(continued from Part 1) - Click here to read Part 1 of this primer

At this point, banks were no longer seen just as a stable investment. Without any real innovation in the underlying business model - except for innovation in financial instruments, banks had become an investor’s delight. Valuation of banks soared as return on equity soared. Yet, nothing had fundamentally changed in the business model or efficiency. If anything, operational efficiencies were receding as enhanced profits allowed for, at times, frivolous spending. Balance sheet management had, by now, become a template that didn’t even require innovation in financial instruments. 

Even as growth continued unabated, banks continued to seek out new methods of squeezing profit off the balance sheet. For the longest time, measures like the Glass-Steagall Act kept investment banking and commercial banking activities segregated. By the end of the 20th century, lessons from the Great Depression were forgotten. With the Glass-Steagall Act virtually nullified, banks could use their balance sheet to take on market risk like never before. Market risk management, which until then primarily covered limited mismatches in foreign currency positions and very little proprietary positions, was about to be transformed entirely. 

Banks were not satisfied with writing and securitizing credit. It was time to trade credit and pretty much anything that could change hands on paper. Where something could not change hands on paper, a surrogate method of profiting from change of hands without actually doing so was achieved through the use of derivatives. After a point, much like with credit, market risk could be structured in any way imaginable to get around prudential norms and regulatory capital requirements. The most important way around was marking to market and eventually marking to model. 

Marking to model or marking to “anything” allowed for artificial recognition of value which could be derived from the value of the underlying asset that was supposed to change hands in the first place. Managing balance sheet risks on account of market movements had been relegated to figuring out the real value or in many cases finding a value that would justify the trade in the first place.

The impact of the 2008 financial crisis on banking balance sheets

In 2008, the uncapped use of the balance sheet finally came to a head. By then, balance sheets had been levered many times over, credit had been written virtually beyond available underlying asset and derivatives had been structured to a point where even complex theoretical models ran out of any basis to value them. Eventually credit defaults caught up and their multiplicative effects caused by derivatives written against them caused the Financial Crisis. Interconnected balance sheets started to feel the stress. The implicit understanding of liquidity backstop was tested to the fullest and at times proved wrong.

Every failure and learning from the Financial Crisis of 2008-09 pointed to one thing – balance sheet management had failed the conscience of the banks. A new era of banking was on the anvil. The old challenges of technology redundancy and challenger banks on the anvil hadn’t receded. If anything, they had strengthened. The one prized asset of banks that lent stability and perceived security, their balance sheet, had all but crumbled. The era of banking dis-aggregation had begun.

Regulatory changes post the 2008 financial crisis

Post 2008, there were a slew of regulatory changes. Notable among those were introduction of leverage ratios intended to tame unabated lending including off-balance sheet lending. Liquidity ratios in the form of liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) were introduced. Over the years, fractional reserve banking had been diluted as reserve ratios maintained by banks had become a monetary policy tool of central banks as opposed to a liquidity risk management buffer of commercial banks. Drop in reserve ratios to support monetary expansion had rendered buffers minute or non-available.

Liquidity ratios were intended to restore the sanctity of fractional reserve banking. Good old balance sheet ratios were reintroduced. Prudential and regulatory limits were placed on these ratios. Capital adequacy ratios were strengthened. More importantly, the ability to evade capital adequacy norms was curtailed as securitized portfolios were brought within the ambit of capital adequacy. There was a general increase in both the quality and quantum of capital required. In general, return on equity was inevitably going to take a hard knock.

The impact of new entrants in the financial services industry

The new regulatory tightening coupled with already receding net interest margins inevitably impacted return on equity for banks. Incumbent banks, followed by a new wave of financial technology companies, began chipping away at the fee-based or transaction banking revenue streams of banks. Net interest margin revenue earlier augmented fee-based revenue. This was now starting to be chipped away at by fintech, neo banks and pretty much any player who could use technology to offer service traditionally within the realm of transaction banking and clearing services. Banking dis-aggregation was now truly in effect and continues to this day.

Banks continue to operate at reasonable scale, given their customer base created on account of their legacy, historic stability and guarantees afforded in the form of deposit insurance and other regulatory support. While return on equity becomes an increasingly difficult task to handle, neo banks and FinTechs are recognizing many times the hard way that customer acquisition is tough and expensive. 

More importantly, while banks may have squandered away their core strength, their balance sheet; the other strengths persist for now – existing customer base and regulatory support. Balance sheet management which has been the pendulum swing from boring old net interest margin management to innovative albeit risky structuring is now more important than ever. 

Transitioning balance sheet management to the new paradigm

Banks have learnt their lessons of leveraging the balance sheet beyond its capacity. They have also learnt the lessons of forgetting balance sheet risk. As the dis-aggregation challenge daunts, balance sheet management has transitioned to a new paradigm.

Balance sheet management must evolve beyond the traditional asset liability management and cost-plus fund transfer pricing methodologies. It also must evolve in its approach to risk management from traditional liquidity risk and interest rate risk in the banking book (IRRBB) measures respectively. 

Balance sheet management must help price products correctly, help evolve new deposit and lending products, restore margins and profitability while at every step adapting to the changing business model of banks. It must recognize the value of and generate return from the asset banks continue to hang on to – the customer. It must help restore the cost of operations to levels that preceded the frivolity that led to the Financial Crisis. 

Balance sheet management can no longer be about ratios and limits. It must evolve into a holistic planning, strategizing, pricing and monetizing function in addition to its traditional responsibility of managing ratios and balance sheet risk.

Managing the dis-aggregated balance sheet of a bank

Banks have inherently already dis-aggregated whether recognized as such or not. Managing the dis-aggregated balance sheet requires recognizing the varying business models and aligning the balance sheet and operational metrics in line with the dis-aggregated business model.

Commercial banks even where they operate under the umbrella of a single balance sheet have been dis-aggregated into the following types of banks:

• Traditional lending bank driven by the legacy banking principles of earning net interest margin
• Investment bank focused on providing advisory services, managing and underwriting capital issuances and for limited time periods providing liquidity prior to structural fund raising
• Transaction banks focused on providing transaction processing, payment processing, wealth management, clearing and value chain management services at the lowest possible cost
• Digital banks focused on customer acquisition, supporting eco system banking and deriving value from reselling third party products to their existing customer base
• Development banks supporting monetary policy transmission, financial inclusion and other structural fiscal and monetary measures
• Some commercial banks in certain geographies continue to undertake limited central banking roles in the form of printing currency and providing interbank clearing and settlement services

Balance sheet management comprising of balance sheet planning, product pricing (traditionally fund transfer pricing), management of return on equity, regulatory capital management, liquidity risk management, interest rate risk management and structural balance sheet management now enters a now paradigm with different strategies, methods, metrics and risk management principles underlying each dis-aggregated bank.

While the different silos of the bank and newer silos emanating from new business models emerge, maintaining an integrated view of risk and return across the spectrum of business is of paramount importance.



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