1 Capital Management as a mean means to create value

The core message of the book is that capital management is

essential for creating value in financial institutions. Capital
management primarily aims to optimize the capital structure and
optimize performance. Achieving these objectives involves
various activities, including financing business operations to
achieve an optimal cost of capital and overseeing the optimization
process for maximum return on capital. Figure 1.1 outlines the
main activities required to fulfill these objectives, which are
crucial for creating maximum value in financial institutions.

optimisation of capital structure

Figure 1.1 outlines the four main responsibilities of capital
management to optimize the capital structure, ultimately resulting
in an optimal cost of capital. These responsibilities are:

1. Fulfill regulatory requirements: Capital management

ensures that the financial institution's available capital exceeds
required capital as mandated by regulatory authorities.

2. Satisfy stakeholder expectations: Capital management

conducts stakeholder analyses to understand and meet the
expectations of relevant stakeholders, avoiding negative
consequences of unsatisfied stakeholders.

3. Determine optimal level of debt financing: Capital

management determines the ideal balance between debt and
equity financing, considering stakeholder expectations and
regulatory requirements.

4. Make optimal corporate finance decisions: Capital

management makes strategic decisions such as acquisitions,
carefully considering their impact on the capital structure and cost
of capital.

These responsibilities are discussed throughout the book, with a

focus on optimizing the capital structure to create maximum
value.

optimization of performance

To achieve an optimal return on capital, capital management

relies on the following activities:

1. Translate strategy into capital allocation: Capital is

allocated in alignment with the corporate strategy, considering the
size and growth trajectory of individual businesses over time.

2. Optimize economic profit per business line: Individual

businesses, with support from business risk management, work to
maximize economic profit by operating within established
guidelines and continually improving performance.
3. Evaluate performance per business line: Capital
management evaluates business performance, comparing risk-
adjusted return on capital (RAROC) and economic profit growth
potential to identify areas for improvement.

4. Optimize capital allocation: Based on performance

evaluation, capital management adjusts capital allocation,
reallocating resources from underperforming or low-growth
businesses to high-performing and high-growth areas.

These activities ensure that capital is efficiently allocated and

utilized across the organization to achieve maximum return on
investment.

Chapter 2
Bank business model
Different types of banks cater to distinct client segments and have
varying business models:

1. Retail Banking:
- Focuses on attracting deposits from consumers and lending to
them.
- Includes savings banks (offering attractive savings rates) and
consumer finance banks (focusing on consumer lending and
potentially wholesale funding).
- Requires strong asset and liability management (ALM) and
credit assessment capabilities.
2. Private Banking:
- Serves high-net-worth individuals with deposit management
and advisory services.
- Generates fee income through services rather than interest
spread.

3. Commercial Banking:
- Caters to small and medium-sized enterprises (SMEs).
- Combines retail and private banking capabilities, providing
products to optimize business finances and offering advisory
services focused on financial optimization.
- Needs robust infrastructure for services like international
payments and cash management.

4. Investment Banking:
- Provides risk management and financing solutions to large
corporates.
- Facilitates access to capital markets, mergers and acquisitions,
and syndicated lending.
- Takes on market risk by engaging in transactions to reduce
client exposure to market volatility.
- Unlike other banks, investment banks typically do not focus
on attracting deposits from clients.

insurance business model

Insurance companies operate based on the types of products they
offer, segmented primarily into life and non-life insurance:

1. Life Insurance Companies:

- Offer policies related to a person's life, such as pensions, life
annuities (benefits paid while alive), or life insurance (benefits
paid upon death).
- Premiums can be paid either as a single lump sum or
periodically (e.g., annually).

2. Non-Life Insurance Companies:

- Include health insurance, property insurance, and casualty
insurance, covering all policies not directly tied to an individual's
life.

The business model also depends significantly on the distribution

network, which may include brokers, independent agents, bank
channels, tied agents, or direct selling. Despite the variety in
business models, all insurance companies share the fundamental
concept of "risk pooling"—spreading risk costs across many
people to cater to the inherent risk aversion of individuals. This
pooling maximizes expected utility by providing a measure of
relative satisfaction through risk management.

balance sheet of banks and insurance companies

Banks and insurance companies operate with different business
models compared to non-financial companies. While non-
financial companies primarily deal with assets on their balance
sheets, financial companies focus on liabilities, reflecting their
interactions with customers.

- Non-financial companies: Customer activity is reflected on the

asset side of the balance sheet. For example, when a customer
buys a product, it reduces the inventory (an asset) and increases
cash or accounts receivable.

- Financial companies: Client activity is mainly on the liability

side of the balance sheet. Customers typically have a creditor
relationship, where the financial company owes the customer
money. Customers trust financial companies to store their money,
expecting it back later.

