PIN THE CAPITAL ON THE DEPARTMENT

If you want to have some real fun at your next strategic management retreat, try this hilarious game – pin-the-capital-on-the-business-line. Like the tail-on-the-donkey game, this diversion is full of surprises and offers endless hi-jinks. To play, divide into teams that represent each revenue producing department in the bank. Next, remind each team what their long-term budget goals are (a 3Y or 5Y goal) and have groups "request" an amount of capital that they believe is required to produce a stated amount of growth over the next 3 years. Forget about the total capital that the bank actually has and don't worry about trying to figure in any marketing advantage to holding excess capital. Since capital plus reserves should be correlated to risk, the more volatile a revenue stream, the more capital should be required. By the same token, the faster the required growth, the more capital that is required. Lending lines, geography, loan structure (size, maturity, etc.) and operations all require capital to ensure an institution's survival. Finally, add up each team's desired capital and ask them to reconcile to the bank's actual capital. If the institution is anything like the ones we have been around, step back and watch the hilarity ensue. Granted we may have a twisted idea of what passes for entertainment, but listening to once docile bankers either try to re-assign excess capital to any team but their own, or try to talk other teams into giving up their capital, is funnier than a 2nd grade class with their shoes tied together. If each team takes their appropriate income stream over their departmental capital, bankers will notice that results vary widely from 6% to 70% return on capital. Some of this difference is explainable, as return should reflect the risk embodied in the generation of that revenue. Single family residential to "A" borrowers and a bank's investment portfolio for example, have much lower returns than hotel lending. However, some of the return stems from inefficient allocation of capital. A business line that attracts an above average return (say, 25%) would obviously attract more competition. This may be a case where not enough capital is dispensed to cover the risk in that business unit or not enough resources are allocated to help this business line grow further. Hurdle rates should be assigned based on industry information (such as projected default risk or where other publicly traded companies that specialize in that business line return) and should be reviewed annually for appropriateness. This exercise points out the problems with proper capital deployment and highlights business line attributes such as risk, leverage, regulatory capital requirements, cost of capital and return. Since raw land loans now have 3x the default rate than office lending, more capital needs to be allocated to the department or lender that does raw land loans. As a result, a greater nominal return is required to return the same risk-adjusted ROE as other departments. Once all the departments have the correct allocated capital, it is then up to the CEO and CFO to explain how they are either going to raise more capital or what are they going to do with the excess. To improve efficiency if a CEO has allocated capital across business lines correctly (taking into account risk and growth), then to optimize return, he or she should either return the capital to their shareholders or find an acquisition the returns a risk-adjusted rate (on a pro forma basis) higher than the average of the bank's current business lines. While not as much fun as golf at an offsite, assigning capital is an interesting exercise that gives management a better way to optimize departmental performance.