2004, in retrospect, ended on a more optimistic note than was foreseen a few months back. The completion of the US Presidential election; oil prices tapering off within weeks of rising to record highs; interest rates rising less sharply than expected; robust growth in China; and the modest recovery in Japan have contributed to this optimism and reflected in the good results of banks worldwide. While banks are hopeful that these positive trends will continue in 2005, there are some concerns – the US current account deficit has lead to a weak Dollar and threatens to undermine it as the World’s reserve currency; the continued high oil prices threaten to slow down economic growth; and there is also the fear that China might experience a slow down. While banks realign their imperatives to be in sync with these developments in the external environment, there is a need to balance these changes against the long-term imperatives that span multiple years.
Basel II Compliance
Basel II (BII) programs in banks have reached the point where specific requirements, business and technical designs have been crystallised. In 2005, the focus will be on implementation and the action items are:
- Continue engagement with regulators: Quantative Impact Study (QIS) 4 and the BII application process for certification, clarifications on home-host regulator jurisdictions and ensuring consistency across jurisdictions will be the main areas of interaction.
- Managing program complexity: Efforts will be directed to managing implementation projects across different businesses, products/services, systems, platforms and geographies. BII programs will face a high level of scrutiny of their implementation progress from Top Management, as the compliance to BII is a board agenda item, involving reputation of the bank and potential reduction in regulatory capital amongst other incentives.
- Risk data management: Data challenges relating to definition, collation, aggregation and quality are key pieces towards implementation of a robust risk data warehouse. BII requires sophisticated risk models that incorporate more internal data. As more data becomes available, an iterative process to validate and recalibrate risk models must be put in place.
- Focus on Pillar 2 requirements: Regulatory reporting requirements will become clearer during the year and banks will have to focus on these. Also, banks will begin implementing methodologies and systems for stress testing and analysing capital adequacy.
- Finalize testing and rollout strategy: Most banks should be ready with test strategies and roll-out plans for parallel runs in 2005.
Resource Optimization
Banking has become extremely competitive with continuing downward pressure on margins, diminishing differentiators and the need for agility in a fast changing environment. Availability of capital for growth has been restricted by shareholders who are demanding higher returns from their investments. In response, banks are pursuing multiple strategies – some outward looking such as mergers and consolidation/divesting non-core businesses, new product introduction/entry into new markets and some inward looking, for example, cost reduction and maximizing operational efficiencies.
Allocation of capital to businesses that provide the best risk-return trade-off, business entry/exit decisions based on the Risk-Adjusted Return On Capital (RAROC), similar frameworks or balance-sheet optimisation are core business functions for banks. Banks will now need to go beyond capital allocation to focus on other resources where greater optimization can be achieved:
- Asset optimization: Banks have built vast holdings of prime real estate that were mostly acquired decades back. This has appreciated significantly and represents a tremendous value waiting to be unlocked. Managing such assets also demands attention from the bank’s management diverting them from the core business of banking. For banks aiming to increase their capital base, selling off a portion of their real estate will provide a significant injection to their capital reserves. Leasing back the office space would also lead to increased transparency as it enables banks to bring it within the ambit of cost budgeting. Deutsche Bank and Nordea, for example, have been aggressively pursuing this strategy.
- Human resources optimization: The banking industry is constantly evolving and there is a continuous need for operating personnel to be trained and re-skilled to keep up with changes in the business environment. Banks must invest in knowledge management programs that will identify learning requirements, disseminate information and impart appropriate training. BII identifies people risk as an important part of operational risk; thus, improving the quality of human resources and reducing people related errors in operations becomes a priority for banks.
- Value sourcing: Banks globally are moving towards “Value Sourcing” from traditional buying of product and services from third parties. Value sourcing denotes that banks are evaluating sourcing based on associated benefits, risks, and not as a mere cost arbitrage opportunity.
Information Security
Information security is a continual imperative for banks as vulnerabilities in information security/availability are continuously exploited in new ways. Hence, the specific area of focus changes in tandem with the vulnerabilities attacked. For instance, in 2004, scandals such as Parmalat forced a slew of corporate governance regulations on banks, which in turn led to significant enhancements in compliance related reporting in the information systems of banks. This year, the focus has shifted onto the security of new technologies/channels, for example, e-commerce, online banking and debit cards driven by the increase in fraud related losses in these areas.
“Phishing” or online identity theft is currently the “hottest” fraud. A few months back, Phishing mails were almost a joke, given the poor text formatting and incorrect grammar. Banks today no longer find Phishing a laughing matter. It is estimated that two million checking accounts in the US have been Phished. Techniques are getting sophisticated with Phishers sometimes hijacking the legitimate sites of financial institutions or downloading Spyware onto users systems to steal sensitive information. While fraud takes place at the individual account level and the amounts involved are often small, the victims of Phishing are banks considering the reputation risks. Until now, the top banks have been the main victims of Phishing, but as they curb attacks using their considerable technological prowess, the focus of Phishers will move onto other banks.
