FINspeak

Time and again, the Value at Risk (VaR) model has been threatened but it somehow survived the financial turmoil owing to the market's resilience and inertia to change. However, VaR now seems to be on its deathbed with the Basel Committee all set to replace it.

VaR proponents had always backed it because of its simple and objective approach, but it failed miserably during the financial crises owing to the underlying weakness in the basic model itself as well as its ignorance to black swans, which exposes banks and financial institutions to catastrophic countercyclical scenarios. Events like the black Friday or the recent US$ 2 billion loss reported by JP Morgan has exposed the vulnerabilities in VaR and its ignorance to the flat tail risk.

VaR as a model does not venture beyond the 1% threshold. Ironically the widespread use of VaR as a risk control metric prompted traders to drag the eminent risk to below the 1% VaR threshold. While this ensured that they were complying with the trading book rules, it eventually exposed the system to catastrophic and extreme losses which VaR was never intended to address. VaR leaves a lot of room for capital arbitrage as it ignores the patterns and severity of losses at both extremes of the tails.

Is weakness in the model to be blamed for the catastrophic losses or is it the urge of the financial system to lookout for every possible arbitrage opportunity? The crisis arising out of the vulnerabilities in VaR could have been subdued had the industry taken cognizance of its widely known pitfalls and used stress testing and scenario analysis in conjunction with VaR.

Nonetheless, the Basel committee is all set to mend the trading book rules and has proposed scrapping the "Value at Risk" model with the "Expected Shortfall" approach, which unlike VaR is a coherent risk measure. The expected shortfall being a convex function is also sub-additive in nature. It does not penalize diversification; thereby overcoming a severe deficiency in VaR. Though expected shortfall is theoretically superior to VaR and addresses the tail risk (at least as a conditional expectation) in a better way, the operational details can turn out to be quite challenging entailing a painful system overhaul. Outliers and black swans reside in the tail of the distribution and the expected shortfall intends to address this world of ambiguity which is a disturbing fact for many risk professionals.

The risk fraternity may back a particular model but the measuring scale named "VaR" has certainly lived its life and calls for replacement with a new scale called "Expected Shortfall". All the more, this new landscape presents ample business process change opportunities for the IT industry.

In my next blog post, I will dive deeper into some of the opportunities that exist for the IT industry. In the meantime, I look forward to hearing your views on VaR vis-à-vis Expected Shortfall.

Posted by Vishal Godawat at 7:41 AM | Permalink | Comments (0) | TrackBacks (0)

The recent Greece elections have given some hope that the country remains within the European Union (EU). With this, the global financial world has heaved a huge sigh of relief. However, deep down, the possible exit of Greece and other weaker economies from the Euro is still haunting many.  The German chancellor's view that weaker economies have to do much more than they promise is gaining support in the market. Though, no one wants the exit of Greece (at least for now), fundamental principles that have supported a single currency and unified business region are coming under increasing pressure.

The concept of a single currency, potential of increased inter-region trades and improved labour mobility within the EU was expected to deliver sustainable growth, lower the unemployment rate and improve disposable incomes. However what has been accomplished is far from these objectives. Hot money flow spurred up demand for houses and created a housing bubble, weakened the banking systems and could not sustain employment. The increased money flow worldwide has not improved the efficiency, productivity and the macro variables of the economy. The perceived re-insurance by the European Commission moved multi-billion Euro investments into Greece. The irony is that the debt itself is becoming the core of the problem, threatening the fragile equilibrium of the world economy.

Though not immediate, there is a possibility that some of these economies such as Greece and Spain opt out of the Euro. While it is difficult to estimate the effect of the contagion on the global banking business, it may be far less complicated to understand the impact of these potential events on the information technology landscape of the banking industry. From the business of retail banking to the complex operations of investment management and investment banking, it is important that CIOs have a clear view on what to do if such events occurred. Based upon my interactions with CIOs of large banks, I have tried to capture key areas which call for immediate attention:

