Capital OptimizationRealign your operations to limit the capital squeeze

2

Banks are experiencing unprecedented pressure: from earnings erosion, on one hand, to rising operating costs on the other. This pressure is increased by the raft of new regulations, spearheaded by Basel III, which will increase requirements for both regulatory and economic capital and drive up capital costs. Current turbulence in the markets has led to higher operating costs and in turn to changes in the overall business strategy, to protect shareholder value and improve business performance. Capital is now a precious resource, critical to the survival and growth of banks.

A bank’s balance sheet provides the best place to see how capital is utilized. The balance sheet illustrates the income flows generated, the assets that generate the income, and the liabilities that provide the funding for the bank. In the process of delivering shareholder value (equity) the bank must provide sufficient loss absorption. The Tier 1 Capital Ratio, which captures and measures the threats to the potential income flows of the bank, completes the picture of the way the bank is geared to meet its strategic objectives.

The performance of most banks on most components of the balance sheet is compressing into a fairly narrow range, but there are a number of opportunities for banks to achieve competitive differentiation through their capital structure and utilization (see Figure 1).

Under the new regulations such as Basel III, capital requirements will increase significantly for market risk, reflecting Credit Valuation Adjustments (CVA) for all global banks and changes in risk weighting for certain securitizations. The average Risk Weighted Assets (RWAs) increase for Basel III is estimated to be up to 40% before mitigation measures [Source: J.P. Morgan Research - Global Investment Banks: Investment Banking wallet outlook - all eyes on equity derivatives, Global Equity Research 08, September 2010].

We recognise that financial institutions need to achieve the right balance between performance and risk in the post credit crunch environment by adopting new strategies, such as short deleveraging (reducing risky assets) followed by a return to a leveraging phase and a race to take on risk; or a securitization exit strategy; and /or restrained growth, meaning that financial institutions could limit their balance sheet size and curb leverage. Regardless of the strategy each financial institution follows, we believe banks can protect their capital from further regulatory demands by improving the operational performance on all business processes involved in managing RWAs.

Banks face an equally challenging task in defining a new capital supply strategy, as they face demands from the regulators for adequate funding planning and as the markets increase the cost of funding. Banks’ senior management and boards have initiated changes designed to maintain oversight over the liquidity position of the bank and the sign-off of regulatory reports. However, challenges still persist in establishing a forward-looking, firm-wide liquidity risk appetite and aggregated liquidity position for the bank.

One of the innovative ways financial institutions can contribute to managing the regulatory capital demand and protect shareholder value is to develop and implement a capital optimization strategy by identifying and redesigning inefficient activities within the capital management process. We estimate an average bank could increase its Return on Equity (RoE) to a range of 17 to 20 percent (a three to five percentage point uplift) and a front office to back office risk management operational efficiency target of Cost-to-Income Ratio (C/I Ratio) of less than 60 percent [Source: Based upon research work and analysis completed by Accenture Risk Management in 2010 using publically available analyst information].

The Capital Optimization drive – Can banks avoid the capital squeeze?

3

Income ~10%

RoE ~15%

Cost /Income Ratio ~65%

Tier1 Ratio ≥ 10%

Leverage ≤ 25%

Perf

orm

ance

Cons

trai

nt

Opportunities for performance uplift

3.

Revenue Growth ~ 8 %(*)

The industry converges on the performance targets and constraint coefficients. However, there are opportunities to increase the numerator and reduce the denominator.

(*) Target average figures based on analysis by a pool of banks – Risk Management Research

1. Improve RoE vs RARoC• Current RoE is under threat for a number of LoBs (Lines of Businesses)

2. Improve C/I ratio on revenue path processes• Potential to improve C/I Ratio to ≤ 60% for client capture & risk management processes• Potential to improve C/I Ratio by process realignment and integration• Potential to improve C/I by IT infrastructure refresh

3. Reduce / Contain Tier 1 Capital• Reduce Tier 1 Capital by improving Credit Risk RWA (process/data)• Redefine core and optimize non-core activities • Further reduce RWA Capital by driving “operational excellence” – optimum business control framework

Figure 1: Balance Sheet Structure

4

This contribution can be achieved using three levers (See Figure 2):

Lever 1: Operational Excellence for RWA processes The RWA processes include a number of processes which have direct and indirect impact on the RWA of the bank and cover front, middle and back office operations:

• Achieve operational excellence for processes that have a direct impact on regulatory capital release such as collateral, hedging, netting, counterparty limits, client on-boarding and others

• Improve effectiveness in line with risk mitigation and business strategy

• Improve accuracy of RWAs, as regulators will recognize and reward operational risk management of risk mitigation processes and risk oversight including CVA monitoring, wrong way, and risk concentrations

Operational excellence in these areas creates a risk management environment which enables the financial organization to reduce its RWA by containing any capital increase due to CVAs and from changes in the risk weighting for certain securitizations, while aligning the organization to its business strategy, for instance by readjusting its securitization strategy and repositioning itself for the development and launch of new products.

Lever 2: Cost-of-Capital to pricing strategyThe pricing strategy of a bank is intricately dependent on having a holistic understanding of the Cost-of-Capital for serving a client’s needs:

• Manage counterparty risk performance

• Increase product/asset return (Return on Asset/Return on Equity)

• Lower cost of execution and servicing a deal

These initiatives help provide an efficient and effective client management workflow, delivering consistent global pricing for clients and truly reflecting the Cost-of-Capital in each transaction.

Lever 3: Operational Realignment – Efficient ProcessesThe operational costs of a bank can have a major negative impact on the profitability and capital reserve demands:

• Improve operational efficiency to reach C/I Ratios of around 40%

• Improve data quality on front-to-back processes for calculating market and credit risk, which will lead to RWA reduction

(*) Target average figures based on analysis by a pool of banks – Risk Management Research

Linking Cost-of-Capital to Customer Pricing

OperationalRealignment for Efficient Processes

Operational Excellence on RWA Processes

Leverage ≤ 25%

Income ~10%

Revenue Growth ~ 8 %

RoE ~15%

Cost /Income Ratio ~65%

Tier1 Ratio ≥10%

Perf

orm

ance

Cons

trai

nt

(*)

Balance Sheet Structure

Figure 2: Capital Optimization and Three Lever Framework

5

6

The proposed approach provides enough flexibility for banks to tailor the elements to their own environment and select the levers that will deliver maximum return given the current state of their organization.

Lever 1: Operational Excellence for RWA processesAnalysis of the effectiveness of the processes involved in the calculation and management of RWAs shows that in most organizations, processes are disconnected and important risk measures are lost during the RWA calculation and attribution, creating a type of data leakage. The problem becomes more acute in reviewing certain asset types (such as OTC products and collateralized portfolios) and when specific risk mitigation strategies are applied.

There are a number of processes which can help release RWA Capital and which play a direct or indirect role in RWA measurement.

Within the wide range of RWA processes we believe financial institutions should concentrate on those processes which are associated with RWA intensive assets (such as OTC products) and place particular emphasis on the way collateral strategy, growth and volatility are executed throughout the organization. This will help establish the linkage of collateral processes to operating risk. Figure 3: RWA Process “Heat Map”, identifies the processes and associated services requiring operational excellence.

Another area of RWA improvement is the processes associated with market risk and the contribution of CVA. The seamless integration and high business performance of front office (CVA pricing, wrong way risk) and middle office are critical in delivering improved RWA ratios. This operational excellence performance should be assessed via a number of key performance indicators, such as the percentage of term sheets generated after execution, the percentage of trades or transactions not booked on trade date, and the number of trades which have been amended, among others.

Basel III provides an additional incentive to reach the point at which regulatory capital can be released by improving operational performance in areas such as margining management, back-testing, and stress testing. This provides further input into the process areas and the needs of financial institution to enhance their capabilities and performance. This performance uplift may include: flow product confirmations issued by T+2, structured products confirmations issued by T+4, the provision of cash forecasts to treasury by the agreed cut off, queues that impact posting to books and records cleared on T0, margining and collateral principle timely drawn, Sign off Trading Balance Sheet on T+1 and Backtesting completed T+1.

An opportunity exists for financial institutions to improve their RWA efficiency by focusing on the weak link processes in the RWA calculation. Evaluating current operating models in the aforementioned areas can provide an RWA boost to help counter forthcoming regulatory demand for higher levels of capital.

Lever 2: Cost-of-Capital to pricing strategyAn analysis of client performance against product profitability and risk contribution will highlight areas of RWA performance to be addressed.

