MANAGING RISK AND CAPITAL Banks have travelled a hard road since the global financial crash of 2008. They have had to weave their way through the wreckage of bad debt, volatile funding markets and an uncertain economic environment. Now, tough new rules under Basel III and a host of local regulations will require banks to significantly increase capital and adhere to stringent new liquidity and funding mandates. Meeting the new standards will put a big dent in banks return on equity and make it much harder for them to exceed their cost of capital. As banks begin to come to grips with these new realities, many have been using an incomplete map to guide their business. The pursuit of revenue and earnings growth with insufficient attention to the balance sheet ran them into a ditch. A comprehensive analysis by Bain & Company of approximately 200 banks around the world and interviews with more than 50 senior executives at more than 30 global institutions reveal how banks are modifying a broad range of practices they relied on before the crisis in order to better compete in the new environment. During the pre-crisis years of benign credit conditions and readily available liquidity, the disciplines of managing the balance sheet atrophied, becoming the almost exclusive preserve at many institutions of a small team of highly skilled technocrats working from corporate headquarters. Leading banks now recognize that the ability to fully account for risk, capital and liquidity in line decisions will be a source of competitive advantage. As they come to terms with how to strengthen balance sheet disciplines, bankers need to recognize the common set of challenges they face and the range of practices available to address them. In these executive surveys, it has been established that large differences in the understanding of risk, capital and liquidity and their implications on the balance sheet, both across business units and especially between the group-level functional specialists, on the one hand, and frontline commercial managers, on the other. This gulf reflects deeply ingrained habits and incentives that will be difficult to uproot. Distracted by the quarterly earnings drumbeat, senior group leaders and line executives often have had little motivation to think like balance sheet custodians. Because the organizations reward systems are often aligned to the profitand- loss statement, critical qualities of business judgment can be missing. Lacking incentives to focus on risk- and capitaladjusted results, commercial managers either pay token heed to capital deployment, or they rely on the metrics that black box models generate without fully understanding what they mean. To successfully navigate the difficult journey ahead, industry leading banks are implanting better balance sheet management capabilities throughout the organizationand particularly within their general management ranks. They recognize that there are no technical shortcuts. While strong, supporting technical expertise is necessary, it is not sufficient. If board members, senior executives and line managers do not anchor their business decisions in a risk- and capitaladjusted mindset, even the best technology does not count for much. An effective approach to managing through the balance sheet requires putting risk and capital at the heart of the banks strategy, the objectives that management sets, how the organization is governed, and how the business is run and monitored on a daily basis. During the interviews, senior bank executives indicated that they were wrestling with how best to forge this joined-up view of the business. Many spoke of the need to invest more board-level time and attention into defining the enterprises overall risk appetite as the critical starting point for setting its portfolio and corporate strategy. Others told us that they are redefining managerial roles and putting in place processes, policies and limits to give risk, capital and liquidity a central role in their banks planning cycle. They described steps they were taking to shore up the structures, risk modeling and measurements, information technology and compliance capabilities that are the underpinnings of the banks core budgeting and management functions. Taken together, the comments from bankers across the industry suggest that views are coalescing around new ways to think about running the bank with greater heed to the consequences of decisions on the balance sheet. They are best captured in common disciplines that form the connective tissue for a top-to-bottom system of risk and capital-adjusted decision making (RaCADTM) (see Figure 1). This approach links the banks overall strategy into concrete objectives, governance and processes for managing risk, capital and liquidity at the level of each of its businesses, linked to the day-to- day decisions taken by operating managers

1.1 An effective approach to managing through the balance sheet requires putting risk and capital at the heart of the banks strategy. With reference to the banking sector, critically discuss the elements that should be prioritised when formulating a risk management strategy.

1.2 As highlighted in the study results, many bank executives spoke of the need to invest more board-level time and attention into defining the enterprises overall risk appetite as the critical starting point for setting its portfolio and corporate strategy. Do you agree with this statement? Provide relevant evidence to substantiate your response.