Following the financial crisis banks – and their supervisors – are monitoring closely the wide range of regulatory key performance indicators (KPIs) that have been introduced. All of these are of more or less equal importance, since as a violation of any one of them may cause supervisory action, and in extreme cases more severe and formal disciplinary actions.

The simultaneous management of these KPIs is of particular importance from a capital management perspective, because an investor’s view of the “value” of a bank will be materially determined by discounted future distributions and potential supervisory restrictions on dividends and distributions.

Indeed, regulatory and supervisory determinants are playing an increasing role in investors’ views of the distributable profit of a bank, besides the “traditional” macro, market and business factors.

Beyond the “core requirements” from CRR/CRD IV on regulatory capital, the main new regulatory and supervisory indicators are:

• A leverage ratio will, in all likelihood, be introduced as a binding limitation as from 2019. The currently discussed limitation is a ratio of at least 3 percent, which is to be defined as regulatory tier 1 capital over total assets, including equivalent amounts for off-balance sheet items. However, market expectations are for a future limit of as high as 5 percent.
• The ECB setting individual regulatory capital requirements for banks on a regular basis – with total CET1 requirements of between 9.5 percent and 10.5 percent being by no means uncommon. In addition, from 2016 onwards, further capital buffers (e.g. a counter-cyclical buffer, D-SIB or G-SIB buffers) will be phased in and added on top, at least partially.
• The requirement that failing banks should be capable of being resolved without the use of public funds has led to additional requirements according to which banks are to hold a certain amount of minimum loss absorption capacity (MREL – minimum requirement for own funds and eligible liabilities). MREL may consist of regulatory capital and precisely defined debt instruments. Even if the specific amount of MREL has not yet been defined on a bank-by-bank basis by each resolution authority, systemically important banks may be required to hold MREL of at least 8 percent of their total liabilities.
• In addition to the capital requirements, a new liquidity indicator, the liquidity coverage ratio, is designed to ensure that banks have sufficient liquidity for at least 30 days, even under stressed conditions. A structural refinancing indicator, the net stable funding ratio, is also being introduced, to ensure that long-term loans are associated with stable funding.

As the supervisory law provides for distribution restrictions¹ and all stated factors and indicators are concurrent and must be complied with at any time, regulatory capital is one of the major parameters with regard to the valuation of banks. This capital distinctively determines distribution capability. Moreover, the regulatory requirement may change very quickly, for example as a result of stress testing, while bank balance sheets can respond only slowly to management action. Changing course can be undertaken only according to a certain time frame.

Considering such a complex system, it is necessary, but not always easy, to answer questions such as: How high is the added value provided by an individual financial product? Which indicators are influenced by which products? In which direction? For example, raising fresh deposits to invest in a government bond should influence the interest margin positively – at least if there is a generally positive interest rate level. This will also benefit the liquidity coverage ratio. However, the leverage ratio would decrease. Thus, it needs to be evaluated individually whether this investment earns its capital costs taking into account the risk, costs of refinancing and maturity transformation.

In order to be able to manage a bank balance subject to such a wide range of constraints and frameworks in a forward-looking way, certain elements are necessary:

• A data base which is able to integrate enough information on a granular level (product level). This is the only way to split and adequately measure, manage and plan for example the interest rate risk of an unlimited deposit. For many large banks, the complete rebuilding of an integrated data room with front office, risk, finance and reporting information would be difficult or (too) expensive to run. However, a clear transition ability, interfaces and definitions of responsibility, as well as a stronger data quality framework – all of which are included in the Basel Committee principles on risk data aggregation and reporting – are steps that may also be taken with decentralized data structures.
• It is also necessary to know the major revenue, cost and risk drivers of a bank, its clients, products and markets. Example: A new financial product is generating revenues by means of interest or commissions. However, this bears development and distribution costs for various areas of the bank. Moreover, refinancing costs may also be occurring. Claims by customers or macroeconomic developments (interest, GDP, unemployment rates etc.) may also affect the risk side. Many banks remain unable to slice and dice the data in various ways alongside the value chain.
• A detailed analysis of the value driver tree including its influencing factors. In many banks the influencing factors for the profit contributions of financial products are analyzed only in little detail or attributed only to roughly elaborated macroeconomic factors.

If there is such a value and risk driver tree, it may be used to validate simultaneously the influence of business activities on various indicators not only with regard to the regulatory, but also to the financial indicators. This should provide a solid basis for management and planning; and for the simulation of various stress scenarios, which are increasingly gaining importance in the regulatory context. Such a planning and management approach would therefore also support the strategy discussion and the solution of the aforementioned optimization problem with regard to increasing the company value – and thus ultimately result in a more solidly founded business and risk strategy, which must be detailed enough to be able to reflect both the variety of the requirements and the variety of the banking businesses. This should result in banking businesses without surprises with regard to their influence on financial and regulatory indicators, and in an increased trust of all investors and stakeholders.

¹One recent example: At the beginning of 2015, following the Comprehensive Assessment (CA), the ECB published a recommendation in which it asked banks to forgo distributions if the capital targets of CA were not met. If the CA target was met, but the entire capital requirements of CRR were not yet met after the transitional arrangements, only a very prudent distribution should be carried out and the way towards full compliance should be clearly demonstrated.