Operational Risk Management in the Nordic Financial Sector
In a report issued in mid-2008, Fitch Ratings said that the performance of the major Scandinavian/Nordic banks is likely to weaken in the medium-term. However, the banks should prove resilient to deteriorating operating environments. “The major banks in the region will be hard-pressed to replicate the very strong levels of profitability achieved in 2006 and 2007 as operating environments deteriorate,” said Alexandre Birry, director in Fitch’s financial institutions group. “However, the banks’ performance should benefit from their sound risk management and good diversification of revenue and exposure.”
A recent development in the Nordic financial sector affirms the importance that the region’s financial industry gives to risk management and, in particular, operational risk management.
In mid-2008, the Swedish Financial Supervisory Authority, together with authorities in eight different European countries, granted the north European financial group SEB the approval to apply advanced measurement approach (AMA) for determining the capital requirement for operational risk. SEB became one of the first banking groups in Europe and the first Nordic banking group to receive this stamp of quality.
Basel II, the capital adequacy framework, offers three varying ways for determining the capital requirement for operational risk. AMA is the most advanced of these methods and requires supervisory approval. In contrast to the other two, more naive, methods, AMA embeds the bank’s own risk methods and data reflecting risk profile of the organisation and its operational risk management.
An institution gets AMA approval only after an in-depth review of all its processes. SEB has shown to the regulators of all the countries they work in that they apply the highest possible risk management standards. They apply these risk management standards uniformly across borders and departments.
This development is a major step in operational risk management in the Nordic financial markets. The other major Nordic financial institutions are expected to follow suit in strengthening their operational risk management.
The Nordic financial institutions seem to be doing decently well in operational risk management. However, with the increased trading complexity and increased transaction volumes expected in the next few years, the Nordic players need to do much more.
According to the Basel Committee on Banking Supervision (BCBS): “Operational risk is the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems, or from external events.” Hence it is important to intelligently manage your systems and the people handling/using them.
The degree of integration between the front office and the middle/back office in the Nordic market is reasonably high, which helps to manage operational risk. Research by BNY Mellon, in conjunction with McKinsey & Company, which drew from interviews with executives at 25 asset management departments of leading Nordic pension funds and insurers, points out that one reason for the favourable integration is the relatively small organisation size that characterises most pension funds and insurers in the Nordic region. On average, the middle and back office has only about 15 full-time employees (FTEs), while the entire asset management organisation in this region has an average of about 50 FTEs. Taking advantage of the narrow geographic focus, most organisations have chosen to co-locate the middle/back office with the front office – usually in same floor of one building, if not in the same room.
Also, it is not uncommon for senior operational staff to have front-office experience, which also aids their communication with trading and investment teams and helps in managing operational risk.
Many firms equate operations improvement with greater automation. In operations, most pension funds and insurers in the Nordic region have focused on ‘building’ rather than ‘optimising’ the middle and back office processes.
The Nordic firms have invested little in process standardisation and operational performance monitoring (e.g. error frequency, system productivity, etc). Neither have most of them invested in initiating continuous improvement programmes. This might be attributed to the fact that the organisations are relatively young and small (e.g. a lean or six-sigma programme in a 10-15 FTE operation is usually not practical).
However, as transaction volumes grow in complex asset classes and instruments, many organisations will have no choice but to dedicate more people to middle and back office processes in order to be competitive. This will definitely require more operational focus and continual improvement programmes, or else the costs and operational risk will increase.
The Nordic financial players involve many external partners (IT service providers, custodians, etc) in order to focus on their core competency, use best in class services of specialists and rationalise cost. If these partnerships are not managed well, this might add to the operational risk.
Nordic firms have so far involved mostly the local partners. The smaller of the local partners are sometimes unable to scale up, are in crisis because of the sudden departure of key personnel and do not have the experience of executing complex and large initiatives. Hence, this increases the operational risk for Nordic firms. To enhance scale, get benefits of low costs and leverage on the global experience, the trend is towards involving global players, sometimes together with the local players. The Nordic firms need to ensure that they have the necessary people, processes and management support to manage and grow these relationships. Time is ripe to start the relationship with the global players, test their capability, each other’s compatibility, and use their full range of services when the business grows in the near future.
Operational risk management, in general, is an immature risk category. Operational risk contrasts from other risk categories since there is no apparent return directly linked to this risk. Hence, many players in the financial services industry have probably under-invested in operational risk management. The Nordic financial institutions have done decently in handling the operational risk. They should continue to invest and expand their investment in operational risk management to ensure that they are well prepared for the increasing business and complex transaction handling and make best use of the growing global interest in this region.