Forward-Looking Indicators: the Next Stage for Asia Regulation
In many markets across Asia, regulators have focused in recent years on using Basel III and other regulatory requirements to manage risk and build confidence in financial market integrity. In markets such as Hong Kong or Korea, whose weaknesses were exposed when liquidity disappeared during the 2008-09 financial crisis, for example, regulators have focused on improving liquidity and on modeling the balance sheet. In advanced economies such as Australia, regulators are driving capital requirements and being very directive-focused about banks meeting liquidity requirements.
While these regulations can increase banks’ resilience, they have largely focused on reporting or stress-testing that uses snapshots of current or past data. To ensure that banks are better prepared for the future a major shift is occurring, reports Foulley, as regulators start to use forward-looking indicators of capital utilisation that focus at least nine financial quarters ahead. This concept, which began in the US, is now being taken up in Asia. Along with being valuable in assessing future risks, the forward-looking indicator also enhances protection for shareholders.
To implement these forward-looking indicators, regulators are considering new stress tests, translating their impact to income statements and the balance sheet, and telling banks what needs to happen. This means less disparity between banks and encouraging changes that bring finance and risk management closer together. Among the regulators that have been first in adopting the approach of indicators that project nine quarters ahead has been the Reserve Bank of India (RBI).
The Technology Conundrum and Opportunity
Given the complexity of developing indicators that project further into the future, the shift will necessitate banks using better technology to bring data into a single mechanism that is easy to exploit. Stress testing has traditionally been uncoordinated and different units conduct stress tests multiple times to determine the impact of a single change – such as movement in the three-year interest rate, for example. Banks are now starting to look for ways to reduce systems complexity and decrease duplication.
Foulley cites one bank in Australia with no less than 110 systems for risk, each of which has data that needs to be maintained and computed, and each of which will be upgraded regularly as regulatory or other requirements change. There are also 20 sources for the data these systems use, such as core banking systems or collateral management systems. The net result is that more than 2,000 pieces of software populate the risk engine.
To deal with such complexity, leading banks are working to develop a common staging area for their data. By feeding information from 20 systems into a common staging area servicing all the different risk systems, the number of spaghetti-like connections could be reduced from a couple of thousand to about one hundred or less. The next step, after solving the dilemma of common data sourcing, is to develop a common layer for calculations and modeling.
While making the shift to a common sourcing platform itself is costly, it can also result in significant benefits. The chief technology officer (CTO) of an Australian bank said that managing regulatory requirements for Basel III alone could cost A$1m per month, so common staging of information that reduces connections by nearly 90% promises to reduce expenses significantly.
This new framework can also position the bank better for a future in which new and constantly evolving requirements require more data, and data manipulation. A single staging platform can enable staff to comply with new requirements quickly and simply, provided they have captured the data that is needed.
The People Piece
Along with enhancing technology, banks are also changing their organisation structure to deal better with the complex regulatory requirements. One strategy is to reorganise risk into a single function, whose staff deal with credit, corporate, liquidity, operational and other risks all brought together. Foulley said that Malaysia’s Maybank is a prime example of a bank breaking down risk silos and creating one big team so that there is aggregation into a single global risk unit.
Given that regulators are working to receive input from both risk and finance, and that both functions are starting to use the same data and technology as well as engines and output, some banks are also working to increase coordination between these two groups. One practice adopted by several Asian banks has been to develop secondment programmes where part of the finance team goes to risk for two to three years so that they can understand the demands of risk and regulators while some of the risk team are sent to finance. Along with increasing overall understanding on both sides of the business, it creates a network of people who can work together more easily.
Deriving Value from Change
Once banks understand the value proposition and future-proofing that technology and organisational change solutions can provide, they often want to do everything at once in a transformational process. Given the high level of complexity in regulatory and management reporting at most banks, however, it is better to develop a step-by-step process and stage the journey by moving from one initiative to the next following strategic priorities.
Foulley says that India presents an interesting case study. Until relatively recently its regulatory requirements were more straightforward and projects were primarily tactically focused on one objective such as Basel III or the US Foreign Account Tax Compliance Act (FATCA). Now that India is trying to leapfrog to the next level and shifting towards forward-looking indicators, however, more than 80% of engagements are architecturally driven and focus on a transformational solution.
While reducing costs by taking out complexity and being prepared for new or future regulatory requirements are beneficial, leading banks are using the changes to go beyond just those objectives and use the systems to derive customer insights. One bank, for example, was using an economic capital model to predict the loss they would be exposed to a year in the future. Having put better forward-looking indicators in place, it found that the expected losses used in the pricing model were high and they were over-pricing their products. Following development of a more flexible system that leveraged a new model and gave a more accurate forecast of expected losses, the bank was able to price more competitively.
As regulation becomes ever more complex and as regulators shift from looking at the present to looking nine or more quarters ahead, banks need to adjust their own practices to keep up with the changes. By enhancing both their technology and organisation structures, they can actually use the change to go beyond regulatory compliance and achieve additional benefits that enhance their competitive positioning.