Banking Sector Benchmark Reforms: Managing Market Structural Risk
The new environment will not just influence the way banks conduct their business operations but also have huge implications for their various corollary business functions, operations and technology support.
Ironically, customers are likely to be apprehensive as to whether banks can continue to meet their financial needs. This is partly due to the widespread loss of faith in the banking industry resulting from tainted benchmarks. It is also because tighter controls around various benchmarks directly or indirectly affect the rates at which banks can borrow and lend. Hence the onus lies with the banks to restore consumer confidence, by putting in place a systematic and structured solution framework that can help them meet the many challenges they now face.
Impact on Risk System Architecture
A key recommendation from the review of the London Interbank Offered Rate (LIBOR) headed by Martin Wheatley, head of conduct at former UK watchdog the Financial Services Authority (FSA), was that the benchmark rate should be reformed rather than scrapped. This carried through into the subsequent International Organisation of Securities Commissions (IOSCO), which agreed that submissions made by contributors must be evidenced by high quality, tangible transactional data rather than unsupported or arbitrary numbers.
A direct impact of this requirement is on the capture and dissemination of this transactional data for all currencies, products and tenor combinations that banks plan to operate in. It means a re-design – or in many cases the creation from the ground-up – of architecture that supports the capture and secured storage of large volumes of trade data. Banks must carefully channel their resources to achieve this efficiently and effectively.
Flexibility and Change
Following allegations about the manipulation of LIBOR and the Euro Interbank Offered Rate (EURIBOR) efforts were made towards better monitoring of the tainted benchmarks. One of the results has been a reduction in the number of currencies and also tenors for which LIBOR is calculated, which has meant re-negotiation of large number of existing contracts.
However, in the absence of certain tenors, interpolation and extrapolation techniques can be used by the banks to create intermediate maturities between the existing data points. This, in turn, depends on the availability of historical data for periods sufficient to support the required statistical analysis.
The discussion on LIBOR is only the start. The complexity becomes exponential when all the other benchmarks are considered. All of this underlines the need for flexible architecture /systems for banks and market participants, to support the ever changing dynamics of regulatory compliance.
The regulators have emphasised the need for a governance framework within the banks. This has led to a clear distinction of the respective roles played and requirements met by the front office, back office or internal audit and compliance teams in the end-to-end benchmark submission process. To be able to fulfil these requirements, there is a need for an elaborate set up of infrastructure and process control mechanisms, which support and monitor a seamless flow of submissions from the banks to the publisher.
Audit and Compliance
A crucial step towards restoring public confidence in the system is increased emphasis on external auditors’ assurance of fair practice in relation to benchmark activities. Banks will be required to keep ‘accurate and accessible’ records of transactions in inter-bank deposits and other relevant financial instruments that act as underlying evidence for the benchmark submissions.
The requirement also extends to maintaining all relevant records relating to the submission process, over and above transaction records. Needless to say, these records must be made available to the relevant governance committees and national regulatory bodies such as the UK’s Financial Conduct Authority (FCA), as and when required.
Global Reporting Requirements
International coordination on regulation and the oversight of benchmarks is imperative, given the dependence on such benchmarks at a global scale. As more regulatory requirements come into place across global financial markets, banks with a wider international footprint will be required to comply with various regulatory bodies. Such increased regulation necessitates a robust, scalable and reliable reporting framework. Banks need to draft a plan for the allocation and utilisation of resources to support this endeavour.
The approach that banks and financial institutions should take is multi-pronged. On the strategic front, it is vital that banks put in place a governance framework for business, process and data within which all the processes are defined and operated. On the operational front, banks will be required to focus on building reliable and consistent analytics and reporting framework. The latter is crucial in providing a high-level dashboard view as well as granular-level information, so that management can identify key areas of concern and take remedial measures or employ control mechanisms.