This distinction underscores the importance of understanding

how customer interactions influence the balance sheet dynamics
of banks and insurance companies.

bank balance sheet

The balance sheet structure of banks can either be asset-driven or

liability-driven. In asset-driven balance sheets, client activity on
the asset side determines the structure, while liability-driven
balance sheets are shaped by activity on the liability side. Despite
variations in business models, most banks have similar balance
sheet components, including deposits and lending. Investment
banks may have deposits but focus on selling structured products
to high-net-worth individuals. Maturity transformation is a key
function of banks, where short-term funds are transformed into
long-term loans. Intangible assets like goodwill and deferred tax
assets play significant roles, especially in determining capital
positions. Profits and losses directly affect the balance sheet, with
profits increasing shareholders' equity. However, exceptions due
to accounting standards can complicate capital management
The main point is that banks can have either asset-driven or
liability-driven balance sheets, influenced by client activity on
either the asset or liability side. Despite variations, most banks
share similar balance sheet components, including deposits and
lending. Maturity transformation and management of intangible
assets like goodwill and deferred tax assets are crucial aspects of
banking operations. Profits directly impact shareholders' equity,
but exceptions due to accounting standards can complicate capital
management.

insurance balance sheet

The main point is that while the balance sheet structure of

insurance companies shares similarities with banks, it is
fundamentally liability-driven. Unlike banks, insurance
companies do not lend money, and their client activity primarily
occurs on the liability side, represented by technical provisions
analogous to deposits in banks. Intangible assets, especially
deferred acquisition costs (DACs), play a significant role in
insurance companies, allowing them to spread upfront costs over
the life of insurance products. However, DAC unlocking may
occur if future premiums are lower than expected, requiring a
direct charge to reflect the shortfall.

Capital management in banks and insurance companies involves

balancing available capital with the risks on the balance sheet,
making it closely linked with balance sheet management. The
challenge lies in the capital management department's limited
control over other departments' activities that impact required
capital. Success depends on the capital manager's ability to
influence these departments and gain the CEO's support, as
capital management serves an advisory role to the CEO.

Goodwill
The main point is that goodwill is an asset that arises when the
takeover price of a company exceeds its net asset book value. It
represents the premium paid for acquiring the company's assets
and is subject to an impairment test to ensure its future
recoverability. Goodwill is recorded on the balance sheet but may
need to be written down if it is no longer realistic to expect it to
be earned back in the future. Understanding the accounting
treatment of goodwill is crucial, especially given its potential
significance on the balance sheet of financial institutions.

4.difference between Banking and Insurance

The main point is that there are significant differences between
retail banking and life insurance in terms of their business models,
balance sheet structure, and liquidity management. Retail banks
serve customers on both the asset and liability sides of the balance
sheet, while life insurance companies primarily interact with
customers on the liability side. Retail banks attract deposits with
short durations and uncertain funding sources, while life
insurance companies have more stable liabilities. Additionally,
the assets of retail banks are illiquid, consisting of longer-term
loans, while life insurance companies typically hold liquid
investments. These differences highlight the distinct nature of
banking and insurance operations.

Economic Capital
Economic capital refers to the amount of capital a financial
institution needs to hold to cover the risks it faces and ensure its
survival in severely adverse scenarios. It serves as a crucial
measure for managing risks and maintaining financial stability.
Economic capital is especially instrumental in the financial sector
due to the inherent risk-taking nature of financial institutions and
their significant leverage, which makes them more susceptible to
capital position fluctuations.

Importance of Economic Capital

Financial institutions focus on economic capital because their
business models are built on taking and managing risks. Unlike
non-financial companies, which encounter risks as by-products of
their operations, financial institutions engage directly in risk to
generate returns. This direct engagement necessitates meticulous
risk identification, quantification, and management to prevent
insolvency. The high leverage in financial institutions amplifies
the impact of losses, making robust capital management vital for
their stability.

Quantification of Economic Capital

Quantifying economic capital involves estimating potential losses
under various risk scenarios. Although the exact probability and
impact of these losses cannot be precisely determined, financial
institutions use models to estimate the probability distribution of
potential losses across different risk categories, such as market,
credit, operational, and interest rate risks. This involves:

1. Probability Distribution: Financial institutions plot a

probability distribution of potential loss outcomes, which helps in
estimating economic capital with a specified confidence level.
For instance, a 99.9% confidence level implies that the institution
needs sufficient capital to absorb losses that are smaller than the
estimated loss 99.9% of the time.

2. Stress Testing: Complementing economic capital estimates

with stress tests provides a broader understanding of potential
risks under extreme conditions. These tests help validate the
robustness of the economic capital figure.
3. Correlation Assumptions: Estimating economic capital also
involves making assumptions about the correlations between
different risks. In stress scenarios, correlations between risks may
increase, reducing diversification benefits and requiring higher
economic capital.

4. Distribution Shape: The shape of the loss distribution is

critical in determining economic capital. Institutions must decide
whether to assume normally distributed returns or use other
distributions that better capture the tail risks and extreme loss
events.

