Active Risk and Compliance Management for Sustained Bottom-line Growth

The tidal waves of regulation and increasing stakeholder demands for public scrutiny have moved risk and compliance activities from being transaction focused to integral elements of business management. The challenge, however, is to embed these activities into business planning and execution.

Risk and compliance (R&C) management is an integral part of any business, especially banking. Banks initiated R&C management because of the pressure from regulators and other external bodies. Fortunately, they have largely moved from this phase to the next, viewing R&C management as a necessary cost and something that needs to be performed diligently. It is now time to go a step further and use active risk and compliance management (ARCM) as an effective tool for sustained bottom-line growth. The two trends that bolster this argument are:

1. The shift towards a holistic performance measurement approach, from pure return measures to risk-adjusted performance measures – the risk angle.
2. The focus is moving from increasing shareholder value to increasing stakeholder value as the index of a firm’s success – the compliance angle.

The current scenario sees an emerging significance of R&C. Indisputably, R&C occupies centre-stage today, thanks to a number of contributing factors:

Multiplicity of risks

The complexity of the banking system, owing to multiple factors such as complex products and organisational structures, varied customer profiles, and increasing global presence, among others, has geometrically multiplied the risk that banks carry. Rapid business expansion and diversity serve to only intensify this situation.

Reputational risk at an all-time high

With litigation, fines and settlements rapidly increasing, many organisations find their reputation being hit due to negative publicity. The banking industry survives on the faith and trust of its stakeholders and can ill afford reputational risk.

Multiplicity of regulations

To better monitor and manage the evolving complex banking system, regulatory bodies are imposing multiple regulations that sometimes overlap with each other. The fact that there are multiple regulatory bodies covering the banking industry adds to this and it would be no exaggeration to say that the industry is experiencing ‘regulatory fatigue’. The regulatory environment will only continue to expand to manage the dynamic business environment.

Regulators demand evidence

In a noticeable shift, regulators are now playing an active part in implementing regulations. A report signed by a CXO no longer suffices. Banks now have not only to abide by the details of the regulation but also show that they have done so. Since evidence is demanded, transparency and traceability are critical.

Increased scrutiny from rating agencies

Ratings from prominent rating agencies are now used as barometers of the credibility of the concerned organisations. This has led to increased scrutiny by the rating organisations. These changes throw up a host of challenges. The struggle that R&C administrators face, is to meet the mandates of two sets of masters, the regulators and the management.

The regulators want:

• Strong and good quality controls.
• Full documentation of all decisions.
• Detailed and explicit reporting.
• Transparent systems that allow in-depth scrutiny.
• No backlogs.

The management wants to ensure that the organisation:

• Meets regulators’ expectations.
• Reduces costs.
• Keeps customers happy.
• Follows best practices.
• Is seen as better than competitors.

The challenges that the R&C team faces in executing the above mandates are:

• Industry best practices are not publicly available.
• Regulatory guidance has much room for interpretation.
• Tracking productivity is difficult.
• Data is a big challenge – both availability and reliability.
• Volume of activity is high.
• R&C initiatives require skilled manpower, which is scarce.
• Regulations are dynamic and changing rapidly.

As compliance with regulations and market benchmarks is mandatory, organisations need to deal with these challenges intelligently at all three levels of management – strategic, tactical and operational. The winners are those that convert short-term costs and efforts to long-term business benefits and sustained bottom-line growth. This demands good planning and effective execution, with the result being well worth the effort.

The Costs

In the short term, compliance spends will be large. According to IDC, the global market for compliance information management will grow at 22% a year through 2009 and pass the US$20bn mark in the same year. Celent places the IT spending on compliance, globally, at around US$18bn. Some of the critical quantitative and qualitative aspects that a successful R&C program affects are detailed below.

Quantitative dimensions: the risk angle

With the increasing realisation that risk-adjusted or economic profit is the real profit, risk-adjusted performance measures (RAPM) are the preferred performance indices of the future. Let us consider the RAPM of risk-adjusted return on capital (RAROC) as an example and illustrate how ARCM can help enhance it:

Net effect on RAROC = Better/higher RAROC

This is because positive R&C management, woven into business decisions and practices, increases the risk-adjusted returns while reducing the capital at risk.

Qualitative dimensions – the compliance angle

The qualitative aspects may be difficult to convert into precise numbers but there is no mistaking their impact on bottom lines and, sometimes, on the compliance that is largely with the board of directors and CXO level officials (about 75%, according to a Deloitte study). The associated reputation risk for non-compliance can be much higher.

The second qualitative aspect is the positive impact of healthy compliance in various business practices, including good corporate governance. The bank’s various stakeholders, such as customers, regulators, market players, and staff, will all reward good governance and compliance. The International Finance Corporation has neatly summed this up as: “The other qualitative benefits are greater process efficiency, and more comprehensive and dependable data, which helps in data-based decisions. The key takeaway is that the cost of compliance may be high, but the cost of non-compliance may be the institution’s survival itself.”

Conclusion

The big challenge for banks is to meet R&C requirements while effectively running and growing the rest of business. The trick really is to blend the R&C initiatives into the organisation’s strategy and planning, looping back the insights into business practices to enhance the bottom line, by moving from passive to active R&C management. Slowly but surely, increasing stakeholder value is replacing increasing shareholder value as the index of a company’s success. Stakeholders include owners, customers, regulators, staff and the market. This is the true spirit of almost all the regulations that are being introduced.

Banks are realising that there is a better way to balance the concurrent and sometimes conflicting demands of managing both best practices and multiple regulations, and that they can achieve compliance as a natural outcome of doing business well. The benefits of a positive ARCM can be summed up as:

Quantitative:

• Better risk-adjusted returns.
• Access to cheaper funds through better credit rating.
• Competitive advantage through better pricing (risk-based pricing).
• Better capital management to support business expansion plans.
• Commanding higher share premium as investors will pay for good governance.
• Reducing, if not totally avoiding, financial loss.

Qualitative:

• Better perception by various stakeholders due to greater transparency, resulting in better brand image and perception.
• Well-oiled risk management systems to future-proof the organisation to manage volatile environments.
• Over time, reduced compliance costs due to a holistic and integrated enterprise-wide approach.
• Managing reputation risk well.
• Infusion of best practices, which will enhance the resilience and growth of the organisation’s fabric.

Survival of the fittest is as relevant today as it was when Charles Darwin propounded it. Fitness in the banking world can be directly equated with sustained bottom-line growth and ARCM provides banks with the opportunity to accomplish that. The ultimate goal is to successfully navigate the road from R&C management to stakeholder value creation.