In a blog I posted last week, ‘Lessons learned from the economic downturn’, you may recall my 14-year old son was asking if he could open his own bank account and with which bank he should deposit his hard earned pocket money.

I want to provide you with a follow on posting to let you know how things are progressing or how they are not as the case may be!

I decided to take the path of information overload, and explained that at a high level, a bank should engage in the prudent management of its assets.  This means that a bank needs to balance the interests of its owners and other stakeholders both now and in the future.  Assets need to be deployed efficiently to maximize current profits.  However, the assets also need to be applied in a way that seems likely to produce future revenue streams and opportunities, balanced against the likelihood of future losses resulting from unforeseen events.  In other words, risk needs to be taken into account – and the longer the time period that the bank uses for its business planning, the more import risk management and mitigation techniques become.

My approach to banking education for my son didn’t work too well. The kid is just too smart for his own good, as he retorted by asking the follow on question.  “Dad apart from my money, what other assets does a bank have?” I didn’t even realize he know words such as asset! Too much monopoly I guess. 

I think we would all agree that the financial crisis has caused most if not all banks to re-assess their business activities and practices, but:

What does it mean to be “Well Managed”? 

What are a bank’s assets and does a “Well Managed Bank” utilize them?

A bank has three main assets; customers (from whom all revenue and business ultimately comes), staff (all banking operations depend on skilled staff, however much they are leveraged by technology) and capital (the buffer against loss which a bank maintains).

Let’s focus on capital for this discussion.  A bank’s capital represents the initial funds contributed by the banks stakeholders. 

Capital is by definition, a scarce resource within the bank.  It should therefore be used in a way that generates the best long-term profits, and preserved by reducing the level of risk to an appropriate and manageable level.

It isn’t easy to measure how effectively a bank uses its capital as capital is never actually used until the bank sustains a loss or liquidity shortage.  At that point, it is too late to either measure whether there is sufficient capital or to calculate how best to use the amount of capital a bank has at its disposal.

Capital is thus allocated according to risk of a transaction or business line within a bank.  This equates to the chance of a loss or other capital consuming event happening in any particular part of the business – in other words, the risk.  A bank needs to measure all kinds of risk, specifically market risk, credit risk and operational risk. 

Following recent events, these are now increasingly joined by liquidity risk. 

Having established how capital is allocated according to various risk management mechanisms, the bank must finally ensure that these allocations are correct in terms of revenue as a return on capital.  In other words, the real question that needs to be answered from a capital perspective is, could overall revenue be increased if the business shifted its focus to different priorities and the pattern of capital allocation changed?

This is sure to spawn further questions from young Master Day.  I do know that he is going to be very interested in how much risk his new bank is going to take with his hard earned pocket money, all £5.00 of it.  The question is, why aren’t we thinking the same thing?