Other forms of identity theft are also rising significantly, for instance, new account fraud, payment fraud and account takeover frauds. Channels like mobile banking are also likely to be a source of identity theft in future. Though identity theft is nothing new, what differentiates the current attacks is the speed (usually real time) with which they take place and the large number of victims attacked simultaneously.Some other frauds that might potentially take place are Check 21 related fraud (particularly in the short term) and Automated Clearing House (ACH) fraud.
Strategies to curb these types of fraud will have to be at:
- Bank level: Banks will have to re-examine security features of products and create enhancements such as authentication and increased password security, etc. Also, banks have to educate customers about frauds like Phishing while maintaining customers’ trust in these channels.
- Industry level: Though banks compete fiercely in the marketplace, they would have to co-operate to curb fraud, for example, the Anti-Phishing Working Group formed to disseminate information on Phishing.
- Regulatory level: The US attempt to curb Phishing through legislation may not bring fraudsters to justice; but it certainly acts as a deterrent. It would help if countries from which Phishing attacks originate co-operated, recognizing the international nature of the fraud.
Driving Shareholder Value
In the recent past, banks have focused extensively on improving operational efficiencies, cost control and divestment of non-core businesses to enhance shareholder value. This year, strengthened balance sheets and the diminishing margins in existing lines of business compel banks to look for new lines of businesses to improve shareholder value. Going forward, growth will be as much a driver for enhancing shareholder value as improvement in operational efficiencies. Simultaneously, a number of opportunities in markets as well as products/lines of business have emerged to facilitate this growth.
Asian Markets
- China’s accession to the World Trade Organisation (WTO) is opening its banking sector to foreign banks. In 2004, some global banks took tentative steps: NewBridge acquired an 18 per cent stake (20 per cent is the limit) in Shenzhen Development Bank for $150m in May 2004; HSBC acquired a 20 per cent stake in Bank of Communications for $1.7bn in August 2004; Hang Seng Bank acquired a stake in Industrial Bank; and Citi has a stake in Shanghai Pudong Development Bank. Others like Standard Chartered are expanding branch networks. This is a trend that is expected to strengthen in 2005.
- Markets like India, due to its IT/ITES led economic growth and the Middle East, thanks to the massive economic boost from high oil prices, are also likely to be on the radar of global banks in 2005.
- In 2004, the Japanese economy experienced a modest turnaround. The city banks of Tokyo have brought their assets under control and are developing strategies for growth rather than survival leading to a revival of interest in Japan.
Products
- Credit Derivatives markets have matured in terms of the number of credits, the depth of markets and the sophistication of products. Banks will look at credit derivatives as a source of fee income, apart from being a tool for risk management and portfolio diversification.
- Energy trading has gained importance due to high oil prices. Banks, with their experience in derivatives and their strong balance sheets are ideal counterparties for energy trading.
- The high US current account deficit and the emergence of the euro as an alternate may see the US Dollar supplanted as the reserve currency of the world. This creates opportunities for banks in currency trading. A substantial devaluation would also enable global banks to enter the US market.
- Driven by demand from their sophisticated clients who wish to take up hedge fund exposure, banks have started offering “fund of funds” as an investment product. Other banks will look at acquiring stakes in hedge fund managers or setting up hedge funds of their own.
Customer Experience
The intent of enhancing Customer Experience (CE) is to acquire, manage, retain and enhance customer profitability. Improving CE, measured by customer satisfaction scores, has been the target of banks for years and has been one of the important goals of customer relationship management (CRM) implementation. 2005 will provide an opportunity to enhance existing implementations by re-using effort spent in complying with regulations. For example, development of Customer Transaction Information Marts for BII compliance will support integration of transactional information across lines of business and booking systems. For 2005, initiatives in CE will have opportunities in the following fields:
- Uniform transaction experience: Banks have been attempting to bring in a uniform transaction experience for their clients, irrespective of the channel of transaction, product lines or even geographies. This means a customer can effect a part of the transaction online, walk into a branch in a different country, and continue with the transaction from the break point. The implementation of a uniform transaction experience presumes standardized processes for the bank that carries multiple benefits: process re-engineering and rationalization; and scalability and aggregation. We expect that process study and rationalization opportunities arising out of work on operational risk mitigation will also support developing processing to improve transaction experience.
- Channel delivery strategies: Delivery platforms are also gaining prominence, as banks try to channel their clients to the appropriate platform, be it branches, online banking, call centers or an ATM. Typically variable transaction costs are highest in branches and lowest in online banking. Given the availability of delivery infrastructure, banks will increasingly resort to differential pricing across platforms. We expect banks to leverage their information marts to calculate/validate product, channel and customer level profitability.
CRM beyond branches: Leveraging customer knowledge at the point of contact will expand across platforms, from the largely branch oriented application to online banking and call center applications. The need for access to a portfolio of products across delivery channels will have to be managed with the ease of providing customer information for the channels to support the products – a task which will be determined by individual business cases. We would expect banks to gain the additional value on client interactions, by ensuring integration across delivery channels (popularly termed as multi-channel integration), so that information and process re-use is available.