A tighter focus on client portfolio performance with target profitability will identify the products with the potential for increased earnings, leading to the possibility of releasing more regulatory capital through improved RoA and RoE. There are a number of key performance indicators (KPIs) that can be applied to operations from customer on-boarding to customer reporting, and from trading to counterparty credit risk, which can clearly mark the path to releasing more capital. Key indicators include:

• Percentage of clients not on-boarded two days prior to trading;

• Percentage of trades booked without full legal documentation;

• Percentage of trades without valid counterparty ID at trade execution;

• Percentage of credit approvals not obtained prior to execution;

• Percentage of term sheets generated after execution;

• Percentage of trades (or transactions) not booked on trade date;

• Percentage of trades which have been amended; and

• Percentage of proprietary and relevant client positions not valued at the end of each day.

The Levers to Unlocking Capital Optimization

7

Sales & Marketing Services Pre Trade Service

1. Distribution Services 2. Product Sales 3. Client On-boarding

4. Client Analytics 5. Client Services

6. Research & Analystics

7. Connectivity

Reference Data Services

Counterparty/ ClientData & Documentation

Product Data

Books / Cost Centres& Hierarchies

Market Data

Calendar / UserPermissions

Firm Wide Management & Control Ledgers & Stock Record

27. General Ledger

26. Sub-ledgers

25. Stock Records

24. Funding & Financing

22. Consolidated Firm wide Reporting (Reg / Fin)

21. Collateral & Margin Management

23. EOD Risk Aggregation

Post Trade Services

17. Lifecycle Event Management

18. Transaction Management

19. Clearing & Settlement

20. Asset Services

Trading & Valuations Services

14. Trade Capture & Amend

11. Market Making & Quote Management

8. Deal Structuring

15. Position Management

12. Order Management

9. Quote Management

16. Risk Management

13. Execution Services

10. Pricing & Risk Analytics

Figure 3: RWA Process “Heat Map”

8

Process realignment in areas such as product control, operations, finance, risk, treasury, compliance and technology will also yield higher profitability for banks. Key focus areas may include late trade booking percentages, OTC trade ISDA (International Swaps and Derivatives Association) “orphans”, and the daily dollar amounts of disputed margin calls. Finally, moving the business validation rules for downstream finance and risk processes to the upstream trade booking process will enable straight through processing. This can eliminate additional operational activities due to trade errors or operational inefficiencies which may result in lower operational costs and improved effectiveness in the RWA performance.

Establishing a clear view into the cost of servicing a client — and understanding the performance of organizations and processes involved in client management and deal servicing – can yield a significant return on investment, which in turn can play an important role in developing strategy for a bank or other financial service organization.

Lever 3: Operational Realignment – Efficient ProcessesThere are multiple dimensions to each operation that could be optimized, and the measure of their performance must be linked to the KPIs defined through the bank’s capital optimization strategy.

ProcessesWe have discussed a number of processes which play an important role in both reducing RWA and increasing client profitability. Developing a cross-asset operation strategy is critical in achieving these goals. Other opportunities, however, may be available to pursue further improvement in the RWAs and client profitability value chains, including improving the operating model by redistributing skill sets, reengineering business processes, changing workforce locations and strengthening IT infrastructure. Although it will be difficult to provide a standard template for achieving operational efficiency for all organisations, it is possible to identify underperforming business units in relatively short order.

Establish Data IntegrityAnother set of operations which, although widely acknowledged, have not been properly recognized in their contribution to capital optimization, are the data management operations for the previously mentioned areas such as product control, finance, risk, treasury, and compliance. Operational realignment offers the opportunity to establish a common data sourcing policy. The target operating model should adopt common data sourcing from front-to-back for all high value processes and functions, such as trades (pricing, credit terms) and margin data (collateral pricing, netting pools, liquidity pools and other items).

A common data sourcing policy should also establish an integrated framework for managing market and reference data for front-to-back operations for the key business entities. These include trades (pricing, credit terms) and margin data (collateral pricing, netting pools, liquidity pools). The policy should also establish centralized quality and validation rules that lead to improved consistency of analytics and reporting for activities including trade hedging, collateral management and portfolio analysis among others.

Create Shared Calculation EnginesThe deployment of consistent valuation and risk pricing across the different business lines is critical to improving the measurement and usage of risk capital. We believe that the new operating model should fully leverage shared calculation engines, which use common data stores across market risk and credit risk. A single engine, for example, could be used for scenario generation and for reusing pricing models to generate scenario results.

