Managing Bank Capital: Capital Allocation and Performance Measurement, 2nd Edition

Introduction: Capital Allocation in Banking

Giving capital to a bank is like giving a gallon of beer to a drunk. You know what will become of it, but you can't know which wall he will choose.¹

This pungent reflection on the efficiency—or lack thereof—with which banks manage their capital goes a long way towards explaining the increasing interest in the subject of capital allocation seen in recent years. It does indeed seem as if banks, if not whole financial systems, have a propensity to burn up the capital invested in them. In recent years we have seen a number of massive bail-outs, such as the Savings & Loans crisis in the mid-1980s, the losses caused across the banking system through lending to lesser developed countries and property-related lending around 1990, the reconstruction of the Scandinavian banking system, the destruction of virtually every yen of capital held by the Japanese banking system, and most recently the collapse or near-collapse of the financial institutions of a large number of Asian countries. This book, however, is not an historical analysis of how banks have managed to destroy capital; rather, it is concerned with the techniques that we might employ to manage that capital more efficiently, and thus avoid the fate of the gallon of beer.

It is a basic tenet of this book that efficient capital management is a fundamental, necessary precondition for the optimisation of shareholder value for financial institutions. This may seem obvious, and indeed true ...