Many banks are now fundamentally questioning the way they make risk decisions, whether through the use of ever-bigger data sets, machine learning or new methodologies. It may be, however, that the area of greatest innovation in the near term has less to do with these new developments than in rethinking the way banks handle a very old concept: capital.
In the world of high finance, very few topics are guaranteed to kill a good conversation as does any mention of capital. These days the word "capital" is usually uttered in the context of bank regulation and the alchemy of the Basel accords, and it is viewed as a necessary evil to keep us from the brink of financial crisis.
This was not always the case. Such venerable thinkers as Adam Smith were fascinated with the concept and in passing gave us "capitalism" as a market philosophy and shorthand for a way of living and taking risks. This philosophy has proved, in conjunction with democracy, to be capable of reshaping industries and nations. Even that great anti-capitalist Karl Marx couldn't help talking about capital.
But if capital traditionally represented those assets that could be set aside and dedicated to creating a return — "investments" — then why do so many of us in the world of finance now think of capital in its negative aspect, as assets that must be maintained (at great expense) to absorb a loss? There is always a sense in which some tend to view risk through the lens of avoiding loss and some through that of gaining a return, but our current negative view of capital has more to do with recent history.
In the aftermath of the financial crisis in 2008, it was recognized that in spite of sophisticated and well-resourced risk management teams, large banks had failed to allocate and price capital in a way that provided an effective signal to drive good business decisions in the first place. As a result, various regulatory bodies have spent much of the last decade expanding the capital and related liquidity requirements applied to the world's banking institutions.
These new requirements are now in many cases the binding constraints on financial institutions as they seek to operate or expand their financing capabilities. In a way, capital requirements have taken the reins away from erstwhile decision makers as they seek to take on new risks.
Many in the industry have complained, privately and some even publicly, that capital considerations have now overrun those of simply managing the risk. Yet, by one way of thinking, this is exactly as it should be. After all, the argument goes, the banks had invested too little capital to justify returns and cushion their losses.
Whether or not one agrees that this is true, the fact remains that the world of regulated banking is now much more highly capitalized and at greater cost. There is, however, a very significant opportunity this presents that all the complaining about increased regulation has obscured from view: In having to maintain more capital, and deal with the higher cost of doing so, banks must now develop highly sophisticated and efficient tools to deploy, monitor and allocate capital across numerous lines of business and new and old products alike.
The jury is out as to what the new paradigm for capital allocation within large banks may be. But there is an opportunity for the best banks to develop operational excellence at capital deployment that sets them apart from their peers.
As this new frontier evolves, we may learn that some lines of business are not worth doing (in the current way and at current prices) and that others either entirely new or long neglected are poised to have their day. It seems capitalism, the "invisible hand," still has some tricks up its sleeve.
