Managing Risk in an Uncertain World

New risks, be they environmental, economic or political are continually emerging and given prominence, while external pressures on banks and lenders, particularly in relation to regulatory updates, have dominated their agendas over the past 18 months. For instance, the ‘Basel III’ proposals that were first put forward in December 2009, as a way of building stronger buffers into the financial system and creating a less procyclical financial system, have dominated the news agenda in recent months. The impact of these changes on banks will be dramatic, with Wells Fargo claiming that lending would drop by US$3 trillion if US banks shrink their balance sheets to avoid having to raise the estimated US$250-300bn in new capital the Basel Committee’s proposals would require.

Any new regulations must be implemented carefully and on a specific timeframe in order not to place unmanageable pressures on the banks. To avoid the severe economic implications of Basel III updates, the G20 finance ministers recently agreed that these new capital regulations would be phased in over time. Moreover, as banks prepare for these compliance challenges, they are simultaneously working towards improving customer service and rebuilding trust in the industry’s ability to effectively manage risk. In addition, we can expect that existing regulations around data quality and processes will be more strictly enforced. Also, the UK’s new coalition government’s statement that the Financial Services Authority (FSA) should continue as a separate body under Bank of England will remove the uncertainty around who will enforce these rules and how swiftly.

Scalability and Profitability

The crisis in the banking industry was preceded by a decade of strong expansion without a parallel focus on building scalability and control into businesses and banks. While risk profiles gradually increased, profit margins shrank and as a consequence the financial bubble built up steadily. That was in 2008, and these days, banks are on the slow road to recovery after the financial collapse. As a result, several measures have been put into place in the past months. First of all, the focus swiftly shifted to crisis management and securing liquidity by stopping lending and exiting non-core business lines with an extensive liquidity injection from the UK government. Secondly, banks began to cut costs by slimming down on staff and other expenditure including IT investments. Where previously, investments were mainly allocated to arrears management and documenting risk profiles, we are now in a phase where we see banks beginning to look forward again and prepare for economic recovery.

This focus on cost-cutting is also reflected in banks’ approach to investment in technology and innovation. Recent research from Gartner shows that IT is viewed as only useful for cutting costs. Now, banks must begin to look at IT investments in risk management not as isolated expenditure but as a way to find an integrated solution to improve overall business processes. While cost-cutting actions that have an immediate impact on the banks’ bottom line will continue to dominate, at this stage many banks may not have solved underlying challenge to improve efficiency, quality and control of processes. This is due to the fact that the bank’s core solution platforms could have a history of up to 30-40 years. For the banks to catch up and adapt to IT changes in the market often requires a transformation of their platforms that involve great risk, large investments and new competence. It seems that this should be a good time for considering alternative delivery models with proven solutions, fast time to market and shared cost. However, buying services from a third party is not inherent to the culture of the UK banking industry and is not something this sector has experience with. As such, banking industry buying services and cost sharing is something that mainly new banks and other payment institutions such as supermarkets can benefit from.

It is important not to forget to build scalability into lending processes in advance of the anticipated economic recovery. If this opportunity is missed, then the effect on the bottom line could be short-lived. Moreover, poor data quality presents a huge challenge to risk managers, as it is impossible to build a sustainable solution on top of inadequate business processes. It is therefore vital that bankers and lenders ensure that their processes are both efficient and high quality, in order to be prepared for the future economic recovery. Those banks that are fully prepared for the upturn – and ensure that the data capturing process is high quality – will be best placed to gain significant competitive advantage and profitable growth.

Simplicity as a Competitive Differentiator

The collapse of confidence in the banking industry’s risk management tools and techniques has had a massive impact on the lending industry over the past two years. A lack of confidence in the quality of the data basis for the risk evaluation and in the evaluation models, along with a lack of transparency and lack of ability to document their risk profiles, made it impossible for even the sound banks to obtain funding in the interbank market. While regulation designed to address risk management and capital adequacy failings is still in the planning phase, it is crucial to regain the confidence in the banking sector by demonstrating fundamental changes in the whole risk management system. Banks should work towards an enterprise-wide view of all operations rather than the siloed approach to risk management. This includes applying technology at a business level rather than in isolation.

As well as taking a more holistic approach to risk management, some banks are moving towards greater simplicity in banking, also known as a ‘back-to-basics’ approach. For instance, online banks that have been set up around Europe using very simple products and processes have already achieved a great deal of success, and more banks will also look to meet the competition through their own direct banking channels. This concept can also apply to branch banking, Vernon Hill, the founder of the new British ‘Metro Bank’, wants to go back to basics, as “each branch will have a manager you can speak to and make decisions on your account rather than it being done centrally; each branch will have safety deposit boxes; all branches will be free of barrier screens”.1

Conclusion

Those banks that encourage a culture of simplicity may be able to both improve efficiency and also strengthen relationships with customers. While compliance issues will continue to be a focus for banks’ risk management teams, preparing for economic recovery and building efficiency into their processes should not be forgotten as banks attempt to tick the regulatory boxes. Moreover, achieving a balance between risk management, scalability and profitability will mean that banks are best placed to ride the wave of regulatory changes still to come.

1This Is Money, 18 May 2010.

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