2005 saw more than its fair share of disasters both natural and manmade. It started with the South-East Asian tsunami, followed by the London bombings, Hurricane Katrina and the South Asia earthquake. Although these events caused significant damage both to life and property (insurance companies have estimated the damage from hurricane Katrina alone at $25bn), global financial markets showed their resilience by rebounding after each disaster.
Major equity markets, barring the US, witnessed excellent growth. The Nikkei ended 2005 up 40 per cent while the FTSE gained 14 per cent, the CAC 24 per cent and the DAX 25 per cent. The US dollar, with a steady stream of rate hikes, posted its best gain in eight years against an index of currencies. The ECB effected a 0.25 per cent rate hike in December to 2.25 per cent, its first in five years. Commodities ended 2005 on a strong note. Crude oil prices in 2005 averaged almost a third above its 2004 average. Gold recorded a 25-year high in December, with an annual increase of almost 25 per cent. The traditionally inverse relationship between the greenback and gold weakened in Q4 2005, when gold recorded gains of almost 19 per cent, despite a rise in the dollar. GDP growth in US continued to be positive and Japan experienced a revival in its economic fortunes. China continued to propel world demand for most commodities and its GDP witnessed yet another stellar performance.
In 2006, the market expects the euro to perform better against the dollar due to interest rate hikes by the ECB. Oil prices may experience volatility owing to sustained demand from emerging markets and the political situation in the Middle East. For the US, the outlook is promising with the blue chip panel of forecasters projecting 3.3 per cent growth aided by the recovery and rebuilding after the hurricanes. Given the significant run up in emerging markets in the past year, some investors may seek to book profits.
1. New Growth Markets
In 2006, the emerging markets, particularly the BRICS, will be an imperative for banks in their bid for topline growth.
Ahead of China opening its banking sector to international competition by end 2006 under WTO commitments there were a flurry of deals announced by global banks for taking up minority stakes in large Chinese banks. In December 2005, Chinese regulators announced that they were opening seven more cities to foreign banks taking the total number to 25. For 2006 the trend is clear: global banks will do whatever it takes to start operations in China.
In contrast, there was little excitement for international players tracking banking developments in India. This had less too do with a lack of interest than with the measured stance of the regulators with regard to foreign investment in the Indian banking sector. Perhaps this is because the timetable for opening up Indian banking to international competition under its WTO obligations (India has until 2010).
Another trend that started in 2005 has been cross-border mergers and acquisitions in Europe. For years this has been dogged by regulatory intervention. But now, under EU norms for cross border acquisitions, this looks increasingly possible. The driver here is efficiencies of scale rather than topline growth.
2. Renewed Focus on Product Portfolio Management
Banks are facing increased compliance requirements and pressure to grow revenues through entry into new markets. Product managers are increasingly being measured by the returns they provide on the capital they consume. Entry to newer emerging markets like China or India requires banks to adopt different strategies than the ones proven successful in their existing markets. These markets are far from homogeneous and have significant variations at regional and sub-regional levels. In a country like India, there is an emphasis on understanding the local consumer psyche which differs on regional variations or urban/rural divides, etc.
Therefore while mid-office and back-office product operations can take advantage of the existing global infrastructure for transaction processing risk management, there exists a significant need in the front office for customization and localization of the products to make them relevant to the local markets they operate in.
Traditionally banks developed products for their home markets and then introduced them to the newer and emerging markets. There is an increasing trend where products developed in emerging markets are finding their way back into western markets.
In introducing products and services to newer markets, banks face the need to modify them to serve local market requirements, while being faced with the challenge of maintaining the integrity of the product globally. This is critical because the process of product creation to go-to-market is often a lengthy process requiring approvals from a diverse set of stakeholders, such as risk management, legal, operations and business teams, etc and therefore localized product variants should not violate the basic product integrity.
For a global multinational bank, there will be as many variants of the products as the markets they are in or more, hence managing the portfolio of product variants is extremely important. This increases the complexity of the already complicated world of product portfolio management.
3. Information Security
In 2005, phishing or online identity theft was identified as one of the imperatives for banks. Many banks initially assumed that the hype surrounding fraud was larger than the fraud itself and that it was largely caused by customers’ ignorance. They countered this with publicity campaigns aimed at raising customer awareness and with cosmetic efforts at improving authentication methods.
As customers become more aware customers of fraud and start reporting identity theft, it is now apparent that the extent of identity theft has been massively understated. In 2002 it had been estimated that about 250,000 instances of identity theft had occured in the US; today it is estimated at nine million. This cannot be accounted for by increased theft alone. With identity theft being so widespread, banks have realized that they cannot derive smug satisfaction that a competitor has been a victim when it might well be their turn next. Another significant insight was that phishing and identity theft techniques keep morphing. Throughout 2005 we have seen reports that phishing is going down, only to be followed with reports that it has increased but with different techniques for DNS poisoning, cross-site scripting and SQL injection, which do not even require the customer to respond to a phishing mail.
