Magazine article The Journal of Lending & Credit Risk Management

Rebalancing Act

Magazine article The Journal of Lending & Credit Risk Management

Rebalancing Act

Article excerpt

A bank - or any financial services company - is made up of a number of business units. These business units, in effect, make up a portfolio. Each of the bank's business units within the portfolio has a natural momentum reflected in the way the bank does business. Customers, products, markets, margins, and revenues will grow or decline unless management acts to change the momentum of its businesses. Managers have, as well, another option: to change the mix of these business portfolios, to emphasize or deemphasize a business, or to add new businesses. This strategic management concept has always been the case and is so obvious as to seem simplistic. Yet why have only a select few banks been highly successful in consistently rebalancing their business portfolios and thereby creating sustained earnings and shareholder value?

It appears that strategic management in these banks is consciously focused on shaping, adding, or pruning portfolios as competitive and market circumstances dictate. Such portfolio management goes far beyond evaluating a business on return on assets, return on earnings, or materiality. It goes to the heart of strategic decisions:

* Understanding how trends affect the momentum of each business - growing or declining.

* Understanding how trends create new portfolio opportunities - and therefore how and when to take action.

Unfortunately, most banks do not apply the concept of portfolio management and balancing as a core activity in their strategic planning.

There are five activities necessary to understanding and using portfolio thinking as a key to developing management strategies:

1. Identify business portfolios.

2. Understand the momentum in these business portfolios.

3. Recognize how industry forces and competition affect the longevity of business portfolios.

4. Develop an explicit or implicit decision process that handles the problems of trade-offs and decision timing.

5. Commit to a speedy search for and aggressive development of new business portfolios.

Portfolio Identification

The first step is to classify each of the bank's businesses according to the way that business generates its earnings and how it uses capital. This requires disaggregating the bank in a way that is quite different from traditional earnings models. All banks (and all financial services companies for that matter) generate earnings from three sources [ILLUSTRATION FOR FIGURE 1 OMITTED].

Deposit intermediation businesses are those associated with the traditional business of taking deposits and making loans. The primary revenue focus is net interest margin, but fees from loan transactions and deposits are also included. These businesses are "on-balance-sheet" and require capital leverage.

Capital markets businesses include trading for the bank's own account, securitization, merchant banking, placements, hedging and swaps for customers, and so forth. Such activities typically occur off-balance-sheet and have no impact on net interest margin. If the bank is trading on its own account, there will likely be some effect on net interest margin. These businesses can be financed with deposits or market funding and are on-balance-sheet and capital using, or they can be entirely market funded (for example, securitization), be off-balance-sheet, and require minimal capital but substantial risk-mitigation activities.

Fee and specialty intermediation businesses include types of businesses such as consumer finance, credit card processing, and asset management. These specialty intermediation businesses are market funded and when on-balance-sheet use capital and balance sheet leverage. (When deposit funded, these activities are properly part of deposit intermediation businesses.) But most of these specialty lending businesses are off-balance-sheet with loan originations rapidly securitized or placed. The fee businesses require little capital but do need strong risk mitigation and controls. …

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