• Rebuilding payment systems: Over the last decade, payment systems across Europe have undergone a sea change. They can now process different messaging formats, have newer interfaces, consolidated databases and streamlined the supporting infrastructure. Though, increasing adoption of industry standards such as SEPA will continue to serve the business needs, stress testing of payment applications will have to be carried out to prepare the bank for a sudden surge in volumes. In my view, it is like fixing the Y2K bug wherein every system, which has a currency symbol (either as an input or an output) needs to be checked to ensure its integrity.
• Rebuilding the liquidity calculation analytics engine:  During the Lehman bankruptcy, the financial world witnessed the effect of drying up liquidity on the banking business.  In the event of business failures it is liquidity of the asset class that matters the most. Calculating liquidity across asset classes is far more difficult than we had ever imagined. There was no precedent or collective memory in the financial world of a sovereign nation's failure to honor its debt commitment. Therefore there was a limited understanding of how to handle such a situation in case it occurred. With the proliferation of the internet over the last two-decades, the world has become far more inter-connected than it ever was. It is a fact that after any country's exit from the Euro, there may not be market asset classes and associated derivative contracts. Building scenarios and modeling them to capture the extent of liquidity across various asset classes can help build a plan to support trading desks across the enterprise.
• Building frameworks to capture legal entity identifiers: Building intelligent views of counter parties and their legal standing is of paramount importance in the credit risk management function. Standards such as 'Legal Entity Identifier' are in nascent stages within the financial services industry. The current economic conditions call for speedy adoption of such standards. Building standardized reference frameworks for the legal entity identifiers can lend the much-needed support in assessing banks' exposure across counter parties. 
• Rebuilding the trade confirmation platform: Fewer currency symbols have so far helped banks streamline the trade affirmation processes. Some of the complex issues of helping denominations across the asset classes gradually disappeared from the trading world. It also brought in much needed standardization with respect to the settlement calendars, settlement values and settlement processes closure including asset servicing. Rebuilding the cross border trade confirmation platform to meet the changing landscape has to be thought through in detail. The trade confirmation process, which has undergone changes over the last decade, will have to be revisited.

Overall, bank CIOs along with their CEOs need to start preparing their organization to face worst-case scenarios such as the exit of an EU member. In the end, worst-case scenarios may not happen and the financial world may live happily ever after. However, thoughtful preparedness that addresses the question of "what to do" if that happens may well save the day for the business.

Posted by Dr. Ashok Hegde at 10:16 AM | Permalink | Comments (7) | TrackBacks (0)

With operational risk management, organisations aim for an imperforate ambit, exactitude of the numbers and providence to emblematize the contingent. Numbers often grab centre stage, manifesting as milestones, unsurpassable; or financial dominance, resounding. With financial disciplines, this couldn't be more veracious; risk management is no exception.

In its quest for precision, every organisation, inevitably, commits the cardinal sins of - delimiting the unbounded, quantifying the abstruse and postulating the unknown.

For a discipline forced to cope with imperfection emanating from a source, disembodied, yet simultaneously braided within a majority of other event types, aka 'the people factor'; this can often be a tough ask.

In many ways, the 'people' facet of ORM is like directly stumbling onto the end of a book, only to find it abominable. Let's face it, there can nothing complete, accurate or predictable about people risk. The real question is how many organisations care to flip through the book, ending notwithstanding. It's like proposing a travel back in time, with a future, un-impacted by any change to the past. But, why wouldn't you just enjoy the ride?

Of those people risks internal to the organisation, quite a few (frauds, rogue trading), albeit not all (who are we kidding here), can be negated through an appropriate combo of system and process controls, properly implemented. Such incidents having surfaced even in the recent past, is a knock-out punch for the 'compliance' paradigm of risk management.

On the causes of people risk itself - Churn, though afflictive, is a lesser cause of concern for organisations, as against an apathetic workforce. Holding onto that thought, let's ponder the below...

Risk culture can shape risk awareness of the employees and resultantly, the risk profile of the organisation. While, risk culture and awareness are all permeating, arguably the former flows top-down, while the latter is bottom-heavy; either which way, agreeably people-driven, people-communicated, people-actioned structures in any facet of risk management.

Whilst every organisation might have an ethically sounding and perceivably fair set of policies, whether actualized or adopted, its adherence to, and every day actions set the management's tone towards risk culture. And when I say, management, I also mean the senior and middle management, as they often communicate the tone at the top.

Given the heavy reliance of risk management on decentralisation in identifying, tackling and reporting risk, or at bare minimum being cognizant of them in course of daily business, the contribution of risk culture to risk awareness cannot be emphasised enough.

Now, back to my point on the 'apathetic' workforce - This is precisely where organisations may shoot themselves in the foot by hopelessly holding on to the policies, rather than using them as guidelines. If legislations drafted by experts aren't fool proof, neither can an organisation's policies - Employees may start to drag their heels, stick to the job, and much less contribute to managing risks, whilst still being within the 'policy-defined terms of employment'.