As institutions become reluctant to pay for customers’ carelessness, customers have realized that identity theft is no longer an institution’s problem alone. From a bank’s standpoint, improved customer information security is a source of competitive advantage as much as it is a method of cost reduction. The US and UK are under public pressure and have started enacting laws as a deterrent to phishing and identity theft. In retrospect, 2005 will be marked as the year in which the concerns about information security became as important as the need to introduce new banking channels and products.
In 2006, banks have to change their mindset about identity theft. First of all, they will have to develop a long term strategy to curb identity theft that goes beyond the knee jerk reactions of 2005, for example, the information security aspect will have to be an integral part of new product and new channel development, e.g. wireless networks, mobile banking, etc. Next, on the technology front, banks will have to invest heavily in multi-factor authentication and plugging all server side vulnerabilities. Furthermore, customers will continuously have to be informed about new techniques of identity theft and regulators continuously lobbied for stronger laws and action against identity thieves. Finally, lack of co-operation among banks will no longer be an option.
4. Enterprise Risk Management
Banks have long realized the need to manage all risks in a holistic manner. Even risks that are not significant on a stand alone basis have the potential to cause damage when they interact with other events and conditions. It has also been clear to them that ERM would provide them with a framework to understand individual risk elements and their interactions with other risks that determine portfolio risk.
Even with these obvious benefits, for many years the key issues in implementing ERM have been the lack of good quality data and modeling sophistication. With regard to data quality, regulations like Basel II, SOX, etc. which have imposed multiple regulatory requirements on risk management, financial disclosures, accounting standards and corporate governance have had the beneficial side effect of improving data quality. This provides a good platform for banks to graduate to the next level of risk management by adopting ERM.
Given this backdrop, even though the quantitative approach to ERM requires significant modeling breakthroughs, banks should make a start towards ERM in 2006 on account of the following factors:
- Adopting a portfolio approach towards managing individual risk classes. Banks may adopt credit risk portfolio models. This will provide them with the benefit of portfolio diversification that is not provided by the Basel II guidelines. Over time, if banks adopt this practice, it may result in the Basel committee taking a relook at the impact of portfolio diversification benefits.
- Taking the first steps towards ERM by trying to integrate various risks in arriving at a single risk number. As most banks will have put systems in place to be Basel II compliant in the past year, the demands from the investor community and internal stakeholders for risk disclosure will increase. Banks may need to provide investors and analysts risk information that is easy to comprehend and facilitates comparison among peer groups. In addition, for CEOs and the board, having a single number that encapsulates all risks helps them set risk objectives that are transparent across the organization and can be easily monitored
- Requirement for compliance with multiple regulations, and the confidence of banks in defining what they expect of their ERM system will also shape the move towards ERM in the coming year.
5. Enhancing Operational Excellence Using SOA
In a competitive business landscape, banks are under pressure to innovate, improvise and differentiate their products and reduce the time-to-market. The rise of new businesses and newer ways of doing existing business has significantly influenced the need to better assess the business value realized from IT investments through better use and re-use of existing IT assets.
Service oriented architecture (SOA) represents the conceptual model of an enterprise where most of the collaborating systems produce or consume services that are loosely coupled entities representing coarse-grained business functions. SOA is implemented using web services, leverages open standards to provide a flexible model of integration without dependency on specific implementation technology. A fundamental element of SOA is the separation of concerns between service description, implementation, binding and declarative policies governing service interactions. Key features that SOA offers are:
- Ease of integration
- Process flexibility
- Re-usability of IT assets (hardware and software)
The above features of SOA address some of the pressing needs of banks, such as integration of diverse banking systems and applications (in-house developed and vendor provided packages), multiple access channels, hardware and other software spanning multiple generation evolution. While current generation technologies may offer solutions that are flexible and agile it may not be possible for banks to migrate to the newer technologies as mission control applications are still run on mainframes and banks are reluctant to risk total replacement. New product development, flexibility of IT infrastructure to support multiple product variants and faster time to market are some of the other areas where business demands need increased support from the IT organization.
The main benefit that banks can hope to achieve through SOA implementation is an enhancement in operational efficiency – in terms of reduced costs through better re-use of existing IT infrastructure, a flexible IT infrastructure that meets the business demands for agility, configurability of processes and product management that results in faster time-to-market for new products.
While SOA as an architectural concept has been around for sometime, it has become mainstream with the emergence of web services and consequent standardization efforts. Web services facilitate a comprehensive implementation of the SOA concept as most software vendors are providing web service adapters for their products and the ubiquity of the Internet and mobile platforms as an access channel further strengthens the web services proposition. Web service based business process management tools are available which allow business processes to be configured, designed and deployed as easily. Apart from this, increasing convergence on messaging standards and the development of XML vocabularies for the banking domain will ease interoperability and integration between collaborating banks.