment. This is notwithstanding the wider regulatory and supervisory agenda that includes eventual fines banks may have to disburse in case of infringement of money and capital market rules by their employees.
Boardrooms will need to reconsider and redesign their strategies. First, they will need to take stock of their technical, market-making, managerial and human, technological, and capital resources to define the strategies for their banks. Second, they will need to assess the geographic and product segments in which their resources are likely to be most effective in terms of delivering shareholder value. Third, they will need to identify the most appropriate channels to service customers.
Managers will have to translate the strategies designed by their boards into effective business models. This involves selecting an appropriate balance sheet (namely capital, asset and funding structures) and consequently income structure that is consistent with the resources possessed by banks and the strategic orientation given to them by their boards.
Bank business models most often encompass retail, wholesale or capital markets. In the retail model, banks secure funding from stable sources, namely customer deposits or long-term debt, and provide loans to customers. In the wholesale model, banks secure their funding mainly from the interbank market and provide loans to corporate and retail customers and other interbank market participants. In the capital markets or trading or investment model, banks secure their funding primarily from wholesale markets and hold a significant amount of tradable securities.
The categorization of business models is broad and in practice banks maintain their involvement in a mix of models to cater to the needs of their customers with one model predominating over the others. The business model adopted by a particular bank is determined by the composition of loans, securities, trading book and interbank lending on the asset side, and deposits, short-term debt, long-term funding and interbank borrowing on the liability side.
The model selected by the bank will determine its performance, return on assets (ROA) and return on equity (ROE), and risk, the volatility of earnings and the Z-score (the capital to asset ratio plus the equity to total asset ratio divided by the standard deviation of the ROA). These metrics may be elaborated to consider risk-adjusted performance, namely risk-adjusted return on capital (RAROC). These backward-looking, or balance-sheet and income-statement, metrics are key components that markets and rating agencies factor in establishing forward-looking metrics of value, the market to book value (Tobin’s q), and the excess market value (difference between the q of the bank and the q of comparable banks), and risk, the expected default frequency (EDF) and the credit default spreads (CDS).
Extensive empirical analyses are required to determine the model or mix of models that will deliver shareholder value for a proportionate level of risk and guarantee financial stability. Nevertheless, it is important to remember that a business model or mix of business models that may outperform others at one point in time may not necessarily do so at another point in time.
The implementation of the regulatory and supervisory mechanisms may also vary from one jurisdiction to another. This points towards the predominance of one business model or mix of models in certain jurisdictions and the opportunity for geographic diversification, and therefore calls for further oversight from supranational ombudsmen, in particular with respect to grey zones, i.e. parts of jurisdictions that do not fall under the home and host country oversight. The banking union in Europe also aims to address this issue.
Creating shareholder value that is proportionate to the level of risk amid the complex regulatory and supervisory landscapes is indeed a tough challenge. Banks have shown over time that they can adapt to the changing regulatory and supervisory landscapes. With the right strategies and appropriate mix of business models, boardrooms and managers will deliver shareholder value to their investors not least because it is through value creation that they will guarantee the long-term sustainability of their banks.
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