Application and Regulation

Economic capital models are essential tools not only for internal
risk management but also for regulatory purposes. Regulators use
these models to ensure that financial institutions maintain
adequate capital buffers to withstand financial shocks, thereby
protecting the broader financial system. Despite the reliance on
regulatory frameworks, financial institutions would still employ
economic capital models to optimize their risk-return profiles and
ensure long-term sustainability.

Conclusion
Economic capital is a fundamental concept in financial risk
management, providing a quantified measure of the capital
needed to absorb potential losses and maintain solvency under
adverse conditions. It integrates risk identification, quantification,
and management into the core operations of financial institutions,
ensuring they can navigate the uncertainties of the financial
landscape while meeting regulatory requirements.

function versus department responsibilities

The book focuses on capital management in banks and insurance
companies, emphasizing its interaction with various departments.
Key points include:

1. CEO Role: The CEO is ultimately responsible for all company

decisions, balancing input from different departments.

2. CFO and Capital Management: Capital management falls

under the CFO, responsible for managing available and required
capital. This function is advisory but also executes decisions, such
as equity raising.

3. Treasury: Manages cash flows and liquidity, ensuring

obligations are met and cash inflows are properly allocated.
Treasury can sometimes include capital management, though this
may blur the distinct roles of liquidity and capital management.

4. Business Activities: All revenue-generating activities shape

the balance sheet and associated risks, which the treasury
manages for liquidity and the capital management department
monitors in terms of capital adequacy.
5. Risk Management: Oversees all company risks, sets risk
limits, and advises the CEO, but does not execute actions to avoid
conflicts of interest.

6. ALCO: The Asset-Liability Committee, including

representatives from key departments, discusses and aligns
balance sheet decisions considering business, risk, and finance
perspectives.

This integrated structure ensures balanced decision-making and

effective capital management.

Capital hedging
Banks and insurance companies with international operations
face currency risk, which can affect their capital positions. If a
company attracts capital in one currency (e.g., euros) but needs to
capitalize subsidiaries in another currency (e.g., dollars), currency
movements can impact the consolidated capital position.

Capital Hedging of Currency Exposure:

1. Protecting Investment Value:
- Funding in Subsidiary's Currency: Raise capital in the same
currency as the subsidiary’s base currency.
- Foreign Exchange Hedge: Hedge currency exposure by
shorting the subsidiary’s currency and going long on the domestic
currency, or using forward contracts to lock in exchange rates for
future transactions.
2. Protecting Regulatory Ratios: Discussed in detail elsewhere,
this involves ensuring regulatory compliance despite currency
fluctuations.

Effective capital hedging involves managing these exposures to

prevent currency movements from negatively impacting the
company’s solvency and financial stability.

Expected versus unexpected losses

When managing capital, it's crucial to distinguish between
expected and unexpected losses:

1. Expected Losses: These are predictable and should be priced

into products. For instance, a bank might increase interest rates to
account for a typical 1% loan default rate.
2. Unexpected Losses: These are unforeseen and not directly
priced into products. Capital serves as a buffer against these
losses. However, capital can't cover every extreme scenario; it
typically protects against most unexpected events, with financial
institutions often capitalized to withstand 99.5% of such impacts.

Capital and Pricing:

- While expected losses are included in pricing, unexpected losses
indirectly affect pricing through the capital return requirement. If
returns fall below a desired threshold, institutions can:
1. Increase pricing.
2. Reduce operating costs.
3. Reduce risks to lower unexpected losses and capital usage.

Thus, pricing and unexpected losses are interconnected when

managing returns on capital.

fund transfer price

The Funds Transfer Price (FTP) is managed by the treasury or
ALCO to set internal lending and borrowing rates, allocating
profitability between deposit collection and lending activities. By
adjusting FTP, banks can control balance sheet dynamics, such as
increasing loan volumes or managing deposit growth, ensuring a
spread for profitability and influencing business activities
effectively.

Corporate line
Financial conglomerates manage capital on a corporate level but
allocate it to individual business units, which must comply with
corporate investment policies. Business units, especially
subsidiaries, are required to hold their own capital due to
regulatory requirements.

1. Capital Management:
 - Corporate Level: Capital is raised and then injected into
business units.
- Business Unit Level: Units invest the allocated capital
according to corporate guidelines.

2. Corporate Line Profit and Loss:

- Capital Costs: Includes dividend costs for equity and coupon
payments for hybrid capital.
- Income:
- Dividend Upstreams: Profits from business units paid as
dividends to the corporate level.
- Internal Charges: Costs, such as hybrid coupon payments,
charged to business units. Equity capital charges are based on the
risk-free rate difference between available and economic capital
to ensure fair performance assessment.
- Non-Transferable Costs: Costs incurred at the corporate level
for running the entire company that cannot be passed to business
units.
This structure ensures that capital is efficiently managed and
performance is fairly assessed across the conglomerate.