Financial market catastrophes in the recent past have fuelled banks worldwide to overhaul risk management practices. As Chief Risk Officers (CROs) get questioned on the situational legitimacy of risk processes, for the first time risk management has emerged as the main priority of the CEO. Sumit (2009) introduced a framework for the fundamental yet comprehensive process of capital management, calling it ‘Capital Budgeting & Management Cycle’ (CBMC).

It comprises of six interlinked cross-divisional tasks including capital planning, capital allocation, capital balancing, capital attribution, risk aggregation and performance measurement. These tasks work as a continuous sequence and feed into one another to achieve the end goal of efficient management of bank’s capital and achievement of Economic Value Added (EVA). Credit card

Fig1Capital Budgeting Practices in Quoted-1
Figure 1: A Depiction of CBMC in its Overall Workflow

The tasks 1 to 6 are necessary for ensuring that management of capital in banks becomes logical, follows a process flow and becomes more result oriented – an enabler to attain the end goals. However, a firm-wide risk management mind set and infrastructure is essential for its implementation. This means that risk is treated analogous to capital, and risk taking, exposure management and performance measurement is done with capital as the centrepiece, and all efforts go to maintain its adequacy as well as optimised utilisation.

The cycle starts with long-term planning of capital (done by treasury with inputs on ECAP from risk and regulatory capital from finance) that helps setting budgets for overall group level capital over the planning horizon. Information of capital feeds into capital being allocated to different divisions that are the Primary Allocation Targets (PATs) and from where risk budgets get cascaded down to sub-divisions or different desks. Once allocated, periodic reviews are done to ensure that objectives are getting achieved by business units or it needs to be re-balanced to match performance. As business units take on exposures, measure and control risks, they need to measure the amount of capital on a diversified basis consumed in portfolios vis-a-vis allocated budgets. Using information on capital attribution across portfolios, risk teams aggregate it periodically to find total capital consumption at the level of business units, products, and the group. It leads to a point in the cycle, when ex post performance measurement compares achieved performance with targeted, compares cross-unit performance for compensation and benefit and sets capital planning goals (Sumit, 2009).

According to Acharya and Franks (2009), capital as is used in the banking industry generally refers to bank equity as well as some subordinated kinds of debt. ‘Funding’, in contrast, refers to a bank loans retail deposits, commercial paper and inter-bank loans. This distinction between the two sources of bank financing derives primarily from the regulatory environment, namely capital requirements.

However, when considering a bank’s cost of capital; an economic rather than a regulatory concept, of forms of debt (including retail deposits commercial paper, and interbank loans) as well as equity should be considered to be capital. While banks finance their activities with debt most of the time, debt markets do dry up some of the time, especially when there is an accentuation of credit or liquidity risk (as witnessed in recent times and in past financial crises). When this happens, banks have to raise equity (or, if this is not possible, to seek taxpayer support). At certain times of the economic cycle when the bank is relying on debt capital it may look as though the sole source of capital is based on debt. However, at other points of the economic cycle other sources of capita such as equity will play a greater role. At all times, the cost of capital for banks should reflect the cost of the economic cycle – that is, in both good and bad times.

Even if bank management recognize that a bank’s cost of capital is a weighted average of debt and equity costs, there are two subtle pitfalls in how this recognition translates into implementation. First, banks commonly assume that their cost of equity capital is flat at a level of 10%, along a whole range of leverage in their capital structure. This assumption, we believe, is wrong. Second, measured or reported betas of banks in good times, which often form the basis of bank’s cost of equity, calculations, underestimate the true cost of equity capital

It is easy to see why a bank’s cost of capital is not invariant to its leverage mix, even though this might seem to be the case in certain parts of the economic cycle. Consider a world where a bank’s credit risk were fully priced into its liabilities – that is, a world in which there were Central Bank guarantees (implicit or explicit) and no deadweight costs associated with leverage and default. In such a world, as bank leverage increases, the likelihood of default would rise, raising the cost of debt and the cost of equity; the increase in the cost of debt would, however, be offset by the larger weighing of debt in the capital structure. Since debt consist of the cheaper form of financing, this re-weighting ensure that in the absence of deadweight costs of leverage, the overall cost of capital is invariant to the leverage mix. This is the much – celebrated Modigliani and Miller result from the theory of corporate finance (Acharya and Franks, 2009).

In practice, however, bankruptcies of banks and financial institutions, especially large ones, are costly affairs as bank assets are, and have increasingly become, opaque and their liquidation characterized by significant fire – sale discounts. These discounts reflect a deadweight cost of leverage for banks. In order to avoid these discounts, banks should and do access equity markets for funding before undertaking larger-scale liquidations. Equity issuance, is however, also quite costly, especially given the opaqueness of bank balance sheets. These costs should be priced into the overall cost of bank capital, particularly when considering leverage decision. In principle, this means that, as leverage rises, the cost of both debt and equity rise and so does the deadweight cost of leverage. The overall cost of bank capital should thus increase once leverage and default risk become sufficiently high. By better estimating the cost of capital banks will set realistic capital structures.

However, what explains the deceptively flat cost of debt in good times, which some bankers believe translates into a flat cost of equity and thereby a lower overall cost of capital for a whole range of leverage is that the flat cost of debt is not a reflection of the low business risk of the bank’s assets, but is largely a reflection of the value of the central bank guarantees over some or all parts of bank debt.

The low cost of debt in good times also creates the illusion that the bank cost of equity is also low, albeit higher than the cost of debt. This low cost of equity is usually based on low equity betas, measured only using data in good times, and implies implausibly low levels of business risk. We believe that these low equity betas not only fail to capture realistic estimates of account for the cost of equity in bad times, the latter costs are especially high because of the dilution costs since, as argued above, banks are generally forced to issue, equity only in bad times when there is a certain ‘stigma’ attached to it: accessing equity funding sends an adverse signal to the market that the bank must be in economic value of ‘retained equity’ which in bad times carries significantly high opportunity costs.

Since the flat cost of debt encourages a high level of leverage in bank balance sheets, bank equity is turned into a virtual ‘call’ option on the underlying assets. Thus, it is clear that as leverage increases, the equity of the bank resembles more and more an ‘out-of-the-money’ option on the bank’s assets. At these high levels of leverage, a small change in the bank’s asset value will cause much more than a one-for-one change in its equity value. In particular, a small business loss can wipe out a significant part of the equity value (as witnessed recently), forcing costly asset sales and equity issuance. Put simply, with high leverage, equity is a highly levered bet on a bank’s assets.

This view of equity is important because it implies that bank equity will have a low beta in its assets (and thus on the markets) in good times when the equity options is essential in-the-money’, but a much higher effective beta in bad times when the option is out-of-money (Acharya and Franks, 2009).