In the current world of complexly muddled financial engineering, two remedial calls are growing louder, one for more regulatory impositions (which understandably, is going to be reactive - like Batman solving Riddler-Puzzles albeit, without the forewarnings), and the other is for organisations to be 'risk-smart' i.e. own up risk management. With the latter, agreeably, it's not like the entire organisation is contriving to profit by dodgy means. Au contraire, more often than not, it's a single employee or a team. But, hang on, accountable doesn't mean the employee concerned has a moral epiphany, infact far from it; it means the other employees are sufficiently motivated to 'rat out' (excuse the phrase) the wrongdoers!  

Employees are much like a financial instrument, risk and return, all packaged in one, and as long as the organisation's handling of the living organism deters risk or enables its identification, it's all good!

Posted by Vikram Srinivasan at 8:50 AM | Permalink | Comments (2) | TrackBacks (0)

Over the last few months, I have been receiving mailers from my bankers asking me to register for their mobile banking services (it's a different matter that I have already registered). Looking at these mailers, I do keep wondering, are we seeing the end of good old branches? Never have any of the banks with whom I transact sent me a mailer asking me to come to branches. Where is this heading to? What happens to our branch managers? Will we now see a 'mobile' or 'online' manager replacing the traditional branch manager? Is this a reality waiting to happen? It may or may not happen and only time will tell, but the end may be sooner than later, if banks do not wake up and rejig their branches.  Trying to survive the onslaught from online and mobile banking, today's branches are definitely suffering from an identity crisis and are a shadow of their former self.

The wide-spread belief is that the cost of maintaining branches for a bank, is high and from a consumers view point - they prefer mobile or online banking , and it's time for banks to focus less on branch investments and move away from branches. On the contrary, I think consumers may be moving away from branches to online or mobile since today consumers have a choice. Few years back the options to choose were less, and today there are lot of options for me as a consumer to choose and I as a consumer would always go for options that are more beneficial and convenient to me - maybe that's the reason why the number of users taking to online or mobile banking is on the rise, as I feel branches do not meet my expectations.

The easy way out for banks will be to say, consumers of today do not prefer branches - let's reduce our investment on branches, let's not innovate further in branch banking- if this is the mindset, it's definitely a doomsday for branches.

At this moment, I would like to point to 2 interesting survey results  that came out very recently, a  survey conducted by Fiserv found that - "Gen Y members do not limit themselves to online and mobile banking -- they're more likely than any other age segment to visit a branch, drive up to an ATM or phone a call center";  and a much very recent Cisco study pointed out that 'global consumers still value bank branches for personal attention and favor expanded services that include different kinds of financial advice'. These survey findings clearly show that consumers are not against branches.

Now, it's up to banks to bring the consumers back to the branch, as no consumer will say no,  if branches are able to make a difference, make it more convenient and personal for customers, when they visit branches. The time is ripe for banks to revitalize and re-invent their branches.  Few of the banks have already started doing it and are thinking in terms of coffee-shop branches, internet café, luxurious flag ship stores, concierge services, teller pods, free online access and Wi-Fi for customers, kid's area, interactive touch screens, private seating lounge, high end tele-presence technology (to assist branch customers to connect with investment advisers, mortgage lenders and commercial bankers at other locations), interactive sales walls, enhanced-image ATMs and many more innovations to engage better, the consumers who walk-in to the branch.

The customer is always the king and to satisfy the king, banks should offer services in all channels, offer more choices and not reduce the options by reducing branches. More the choices offered (be it branches, mobile, online, etc.,) higher the chance that a customer is satisfied. In the current challenging economic scenario, branch cost is a real issue, but the apt response from banks should be to reduce costs per branch and not reduce branches.  May, the era of branches continue and let's not sound the death knell so quickly for our beloved branches and branch managers!! Let's keep the idea's running to identify ways to innovate our branches.

Posted by Kiran Kalmadi at 3:55 PM | Permalink | Comments (2) | TrackBacks (0)

Eugene Polley, who died in May 2012, had done great service to consumers by inventing the television remote control. Polley's Flash-Matic device, which was released in 1955, brought control in the hands of television viewers. The vision for multi-channel banking has similarity with that of the remote control - to provide customers the choice and control over their access to banking. In today's hypercompetitive environment where customer loyalty has become even more fragile, providing good multichannel banking experience to customers has become crucial. Changing demography and Gen Y preference for using multiple banking channels; growing acceptance and demand for multichannel banking by customers; need for banks to proactively cross-sell/ up-sell and reduce their channels' operating costs; and the need for banks to enhance their value-proposition; are all factors that are making it crucial for banks to provide good multichannel banking experience.

