The bank’s capital is the form held to reduce the risk of insolvency and ensure the survival and soundness of the bank. Holding minimum capital requirement is required in accordance with Basel published by Basel Committee on Banking Supervision. HSBC is one of the prominent world bank that needs to follow the minimum risk-based capital ratio and reach eight percent capital ratio as stated in Basel III. Capital ratio is a percentage of risk-weighted assets (RWAs) which these assets are adjusted by risk weighting to each type of assets. However, a new capital requirement and a new global liquidity standard put higher pressure on the profitability of the bank and on the investment decisions. In this case, HSBC attempts to figure out the new methods to allocate and manage its capital by discovering new investment places. Emerging markets are dominant market targets apart from Europe and U.S. which would encourage the bank to gain the opportunities in fast-growing countries. This report, therefore, purposes to consider the strategies to optimize its capital level by allocating risk-weighted assets as well as determine the investment markets to gain profits, particular emerging markets. Also, determining the processes to make a decision will be discussed coupled with the participants who involve in this consideration.
Due to increased minimum capital requirement of Basel III, the bank is under pressure on funding more capitals to meet the regulations, and simultaneously gain its profits. Risk-based capital ratio ensures that the bank has sufficient capitals to cover the unexpected losses from risky assets. This high capital reserves lead to diminish the opportunities of investments to earn more profits. Engaging in the strategies to lower risk-weighted assets (RWAs) is desirable. Salmon (2010) mentioned that the heavy increase on capital ratio impacts on the motivation of searching for approaches to lower RWAs in order to generate some returns. To target higher profits would be helped by optimizing RWAs. There are some strategies that could reduce RWAs to reach the regulatory requirement, and possibly produce its profits. First of all, processing the loan sales to rearrange its assets on bank’s balance sheet could reduce risks on assets or RWAs, particularly credit risk exposures. This results in increasing quality and liquidity of bank portfolios, and also lowering the risk weights by replacing illiquid loans with liquid assets. When loan sales are performed, the bank would receive cash exchanging with selling its loans to investors. This, in turn, improves the quality on its balance sheet leading to be able to lower cost of borrowings when engaging in debt financing. Cash reserves that are available for doing its investments together with low borrowing costs could ultimately generate the profits and contribute to maximize shareholder values.
Another mean of allocating satisfied RWAs similar to loan sales is to employ securitization. Engaging in securitization assists searching for new sources of funds, liquidity management, and risk reduction by assembling large number of illiquid loans such as residential mortgage loans which provide constant payment steams and transferring or selling to a new entity, known as special purpose vehicle(SPV) established by the bank or the originator. SPV, in turn, uses these loans as collateral for issuing the securities to investors. When removing the assets from bank’s balance sheet to SPV, the bank receives cash which is highest liquid asset and reduces credit risk exposure from default of borrowers that could be incurred. Securitization, hence, is a tool of raising funds, allocating capital, and diversifying sources of funds. This permits the bank to exchange the asset types on balance sheet to the high quality of assets and to be more liquidity. Moreover, there is an opportunity to earn fee income from monitoring the borrower’s performance, and collecting loan payments as an agent for SPV. This, eventually, allows the bank to manage lower RWAs and utilize funds increasing its profits from other high yield of investment activities.
In addition to loan sales and securitization, derivatives instrument is one of financial tools used to hedge the market risk from market volatility such as the foreign exchange risks which could be the significant measure in reduction of RWAs (Accenture, 2015). There are other strategies that might be able to use in reducing RWAs along with chances to produce its profits, for example, IT and database quality improvement to more accuracy on evaluating asset risk costs, business model revision to adjust or try to reduce risks of each business line, and customer structure arrangement of providing loans by weighting of small, medium, and large customer proportion effectively. These above strategies are possible to address with increased minimum capital requirement. Although increased equity might improve the bank stability, providing loans are confined from regulatory requirement resulting in less growth (Pfleiderer, 2012). The bank, therefore, should allocate RWAs at the optimization level which is suitable for its characteristic type of business to arrive its risk appetite and performance targets.
When the bank could optimize RWAs, the higher capital remaining provides the opportunities to generate the profits in elsewhere. However, HSBC determines emerging market as the future places for seeking higher returns. The fast-growing emerging markets which are in the area comprising of Asia, Middle east, Latin America, and some parts of Europe. The main powerful economic growth nowadays is going to be China and India which they both include approximately 40 percent of the world population, and their output is larger than European Union and United States around $ 8 million (Amadeo, 2017). Rising purchasing power and urbanization in emerging markets creates increased consumption (Franklin Templeton International Services, 2014). These demographic structure and social changes would introduce increasing needs for a long-term investment of pension fund and endowment fund which could benefit if the bank establishes subsidiaries in emerging countries and raises funds for further profitable investments from larger amount of demand deposits. In the same direction, it can be seen that E7 that is included in the emerging market countries is faster expansion than G7 or developed economics (Kose, 2017) as in the graph below;
In addition, although there are fluctuations in equity prices and currency rates that would impact on returns in emerging market countries, stocks and currencies are historically undervalued in comparison to the U.S. which results in additional returns for the investors (Cardenal, 2017). Direct investment in emerging markets is also attractive because their government intends to lower interest rate which would provide growth on returns (Amadeo, 2017). Therefore, the bank could raise the capital by loan sales and securitization as described above in order to free up the capital to invest in emerging markets, and the bank might be able to enlarge their customer bases and market shares regarding customer deposits for lending and other profitable investments. These outcomes might gain the opportunities for HSBC to receive significant profits in the future. However, the management should carefully evaluate potential risks when entering into each country in emerging market due to possible high volatility in their countries.
During decision making of growing profits in emerging markets, it is the need to estimate the growth and assess the risks whether or not it is worth to invest. In the case, HSBC participants share their information and the percentage of growth statistics in the discussion of a variety of growth opportunities, potential risks, economics and social in the countries of emerging market, especially China, Latin America, and Middle east. These significant decisions of investment might influence on the bank’s profits and reputation. Therefore, this should be applied by conservative decision making with prudential analysis. Group decision making would favor with the approval of board of directors. In this case, there are chief executive, the analysts, group chief financial officer, and group chairman that are accountable for each parts of opportunity information which could gather and conclude for the best implementation. More precise decisions are provided better by group decision-making (Bank for International Settlements, 2009). Interpretation via discussion among members and expression through an agreement or voting on the decisions of issues, information, and judgments is much effective than individual decision-making (Bank for International Settlements, 2009).
In conclusion, Basel III requires higher capital requirement in the bank leading to lower risk-weighted assets(RWAs) to meet the criterion. This urges the bank to decrease RWAs in order to increase capital available for gaining its profits. Loan loans, securitization, and other strategies such as derivatives, changing business model, and database improvement are able to reduce asset risks and change capital structure to enhance quality on the bank’ assets. When HSBC could produce liquid assets such as cash available for investment, there are the growth opportunities for making profits in another region, especially in emerging markets. As U.S. has relatively more financial stability and sound economy than emerging markets, emerging markets countries provide faster percentage of growth nowadays. To change the investment decisions, it needs the judgment from a large number of group members to evaluate risks and analyze the economic, social, and politics trend in each area. Consequently, the bank should optimize its RWAs and search for the investment strategies, particularly new high growth markets as emerging markets to achieve its performance targets, and risk appetite, as well as further improvement in the future.