Can European banks crack the capital allocation code?

Even when trying to distinguish themselves from the pack, Europe’s banks can’t seem to avoid groupthink.

HSBC is in the middle of a major strategic review called ‘Project Oak’, which sounds a lot like ‘Project Oak Tree’, former Deutsche Bank chief executive John Cryan’s failed effort to revitalise Germany’s largest lender. By the time Cryan was ousted, Deutsche had embarked on another review of its investment banking operations, dubbed ‘Project Colombo’.

Behind the never-ending cycle of cryptically codenamed strategic reviews, banks are asking themselves some profound questions: what are they good at; where do they have an edge over rivals; and what kind of a business do they want to be?

The difficulty lies in putting these strategic plans into action. Gone are the days when banks were free to allocate capital to business lines as they saw fit. In an overarching regulatory era, banks must meet a battery of capital, liquidity and funding ratios, with enough of a cushion to pass supervisory stress tests. For the largest banks, there is also a capital surcharge, which takes into account factors such as size, complexity, interconnectedness and substitutability.

With so many constraints, banks have limited options for differentiation.

“We are all stuck on the same feedback loop,” says a capital manager at the US subsidiary of a European bank. “You end up crowding into the products that are capital-friendly, and we will never know what happens as a result of that, until it happens.”

To simplify matters, most large banks are using blended capital measures that combine the various regulatory charges into a single figure, which can be tailored to the bank’s binding constraints and risk appetite, and then used to set return hurdles or capital limits on business lines. One bank puts more emphasis on regulatory measures of market and credit risk, but downplays Basel’s operational risk capital requirements. Another puts more weight on stressed losses when setting return hurdles.

The blend can either be applied uniformly across business lines or in a differentiated manner. This is where the broader strategy comes into play. Return hurdles and capital limits can be adjusted to encourage or deter certain activities, and steer the firm towards its strategic goals.

The whole process is more art than science, and US banks – which are generating an average return on equity (RoE) of 12% – seem to be better at it than their European cousins, whose RoE comes in at a measly 6.5% on average.

European banks may need to refine their internal capital measures and be more disciplined in applying them. Too many are holding onto ‘trophy businesses’ and blue-chip clients that no longer generate much in the way of returns.

“The metrics can be quite complex, but it is probably the case that across the industry a large chunk of what goes on has real structural profitability problems,” says Adrian Docherty, head of financial institutions group advisory at BNP Paribas. “If that can’t be repriced and there are no ancillary revenues to justify it, then you have to ask why you are in this business.”

Banks that shy away from this question are storing up trouble – raising capital will become increasingly costly for organisations that have a record of using it poorly. A new crisis could make this an existential issue.

“I’d like to tell you we’d cracked the code, but we haven’t. Can we knowingly double down on something to catch up on P&L, or do we take the portfolio approach, try to diversify risk management and take the risk somewhere else? Or just forgo the opportunity?” says the capital manager at the European bank’s US subsidiary. “These are the kind of discussions we are having.”