Banks are struggling with macro headwinds and regulatory changes that have structurally changed their value proposition. They face continued slow growth, margin pressure and higher regulatory-related expenses.
Many banks are unable to earn sufficient returns on equity to cover their cost of equity. Consequently, valuation multiples remain depressed. Institutions are searching to diversify revenue sources to reduce vulnerability to a prolonged downturn affecting their profitability.
Federal Reserve actions since 2007 have neutered the old spread profit model with near zero interest rates. This is expected to extend into 2015. The expectation has compressed margins and destroyed deposit franchise values. Value is no longer just in the deposit base. It has moved into the ability to grow assets and deliver more products to existing customers. Also, profitability has shifted to consolidation instead of organic growth.
This development gives rise to increased strategic risk. Strategic risk concerns an institution's long-term ability to survive due to the incompatibility of its strategy and resources with industry changes. There are numerous examples of unnoticed fatal strategic risk. Examples include Lehman Brothers, MF Global, WaMu and Wachovia. These institutions failed to consider risk as an input into strategy. Rather, it became an unintended consequence because it is not initially reflected in the income statement. Furthermore, their strategies were inflexible. They were designed only to work in the then-existing state of world. When that state changed, they were unable to adjust.
Strategic risk is likely to increase as banks search for new revenue sources. Some may be tempted to gamble for redemption by expanding into risky areas in which they lack the skills to manage.
The basic problem is management targets return – not risk. The traditional response to a declining core business is to take more risk in the pursuit of nominal income. Return, however, is where risk is located. This leads to a vicious circle of herding into current popular areas like equipment leasing, commercial and industrial loans and wealth management with a predictable erosion of margins and underwriting standards. An escalation of commitment usually follows.
A framework is needed to manage the risk profile inherent in strategy and business model changes consistent with an organization's risk tolerance and capital structure. The board of directors needs to set the strategic direction, risk tolerance and then monitor management to ensure they follow the board's wishes.
A key component of this framework is to improve the profitability of the legacy business lines. Otherwise, resource demands will expose the bank to new risks it is unable to manage. You cannot transform fast enough to offset the continued deterioration of your historical core business units. This would involve shrinking these businesses to a defensible core based on the institution's identifiable competitive advantage.
Evaluating new strategic initiatives starts with the review of new markets the bank seeks to enter. The bank needs an identifiable competitive advantage to succeed against expected competitors. If you cannot beat them, then why join them?
A realistic risk assessment is also required of the risks the bank is willing and able to accept in the pursuit of its strategic initiatives. Next, a capital plan is required to raise the capital to fund the new risk exposure and be compatible with regulatory expectations. The institution also must ensure that it has the necessary skills to manage the risk involved. Finally, capital must be allocated to business units consistent with risk and strategic considerations.
Strategic risk management demands the involvement of active board of directors. This involves balancing the need for managerial experimentation grounded in facts against delusional adventures. They must pay particular attention to large scale transformational changes not based on identifiable competitive advantages. Such actions usually contain hidden exposures to remote risk.