Unfortunately, in spite of banks focusing for the past many years on providing good multichannel banking experience to customers, not many have been successful. For a good number of banks multichannel banking is still an abstract concept. For many others, multichannel banking endeavor has not led to significant reduction in their cost to serve the low commercial value customers. Such banks have also not seen significant commercial contributors from their new channels. Many issues have prevented banks from providing good multichannel banking experience. Sub-optimal approach that is followed for multichannel integration is a key impediment for banks. For example, not many banks integrate their clients' channel preferences and channel behavior into their client segmentation strategy. In the name of multichannel integration, many banks have simply piled on new channels capabilities to their core channels (e.g. branch). These banks lack a holistic and coherent multichannel banking strategy. Many banks are unable to prioritize their channels spending optimally because, they follow sub-optimal approaches. For example, a large number of banks simply co-relate customer's reaction to channel usage - the higher a channel usage, the higher is the investment on that channel. Such reactionary approach has always led these banks playing the catch-up game.  Many other banks hype over a particular channel, to drive their channel investment priorities. Tracking the tangible benefits of multichannel banking endeavor is also a key impediment for many banks. These banks lack the operational KPIs which are needed to objectively measure a channel's commercial contribution.  Several banks allocate all of their sales to branches - irrespective of the role that is played by other channels in supporting the banks' sales. Consequently, identifying and securing channel prioritization and investment is an ongoing challenge for such banks. Operational and organizational hurdles are some of the other major barriers for many banks. These banks are gripped with a combination of internal siloed approach, insecurity manifesting in resistance to change and lack of cooperation for development of new channels, lack of common channels management structure, lack of ownership, legacy IT architecture and more maladies. In many cases, banks' new channels have simply replicated the existing channels in terms of products and services being rendered, lacking a distinct value proposition. Many banks continue to view their branch channel as the only key contact point for customers - even though multichannel banking is a key focus area for such banks, resulting in other channel (example call centers and internet) operations being underdeveloped. These non-branch channels continue to provide only the elementary informational and transactional capabilities. Unwittingly, these banks that have branch-centric distribution model end up with increased operating costs after implementing their multichannel approaches - rather than realizing significant costs benefits expected from such a venture.

What are the other key issues do you think prevent the banks from providing a truly multichannel banking experience to their customers? I would be interested to know your views.

In my next blog, I will share recommendations on the actions banks could take to provide good multichannel banking experience to customers.

Posted by Anjani Kumar at 3:40 PM | Permalink | Comments (0) | TrackBacks (0)

Client familiarity, getting back to basics, customer centric culture etc., are some of the buzzwords in the present day banking universe.  While this is no news that most banks today are re-aligning their operations back to the customer requirement, what needs to be understood are the causes for this change and its impact on operational and financial parameters of the bank.

The major drivers for this change comprise of the trust and value key customer segments - HNI and UHNI (high net worth individual and ultra-high net worth individual) place upon long lasting banking relationships over newer ones.  Also the emergence of the new world markets has forced the banks to look beyond the conventional services and come up with offerings spanning across product, geographies and channels.  The digitally 'smart' customer (more so in the HNI and UHNI segments) expects personalized service on channels of their choice i.e. web, smartphones, tablets etc.

This trend is a complete reversal of the way banks were operating a few years ago using complex product offerings as a competitive advantage to acquire customers. Thanks to the rapid standardization of the products in the financial industry, products are no longer the differentiating factor. Consequently banks understand that, if they need to sustain and be profitable; they need to look beyond products and re-align their operations across the focal point of the industry - the 'customer' itself!!

So what do you think, what will this change imply for the banking industry? How can banks accelerate this change in operations and yet remain profitable? Share your thoughts.

Posted by Navdeep Gill at 6:30 PM | Permalink | Comments (0) | TrackBacks (0)

As the saying goes "Experience is the name everyone gives to their mistakes." If one has to go by this, we must say that the Financial Regulators are more experienced now than they were in 2008. That's undeniably healthy, as there is nothing better than learning from the past and emerging better and stronger. This is precisely what one can observe in today's overhauling regulatory landscape with Basel III proposing stringent Capital Adequacy Ratios, Dodd-Frank endorsing laws around Consumer Protection and HIRE-FATCA modifying rules to enhance internal revenues. These evolving regulations make it even more challenging for Financial Institutions (FIs) to be compliant.

