Punishing Capital – why capital creation is critical


Ewen Fleming

Ewen Fleming

Partner - Financial Services Advisory


In my recent white paper, The Circle of Life, I explored the four forces of change that are impacting Banking and the wider Financial Services sector and that should be considered when developing risk mitigation strategies.

  • Capitalisation: having insufficient reserves to deal with downturns or incidents within prescribed tolerances to avoid the taxpayer bailouts of the past.
  • Regulation: increased regulation from several organisations domestically (Bank of England, Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA)) and internationally as well as the fines and penalties they can levy to organisations that they deem as non-compliant.
  • Competition: particularly from those embracing technology and new business models that appeal to consumers who are willing and eager to self-educate and self-serve online.
  • Obsoletion: the opposite of Futurism or investing in science & technology to safeguard your future, leading to long term decline that cannot be reversed.

Looking in more detail at capitalisation, how can firms bolster and preserve capital so that a lack of capital does not become a punishing vulnerability? Furthermore, and just as vital, once a course of action has been agreed, are all the consequential changes and how they will be implemented & effectively managed within the business fully understood?

Why is capital critical?

Since the last banking crisis, a decade ago, the capital requirements of banks operating in the UK have been overhauled to reduce the risk of failure and to avoid any repeat of the government bailouts of the past.

The amount of capital a bank needs is calculated by adding together three pillars:

  • Pillar one: the basic minimum capital required based on credit, market and operational risk.
  • Pillar two: the regulator’s assessment of bank specific risk. It's a qualitative measure that looks at the bank's size, maturity and operating history.
  • Pillar three: the amount required to support future growth.

Metro Bank’s recent miscalculation of the capital it needed to support some of its commercial lending highlights the importance of the three pillars and the additional capital it now requires to continue its ambitious growth programme.

There are a number of options available when considering how to adjust the level of capital within an organisation, from issuing new equity to lowering the risk profile. 

Option A: Issuing new equity

New capital can be raised by issuing new equity, such as through a rights issue to existing shareholders, an equity offering on the open market or placing a block of shares with an outside investor. This is often unattractive to existing shareholders given that a new share issue tends to reduce the market value of the existing shares. As such it tends to be a crisis measure if it is purely to boost capital for business as usual, as opposed to fund an investment such as an acquisition.

This route is not open to building societies, although Nationwide Building Society raised £500m in December 2013 through the issue of a class of shares called Core Capital Deferred Shares (CCDS). The CCDS class of share allowed Nationwide to retain mutual status and get around the limitations of member ownership where investors get only one share regardless of the amount they invest. It does however mean that, as the most junior-ranking investment, CCDS investors sit behind all other depositors or creditors.

Option B: Retaining profits

Whilst boosting profits would be the way favoured by most organisations it is not always easy and there is also the option of seeking to reduce the share of an organisation’s profit it pays out in dividends. For most traditional banks the key component of their profitability is NIM (Net Interest Margin i.e. the spread between the interest rates it charges for loans and those it pays on its funding). This is why this comes under scrutiny as a key measure of banks’ performance. Whilst marketplace dynamics and competition largely set the parameters for what banks pay for customers’ savings and what they will pay as debit interest on their mortgage, credit card or overdraft facilities, organisations that are cost efficient have a natural advantage to offer more attractive rates or to take a greater spread to profitability than their competitors with a higher cost: income ratio. Coventry Building Society pride themselves on their low cost model and use that advantage to consistently pay amongst the highest savings rates in their sector to reward their members and honouring their mutual status.

Prior to the crash non-interest income formed a greater proportion of banks revenue and profits. This category included fees or commissions relating to pensions, investments, protection products and packaged current account fees. Given the raft of mis-selling cases and fines in the last decade the sources of non-interest income are much curtailed although many banks are cautiously looking at how they can compliantly increase the range of fee bearing products to meet customer needs. Both Santander UK and NatWest have launched robo-adviser investment offerings as a toe in the water to offer a wider range of products and reduce their current reliance on NIM.

Given the plethora of headlines on branch closures and headcount reductions clearly the focus on reducing operating costs and cost: income ratios is very much in vogue, not least to leverage the increased consumer demand for digital products and self-servicing their immediate requirements.

Option C: Shrink the balance sheet

Another choice open to institutions is to change the asset side of their balance sheet. This can be achieved by running down their loan portfolio or selling assets or books and use the proceeds to pay down debt. Recent examples would be Metro Bank’s proposed sale of part of their loan book and Tesco Bank exiting mortgages and selling their existing book. These actions can be primarily driven by strategy as much as to free up capital. An asset sale can also boost capital by way of an accounting gain if the assets attract a higher price than purchase price/ book value.

Less abruptly, institutions can slow lending growth, thereby allowing retained earnings and hence capital to catch up. New assets carry an acquisition cost and can take time to reach break-even and create a profit. 

Option D: Lower their risk profile

Risk adjusted capital can be bolstered by an institution reducing its risk-weighted assets by replacing riskier (higher-weighted) loans with safer ones, or with government securities. It is for this reason that many banks, and challenger banks in particular, given their more stringent capital requirements, favour loans to residential property instead of commercial property. It is also why lending rates are generally lower for residential property, recognising the greater demand by lenders for these assets and the lower risk weighting built into their pricing.

Key take-aways

If we learned anything from the financial crisis a decade ago it is that the banking sector does not work in isolation. The financial ecosystem is complex and is both affected by and affects the wider economy. The intimate relationship surrounding the role of banks within the ecosystem should not be dismissed. They need to navigate a finely charted middle course through stormy seas of inflation or deflation, employment, centrally set interest rates, housing market fluctuations, money supply, stock market prices, amongst many others.

The choices made as outlined above have a strong linkage to the macro economy. For instance, if banks seek to slow lending, or reduce lending to riskier projects, this could constrain investment by consumers and businesses with a knock-on impact on the economy. There is evidence post the banking crisis in 2007-2009 that tighter bank lending standards reduced bank loan supply, even whilst demand was high, resulting in a slowdown in lending growth.

It is unlikely that any one action to boost capital will be done in isolation and choices B to D will all require a holistic view taken, both of the desired impact on capital, and the consequential impact on the organisation and its ability to operate effectively. This holistic view should consider changes required to the future business model and the impact this has on distribution and operations. The Operating model should be revisited, and in particular where costs and controls sit. Given the importance of Senior Managers & Certification Regime (SMCR) this needs to be fully understood and mapped. Any changes must be undertaken in a reasoned and controlled fashion with consideration given to impact on the organisation’s three lines of defence.

If you want to discuss any aspect of the design and translation of your proposed change then please get in touch with me.