Human Capital - Adjusted CompensationThe importance of the quality of the professionals employed in the various functions of the organization is fully recognized by most financial institutions. However, the recent bail-outs have led to increased displeasure about compensation levels, and to calls for more regulation of how banks pay their employees. We suggest that the new realignment should take the compensation factor into account and link it to capital performance.

9

10

Banks are entering a period of uncertainty which will become the normal operating environment for the future. Although the mission for banks is still the same – to deliver shareholder value — the control mandates, higher operational costs and environmental uncertainty create a compelling case for a transformational approach to the banking business. Our approach for achieving capital optimization employs three levers: Operational excellence for RWA processes, linking Cost-of-Capital to pricing strategy, and realigning processes to improve C/I performance. We believe that by following this approach, banks can resist further RWA increases, which could lead to RoE increases of between 17 and 20 percent while achieving operational efficiency of C/I of less than 60 percent.

Banks that do not transform the way they do business could face significant pressure on their share prices. The estimated extra regulatory capital burden could reach up to 42 percent [J.P. Morgan Research - Global Investment Banks: Investment Banking wallet outlook - all eyes on equity derivatives, Global Equity Research 08, September 2010]. The choices for financial institutions are to strengthen Tier 1 Capital with additional equity capital, along with building up other components on the liability side of the balance sheet. In order for the capital increases not to dilute earnings of existing shares, — the additional business generated either through the existing capital or by the new capital must have a higher yield or marginal productivity increases for the coming years. This is different from the current norm, meaning that banks need to realign themselves to the new reality.

Conclusion – Avoiding the Capital Squeeze

Peter BeardshawPeter Beardshaw is executive director – Accenture Risk Management. Based in London, Peter brings over 15 years of deep experience in delivering target operating models and business process redesign initiatives within the credit risk and capital management areas. His broad experience in Investment Banking program management and change management, in addition to his technical experience in multiple asset classes across front, middle and back office helps organizations become high-performance businesses.

Takis SironisTakis Sironis is a senior manager – Accenture Risk Management. Based in London, Takis brings over 18 years of deep experience in business and IT transformation in the risk management space for investment and retail banking. His extensive knowledge and technical skills in risk management processes and methodologies and risk technologies helps Takis drive and implement risk programs, align risk functions to business strategy and bring to market new operating models and risk architectures. With his current focus on Capital Optimization, Stress Testing and Risk Transformation, Takis guides organizations on their journey to high performance.

About the Authors

11

Copyright © 2011 AccentureAll rights reserved.

Accenture, its logo, and High Performance Delivered are trademarks of Accenture.

About AccentureAccenture is a global management consulting, technology services and outsourcing company, with approximately 211,000 people serving clients in more than 120 countries. Combining unparalleled experience, comprehensive capabilities across all industries and business functions, and extensive research on the world’s most successful companies, Accenture collaborates with clients to help them become high-performance businesses and governments. The company generated net revenues of US$21.6 billion for the fiscal year ended August 31, 2010. Its home page is www.accenture.com.

ACC11-0675 / 11-2979

About Accenture Management ConsultingAccenture is a leading provider of management consulting services worldwide. Drawing on the extensive experience of its 13,000 management consultants globally, Accenture Management Consulting helps clients move from issue to outcome, with pace, certainty and strategic agility. We enable companies and governments to achieve high performance by combining broad and deep industry and functional offerings and capabilities across seven service lines: Customer Relationship Management, Finance & Performance Management, Process & Innovation Performance, Risk Management, Talent & Organization Performance, Strategy, and Supply Chain Management.

About Accenture Risk ManagementAccenture Risk Management consulting services work with clients to create and implement integrated risk management capabilities designed to gain higher economic returns, improve shareholder value and increase stakeholder confidence.

Disclaimer

This document is intended for general informational purposes only and does not take into account the reader’s specific circumstances, and may not reflect the most current developments. Accenture disclaims, to the fullest extent permitted by applicable law, any and all liability for the accuracy and completeness of the information in this document and for any acts or omissions made based on such information. Accenture does not provide legal, regulatory, audit, or tax advice. Readers are responsible for obtaining such advice from their own legal counsel or other licensed professionals.