By Rasna Bajaj of the International Banking Directorate, Andrew Binmore and Rupak Dasgupta of the Supervisory Risk Specialist Directorate and Quynh-Anh Vo of the Prudential Policy Directorate.
Banks allocate capital to their business lines to assess those lines’ relative performance, which informs their strategic decisions. Capital allocation, together with Fund Transfer Pricing (FTP), are two important internal processes used by banks to support business optimisation decisions.
This article discusses the range of methods that banks use to allocate equity capital to their business lines, drawing on reviews conducted by the Prudential Regulation Authority (PRA). It complements a previous Quarterly Bulletin article which describes banks’ FTP practices. We also discuss in this article potential implications of capital allocation methods for banks and prudential regulation.
Overview
Banks’ decisions on whether to offer a financial service such as mortgage loan and on what terms are important in aggregate for economic activity and for risk in the financial system. On the one hand, doing the right business on the right terms is essential for the long‑term financial health of banks, which in turn contributes to securing their resilience and the smooth functioning of the financial system. On the other hand, these choices affect the availability and the accessibility of these services for banks’ customers.
The capital allocation framework plays an important role in these decisions. It facilitates the banks’ assessment of relative performance across their business lines. Furthermore it enables banks to account for the use of equity capital — a scarce resource, in the short term at least — in the pricing of their products.
This article discusses the capital allocation practices observed in a sample of banks reviewed by the PRA. In general, risk‑weighted assets (RWAs) — a bank’s assets and off balance sheet exposures, weighted according to their risk as measured under the regulatory framework — are the primary basis of the allocation process. Some banks go further, employing more complex methodologies with a blend of different regulatory capital metrics. An example of this is the inclusion of the leverage ratio requirement — a non risk adjusted metric — in the allocation process. Where relevant, banks also take into account the capital buffer for global systemically important banks (G‑SIBs) and the impact of severe stress scenarios on their equity capital.
The PRA reviews show that there are significant variations in the allocation practices used by banks. It is important for banks to understand the limitations of their practices and the implications of different approaches for their business decisions, strategy and incentives within their organisations. Banks should consider carefully the most appropriate approach for their circumstances (eg their business model) and continue to keep this under review.
From a regulatory perspective, different approaches used by banks may have implications for the effectiveness, and impact of micro and macroprudential policies. For example, some banks allocate capital to business lines proportionate to the individual contributions of those lines to the group’s overall stress losses. This could generate stronger incentives for business lines to take actions to mitigate losses in future periods of stress.
The purpose of sharing the results of these reviews is twofold. First, it is useful for banks to understand the range of practices and thus, consider how to evolve their thinking on a topic which has broad implications. Second, it may encourage researchers and practitioners to develop new thinking. For example, more research is needed to understand the implications for prudential policies or to shed more light on how banks should allocate capital, perhaps considering their business models.
Banks’ internal capital markets: how do banks allocate capital internally?