In these changing times, it is of utmost importance for FIs to be adaptable. This requires every FI to select the right solution for their unique problem. The time and effort spent at an early stage, in analyzing and opting for the right solution would surely go a long way for them towards their ultimate goal of being compliant. To understand the above, let's take an example of a recent enhancement to the regulations.

We all know the role that Credit Risk Agencies (CRAs) played in the 2008 financial crisis. An inappropriate rating of financial instruments like Mortgage Backed Securities and Credit Default Swaps created havoc for FIs. What we see in the aftermath, is a series of regulatory advancements. Basel realized that the loan risk factors they were using to calculate Capital Adequacy Ratios (CARs) directly depended on the Credit Ratings awarded by CRAs, which were not accurate. The Basel committee enhanced these calculations resulting in better CARs, which we see as part of BASEL III today. Similarly realizing the impact of the credit ratings on the consumers, it became implicit for the Dodd-Frank committee to bring the Nationally Recognized Statistical Rating Organization (NRSRO), under the umbrella of its regulations. NRSRO is an entity, which authorizes ratings provided by the CRAs. The Committee mandated in its Title IX, the creation of the Office of Credit Ratings (OCR), to oversee the NRSROs and regulate them.

The examples above depict the ever changing nature of the regulatory landscape and how a common factor can cause significant changes in two completely different regulations. These changes are inevitable and FIs will have to comply with more stringent regulations compared to earlier ones. It is implicit that with every change, implementations of compliance systems cannot be started all over again. This requires FIs to choose smarter technologies, solutions and products which are flexible to implement and are open to modification. Not just that, they also need to have an enterprise wide view of the problem than looking at it in silos or at a Line of Business level. Selection of the right solution is the key, however due to different sizes, structures and strategies no single solution can fit all FIs. A technology partner with a blend of business knowledge can make a difference and greatly help FIs, select the right solution and get ahead of their peers in these evolving times...

Posted by Ajeet Singh Batra at 6:25 AM | Permalink | Comments (0) | TrackBacks (0)

The recent $2 Billion trading loss reported by JP Morgan has again jolted the financial services industry and raised several questions about the regulatory environment as well as the way risk management is done by banks and financial institutions. While the investigating agencies are yet to produce their final report and the quantum of loss incurred is yet to be determined, it is quite evident that banks are still betting huge numbers and continuing to adopt unregulated means for maximizing profits and hedging financial risk. Although, history has shown that such events do not occur in isolation and can bring about a ripple effect on related parties, it is hoped that the losses are contained to a bearable figure.

This and other similar events of the past call for a closer look at regulatory reforms which are still on the table but waiting to get implemented. Volker's Rule is one such regulation which, can limit and regulate complex OTC derivatives trading, if not completely ban it. The rule has been drafted to impose a ban on proprietary trading.  It would also impose more stringent regulations on capital adequacy and greater transparency in reporting, thereby making financial institutions more resilient and accountable.

Though, the objective of regulation is to minimize the risk of big banks from failing but will it ever be possible to completely regulate the complex financial world and their trading practices? Is it not the responsibility of the banks to create their own internal regulations which are strong enough to shield the hard earned consumer deposits from losing value or avoid bailouts which are funded by the taxpayers?

The onus of managing risk within banks and financial institutions should be shared equally amongst all lines of business and at all levels within the hierarchy. Designating a Chief Risk Officer (CRO) and establishing a risk management unit under the CRO is not going to solve the issues unless all lines of business work in a cohesive manner to determine the risk mitigation strategy. Internal buffers need to be added onto federal regulations while arriving at the risk management guidelines for the bank. This will save the bank from marginal errors arising out of trading practices.

Banks need to adopt a comprehensive approach towards risk management encompassing risk identification, measurement and mitigation. An integrated framework should be designed to enable "people ", implement "processes " and leverage "technology"  to streamline the risk management function across the firms operations. People from all sections of the bank should be sensitized to the risk parameters that are to be considered while executing various transactions with a broader perspective of the impact on the bank's financial health. Processes should be implemented with the objective of creating discipline in the operating model to minimize errors and help ascertain the risk exposure at any point in time. Lastly, technology can act as the enabler for implementing processes and educating people about smart and effective risk management.

It is imperative that a continuous focus is required to improve on risk management techniques and processes. Can risk be completely avoided? No, even granting a small consumer loan has risk attached to it. Can risk be better managed? Yes, if banks acknowledge the ownership of managing it.

Posted by Amit Khullar at 12:01 PM | Permalink | Comments (2) | TrackBacks (0)