Unraveling the Complexities of Achieving the Optimal Balance Sheet
Every financial institution wants to create and maintain an optimal balance sheet – a mix of assets and liabilities that maximize returns while mitigating risks. However, determining the optimal balance sheet is a complex process. There is no one right answer. Even when considering the same institution, what is optimal today might not be optimal tomorrow. Financial markets are always changing and allocating capital that is tied up for 5-10 years while the economy changes can impact the strategic decisions of a depository.
Institutions of all sizes face challenges when trying to attain the optimal balance sheet. Here are a few of the most common challenges we see:
• Imperfect information - obtaining accurate data regarding market conditions, borrower profiles, and asset quality is challenging which leads to uncertainties in decision making
• Different access to opportunities - not every institution has access to all profitable opportunities or efficient funding sources. Differences in size, location, and membership can limit available opportunities
• Ever-changing return profiles - return profiles change with the economic environment. As risk and compensation for risk changes, products deserving capital allocation change
Aligning on Growth Expectations
Before quantifying an approach to pursue an optimal balance sheet, key executives and board members must be aligned on growth expectations. It’s important for decision-makers to understand where the institution is today and agree on where they want to go over the next 5 to 10 years.
Understanding Risk Appetites
For teams to align on future goals and targets, they need to understand the institution’s risk appetite. Where does your organization’s risk come from? Are leaders comfortable with the amount of risk being taken, or is there capacity to take on more risk in certain areas to help drive returns? Creating a risk appetite statement that clearly identifies how comfortable an institution is with taking on credit risk, market risk (interest rate and liquidity risk), operational risk, and compliance risk will help ensure that the depository does not stray too far in either direction during the pursuit of an optimal balance sheet.
Evaluating the Feasibility of Growth Targets
After discussing goals and risk alignment, management teams should discuss the feasibility of growth targets. If an institution wants to grow their mortgage portfolio to increase balance sheet duration but does not have the local demand for such products at appropriate rates, then the strategy may need to pivot away from organic origination. When the feasibility of growth is effectively challenged, management will have a clearer picture of where they can grow at current rates and opportunities to become more competitive to capture market share.
Building a Decision-Making Framework
With risk appetite outlined, strategic goals defined, and growth areas assessed, finance teams can start building out a decision-making framework that integrates quantitative analysis with qualitative insights. Throughout the decision-making process, organizations need to assess risk and project potential returns to help elect which opportunities the institution should fund. Return on Risk-Adjusted Capital (RAROC) is calculated by determining the potential net return for a product compared to the capital allocated for risk. Understanding this metric gives insight into an institution’s compensation for risk and whether asset acquisition strategies need to be adjusted to drive returns. When it comes to projecting and evaluating potential returns, finance teams should evaluate and stress test these returns on a risk-adjusted basis to determine if the potential returns adequately compensate the depository for the risk it is assuming. Not all products are built equally and identifying the largest drains on capital can help improve long-run return on equity.
Remaining Agile, Sticking to Long-Term Objectives
Successful institutions are nimble and able to adapt quickly as the economic environment changes. To achieve an optimal balance sheet position while sticking to long-term strategic plans and objectives, it is imperative that depositories remain agile enough to capitalize on emerging opportunities or pivot away from under performing assets.
A Never-Ending Journey
Keep in mind that the optimal balance sheet is not one-size-fits-all. Each institution has its own unique membership or customer base, financial goals, and risk appetite which will drive the shape of that institution’s optimal balance sheet. In addition to institution-specific drivers, several economic factors like rates, spreads, and liquidity, will all impact where value is being derived on the balance sheet. Achieving and maintaining this optimal position is more like a never-ending journey than a specific destination. It requires efficient decision making, understanding an institution’s risk appetite and cost of capital along with the ability to adapt to changing economic environments. An optimal balance sheet is one that is nimble and allocates capital efficiently.
About Author:
Savanah Hall, Director, Balance Sheet Strategy