UK: Achieving Profitability Through Strategic Steering

The European Central Bank (ECB) has published details of how it expects banks to manage the process of setting and executing their business strategy.  This brings some clarity to the long-standing question of how recent supervisory focus on business models – it is again one of the ECB's priorities for the year – will translate into action for banks, but in the process introduces an expectation that banks make significant investments in their capabilities in this area. 

The details were contained in a report on the ECB's thematic review on profitability and business models, which took place between 2016 and Q1 2018 and examined profitability drivers and business models of 90 Significant Institutions (banks) in the Single Supervisory Mechanism (SSM).  There are similarities between the findings from the ECB and the feedback banks in the UK have received about their strategy planning capabilities, including as tested by the Bank of England's biennial exploratory stress testing exercise in 2017.

Strategic steering matters

"Strategic steering" – the term used by the ECB in its report – encompasses governance, processes and methodologies for analysis, reporting and decision-making regarding income and cost drivers, loan pricing and strategy.  It boils down to banks having visibility on how these factors play out within their business, and having the toolkit – both data and analytics – to be able to understand what is happening within the business, by business unit, legal entity and geography. 

For example, for net interest income, supervisors assessed the extent to which banks could distinguish volumes and margin as drivers of income, or commercial and asset/liability management income generation.  Supervisors also looked at how decisions on strategy taken by the board were cascaded through the business in order to be implemented; and how assumptions underlying strategy were challenged by the board.

The focus on the overall coherence and consistency over time of strategy and management actions has a direct read across to the UK, where supervisors have challenged banks on, for example, the consistency of their business strategy with management actions in stress testing exercise responses, or recovery plans.

Another key issue addressed in the review was the integration of risk management with the strategy setting process.  The review found that only half of banks "significantly" involve the risk management function in the formulation of strategy, while a third of banks do not calibrate strategic targets in the risk appetite framework or the internal capital adequacy assessment process (ICAAP).

A number of factors contribute to explaining profitability.  The ECB specifically highlighted that its findings suggested that those banks that demonstrate strong strategic steering capabilities, including interlinkages between risk management and strategy setting, were more profitable.  Conversely, insufficient strategic steering may exacerbate banks'

challenges and reduce profitability.  Banks planning to grow need to make well-informed decisions about risk-taking and make sure their strategic steering capacity commensurate with the risk of their activities. Banks that are planning to cut costs need to ensure that their essential risk management and controls are not affected.

The issues related to strategic steering capabilities identified by supervisors persisted across a number of areas:

Issue area

Next steps for banks

Profits and loss drivers

Banks should have a detailed understanding of the profit and loss drivers across business lines and geographies.  Moreover, banks should implement detailed and effective sensitivity and scenario analysis for net interest income, fee and commission income and net trading income.

Costs

Some banks could improve their understanding of their cost structure, the cost allocation mechanisms and the implementation of cost-reduction programmes.  Banks should have capabilities to provide a breakdown of costs by business lines (or to the lowest level possible) and by distribution channels.

Loan pricing

Most banks need to develop a more comprehensive pricing framework and apply it consistently across the firm. The awareness of the minimum level of pricing needed to cover all costs ("pricing floor") should be heightened.  The use of pricing models as an input to pricing decisions and the monitoring of exceptions are strongly recommended.

Governance and strategic planning

Many banks need to reinforce the process involved in challenging the assumptions underlying their strategy and medium-term goals at the board level.   In particular, the risk management function should be fully involved in the formulation of the strategy and there is a need for strong interlinkage between strategy setting and risk appetite and ICAAP.

Significant subsidiaries

All the above issues are often exacerbated for banks groups with significant subsidiaries.  These can operate independently and require appropriate oversight and control.

Achieving success

In the short term, the results of the review have informed risk mitigation programmes (RMPs) set with individual banks, and will feed into the 2018 Supervisory Review and Evaluation Process. It may also trigger on-site inspections or "deep-dives".  Joint Supervisory Teams will follow-up on RMPs throughout 2018 and 2019.  As part of the RMPs, banks will need to evidence their improvements to keep clear of continuing supervisory attention and potential actions.

Notwithstanding the potential benefits of better integration and embedding of risk management processes with strategy setting, in practice banks have found this integration to be difficult to achieve.  Many banks have developed discrete or siloed processes to, on the one hand, run balance sheets, while on the other to manage risks.  Achieving a meaningful level of embedding and integration will require banks to re-think their strategy setting process in order to develop stronger links with risk management.

The impetus for banks to achieve greater integration and embedding of the ICAAP and wider risk management (including risk appetite) with strategy setting has thus far been due to supervisory pressure. The ECB's March 2018 consultative Guide on the ICAAP previously set out its expectations in this area – the ECB's statement on Governance and Risk Appetite published in June 2016 also insisted on this aspect.  However, given the ECB's findings, banks should view this as more than an exercise in supervisory compliance – there is a real opportunity to achieve higher profitability.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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