Responding to a Dynamic Regulatory Environment
Financial institutions’ business has always been intermediation and risk management, but they have not always been good at measuring, monitoring, and ultimately managing their risk exposure. Faced with a growing number of compliance issues, financial institutions are being forced to not only upgrade multiple risk measurement/reporting systems but also build an organizational structure of checks and balances. While cries of over-regulation have some merit, financial institutions will in the end benefit from the discipline imposed by regulations covering capital adequacy, corporate governance, anti-money laundering (AML), fraud and financial reporting and accounting transparency. In fact, those institutions, which are most effective at minimizing the cost of compliance while optimizing their capital utilization, stand to gain a competitive advantage. Celent expects that by 2006, banks will spend US$1.7bn on risk and compliance related measurement, analysis, and reporting systems.
Banks are looking more toward an integrated, firm-wide approach to managing and measuring risk and return. By promoting a more risk-aware culture and applying more risk management concepts in their business and financial decision-making processes, they are hoping to operate more effectively in uncertain environments, as well as to enable better decision-making at multiple levels. At the organization level, they are creating an infrastructure of checks and balances, comprising firm-level policies and procedures that raise awareness of and accountability for risks. Bankers are refining common metrics to express risk (e.g., economic capital), which improves their ability to measure financial performance and make risk-based capital allocation decisions. The focus today is on dynamic modeling, which integrates multiple risk types and emphasizes risk-adjusted returns and optimized portfolios. Increasingly, bankers are able to set risk limits for individual business units or even individual deal/transaction types and evaluate relative risk-adjusted returns.
At the technological level, risk and financial performance measurement and management are converging, allowing banks to make better business decisions and provide improved transparency of risk exposure and financial performance for both regulators and the marketplace. At the same time, the number of external and internal entities that require this type of data is growing. Each group, however, requires data in its own format and with the frequency it prefers. As a result, banks are looking to their CIOs, consultants, and software vendors for flexible solutions to their reporting and analytical needs.
Banks are gradually shifting from being reactive to regulatory tides, to being proactive. Because the adoption of new regulatory guidelines and supervisory rules takes time and enforcement varies across countries, some global banks are not waiting for regulators to interpret and refine guidelines originating from organizations that do not supervise them directly. Instead, they develop or adopt best practices from other countries. Once enough banks in a single country have implemented a certain methodology, regulators often play a role in standardizing the methodology as a rule and spreading it out to other firms or industry organizations as a best practice. Another area experiencing standardization is financial reporting. In accordance with International Financial Reporting Standards (IFRS), the frequency of reporting is growing and become more standardized. Each year firms must provide their full financial statements with the EC Transparency Obligations Directive requiring that this be done within three months of year-end.
Given shifting regulatory sands, any risk management and performance reporting system that a bank implements today should be able to grow and change as requirements grow and change. These requirements are moving toward a system that can locate, extract, cleanse, and format data in real-time. In addition, the user of these data are looking for visualization and reporting tools that can help them understand and navigate through the terabytes of data and highlight what is most important to them. Consequently, banks are looking for systems that allow them to incorporate the analytical models of their choice for scenario analysis, strategic investment planning, and the calculation of both short- and long-term risk and financial information, such as Value-at-Risk (VaR). The systems should allow them to combine different types of risk, as well as to consolidate risk and financial data across the enterprise. Conversely, they want to be able to disaggregate by desired parameter, such as by risk type, risk center, product line, or portfolio. The introduction of new asset classes should be easily supported; so should the incorporation of local market characteristics for branches and subsidiaries. The system should be able to interface to multiple source and destination system types, as well as support multiple reporting formats and frequencies to various internal and external groups. Finally, workflow, alerting, and monitoring should be supported so that risk limits can be readily created and disseminated.
