Basel II - Regulation and Reconciliation
Since the wheels were set in motion back in January 2001 for the implementation of the Basel II framework, much has been written questioning whether financial institutions in Europe and worldwide would have the necessary IT systems in place for compliance by the 2008 deadline.
There has been an added incentive, aside from compliance, for banks to adapt their systems to meet the requirements of Basel II. By and large, those banks in the UK and the rest of Europe that have been quick to adapt their IT systems, have reaped the considerable additional benefits that compliance can bring.
A case in point is that of Commerzbank, which in addition to meeting Basel II compliance has also used the mandate as an opportunity to update its systems to improve and streamline the bank’s approach to customer credit rating. Implementing business rule technology has allowed Commerzbank to reduce the time required to implement new customer credit applications by 50%. In addition, the technology has provided the bank with the agility it needs to change existing rating assessment criteria in near real-time, providing improved customer service and substantial cost savings.
Banks across Europe are now in a much better position than they found themselves in at the start of 2003, when a number were considered to be a long way behind schedule in their attempts to meet the Basel II deadlines. By the end of 2004, KPMG was already reporting in its ‘Ready for Basel II – how prepared are banks?’ survey that in Europe, “most banks are shifting their focus away from the general concerns and towards more specific issues as their understanding grows.” This compared to the situation in Asia where, “16% of Asian financial institutions surveyed had no Basel II implementation plans.” This trend seems to have continued as most European banks begin to finalise Basel II implementations, while their counterparts around the world are struggling or have chosen to opt out. The main problem therefore now facing European banks is not whether the necessary systems will actually be in place by 2008, but whether the implementation of these systems will have been successful. Many banks are currently facing what could be termed as ‘teething problems’ in the implementation of new risk information systems, particularly in regard to reconciliation with existing financial information systems.
A significant contributory factor to the problem is that risk systems and financial information systems have been implemented with scant recognition or understanding of the requirement for such systems to communicate with each other. Indeed, this is a symptom of the organisational structure of most finance departments, where often only the CFO has a view of both the risk and financial information. Further, the monumental legacy problems that many banks face have prevented them from rectifying this situation with the creation of a golden source through which all data is processed.
Through its inherent requirement for a coherent link between financial information data and risk management data, Basel II has exposed the fact that risk management data is currently often fragmented across organisational silos and, as a result, elements do not operate cohesively. This is compounded by the fact that, as is often the case within any large organisations, methods and processes of gathering risk and financial reporting data lack consistency.
This situation is clearly demonstrated when looking at the emphasis on Pillar 3 in Basel II (Market Discipline) which stipulates that data has to flow in a smooth and transparent way, so all relevant information can be disclosed if need be. However, if risk management information and finance management information is compiled from data fragmented across various departments within the organisation, data will be inconsistent or in some instances duplicated across different silos. As a result, the verification needed for such disclosure will not exist. So, while many European banks have made great steps towards updating their systems to be compliant, the small inconsistencies in data mean that they may still be found not to be fully compliant. This is a major problem and banks are increasingly beginning to realise the need to look at tools that can be used to reconcile the data.
Banks are increasingly being drawn down two different paths when it comes to addressing implementation issues. One of adopting an extract, transform load (ETL) strategy, which focuses on transforming the data, or a second business rules based approach that sorts and clarifies the process through which the operational risk data is reconciled. An ETL strategy works in three ways as its name suggests: by extracting the data from the source systems, then transforming the data through the application of a series of rules or functions to the extracted data and finally loading this transformed data into a reconciled data warehouse. A flaw with this solution is that it treats the problems banks are facing as a data issue only. The parameters of an ETL system across its usage lifetime need to be set out before it is implemented. If the volumes of data that require processing are large or if the time available for processing changes, then the speed at which an ETL deals with the data will slow down. Similarly, another flaw in adopting an ETL solution is one of a lack of consistency. Different silos from which an ETL gathers its data will have varying update cycles. Therefore an ETL system may be required to hold back certain data until all sources are synchronised. This leads to a situation where errors and inconsistency in data are likely to occur.
A business rules management system (BRMS) solution treats the reconciliation problem that banks face as one of business process. A BRMS strategy sets out the processes through which the data is to be aggregated and reconciled. This involves the setting out of validation rules for data consistency between multiple sources as well as data routing rules to the appropriate applications.
Benefits of using a BRMS strategy to solve problems of reconciliation are those of usability and accountability. With a BRMS solution, business users are able to make changes and modifications directly to the business rules in their business language, without the need for any programming or coding skills. Users are able to set out on a journey of continual improvement of the processes that reconcile the data, enabling them to react to changes in the real-time environment.
In addition, the centralised rules repository enables the creation of a clear audit trail in the form of a reconciliation report. This type of report means that any change to the rules guiding the reconciliation of data can be logged, time stamped and authenticated, and as such the history of any alteration or change can be traced and reported. This is important in both demonstrating compliance and providing authenticity to data reconciliation.
A disadvantage of the BRMS approach is that it requires the business and IT to co-ordinate more actively than the alternative ETL approach.
It is worth pointing out that European banks are, on the whole, one step ahead of worldwide counterparts in compliance with Basel II. Nevertheless, European banks cannot become complacent. If the issues around data discrepancies remain unresolved then these teething problems could develop into more serious issues. Banks have made enormous progress towards compliance, and the technology is available to address the few remaining issues, it’s just a matter of putting it in place.