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COPYRIGHT 2006 Institutional Investor, Inc.
A business plan is a formal document that quires bank management to establish the organization's mission, vision, goals, objectives, performance measures and milestones for implementing the plan. Exhibit 1 describes each of the plan's elements and illustrates their relationship to each other. The planning document normally includes a description of the business, marketing plan, management plan, risk management system plan, asset/liability and capital plan for at least three years and a process by which to monitor and revise the plan as needed. Bank regulators typically require newly chartered banks, banks changing ownership or mission and banks with low capital to develop a new business plan or update a prior plan. Bankers often voluntarily update a plan if the equity market assigns their bank a low price/ book ratio relative to peers or the national credit rating agencies assign the institution a credit rating below investment grade. Regulatory initiatives also provide a catalyst for reviewing a business plan.
The Basel Committee on Banking Supervision released a report in 2004 entitled International Convergence of Capital Measurement and Capital Standards: A Revised Framework. The regulatory report is known as Basel II. The regulatory program, proposed to be implemented in the United States and other countries later this decade, affects the attractiveness of lending relative to investing, the appeal of high-risk loans to low-risk loans and the pricing of credits by large, internationally active banks and thrift institutions that adopt the system. Most large banks already evaluate the integrated risks of a portfolio to ensure economic capital is sufficient. However, the regulatory proposal requires adopting banks to disclose more information regarding the credit risk profile of key asset groups. Basel II will affect the competitive environment for smaller banks and thrifts that do not adopt the plan if the market changes the pricing of debt and equity issued by adopting banks. Basel II includes three pillars: capital rules, supervisory review and market discipline. Each pillar affects the business-planning process.
Basel II attempts to achieve the following results from Pillar I, which focuses on capital rules:
* Allows banks covered by Basel II to assess internally the risk of assets and assign risk weights based on the bank's experience that reflects the probability of unexpected default at the 99.9 percent confidence level, the stress loss-given default (LGD), the exposure at default and the correlation of losses within a credit type, subject to supervisory review and a required statistical model
* Requires banks to ensure the allowance for loan losses equals expected loan losses over the next year, to maintain capital that reflects the value at risk of a trading portfolio and to hold capital against operational risk resulting from failed systems, dishonest employees or customers and weak internal and accounting controls--among other sources of operational loss
* Strengthens the soundness and safety of the international banking system and ensures that capital adequacy regulation will not provide a source of competitive inequality among banks in different countries
The business plan must determine how and why the bank's and its competitors' credit risk exposure will change, if at all, as a result of the evolving capital rules.
Basel II may change the actual or perceived strength or weakness of a bank in different product markets. For example, some banks with lower capital requirements than the existing Basel Accord will find they now have additional capital available to take on incrementally more credit risk by increasing the proportion of loans or high-risk loans. Other banks with higher capital requirements will gravitate to lower-risk alternatives or seek additional capital.
Basel II also alters actual or perceived opportunities and threats in the marketplace. For example, if Basel II allows a bank to originate loans with a much lower risk weight than competitors, the adopting institution can price loans cheaper and realize market penetration opportunities. By contrast, if the existing Basel Accord allows nonadopting banks to assign a lower risk weight to an asset than dictated by covered banks, the adopting banks must attempt to respond to the threat with pricing that neither reflects risks nor costs or simply exit the market.
As illustrated by Exhibit 2, banks will expand market share for products where the bank retains competitive strength and excellent opportunities abound. Banks will retreat from products where the institution retains a weak position and the market is considered poor. Adopting banks will find some assets more favorable under Basel II because the loans, such as commercial business loans and commercial real estate loans, will likely require less risk-weighted capital under the strictures of Basel II. Nonadopting banks may find some assets, such as credit card loans, more favorable because adopting banks must originate the same loan with more required capital under the new regulatory paradigm.
Exhibit 2 Business Planning Matrix Products, Delivery Systems, Geographic Regions, Asset/Liability Focus
The principal difference between the Basel Accord and Basel II regarding risk-based loan costing is the proportion of assets required to be provided by high-cost equity versus lower-cost and tax-deductible liabilities. The cost of equity represents the return a bank is expected to generate on behalf of its shareholders. Most models designed to estimate the required return on equity, such as the bond premium model or the capital asset pricing model, suggest low-risk banks must generate a return on equity of at least eight percent to compensate equity investors while high-risk banks must earn a minimum of 12 percent. Most money-center banks adopting Basel II estimate their cost of equity or required return on equity to be approximately 10 percent given current economic conditions. The cost of equity is much higher than the cost of deposits or debt, and there is no tax shield for equity financing. Banks are able to earn consistently a return on equity greater than their required return on equity...
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