As the ramifications of the global credit crisis continue to unfold, they have served to highlight major shortcomings in not only banks’ financial systems but also the regulatory systems. The triggers were undeniably the macroeconomic imbalances that have developed over the past decade, coupled with high-risk financial innovation. This volatile mix was made worse by flaws in the capital and liquidity regulations governing banks, and a mistaken belief that markets were ultimately rational and self-correcting.
With prevention of another crisis the order of the day in 2009, international governments and regulators focused a significant amount of energy on identifying the shortcomings of the existing financial and regulatory systems. High on the list of priorities was the need to strengthen liquidity and supervision, in order to reduce the risk of systemic failure, as well as to increase the amount and quality of capital and liquidity in the global financial system to provide more adequate safety margins and future-proof the industry.
According to industry think-tank JWG, the UK financial industry was flooded with over 2,000 pages of regulatory documents in December alone, including a dozen publications from European supervisory agencies, two major consultations from the Basel Committee on Banking Supervision (BCBS) and over 15 pronouncements from the UK’s Financial Services Authority (FSA). With reams of paper to be absorbed and acted on, bank infrastructure professionals are now grappling to size up the international regulatory gauntlet. If 2009 was the year of regulation, then 2010 will arguably be the year of implementation.
The Renaissance of Liquidity Risk
One area that has received particular attention over the past year has been liquidity risk. Historically, liquidity risk was treated as a consequential risk, in the sense that liquidity issues only arose from problems in other primary risk areas where the risks were not sufficiently controlled and managed – such as market, credit or operational risk. However, with the onslaught of the credit crisis, it became very quickly evident that liquidity risk must be measured and managed as an independent risk in its own right, and as a result came under scrutiny by both governments and regulators in 2009.
As a result, all the major banking supervisory organisations, including the BCBS, Committee of European Banking Supervisors (CEBS) and national regulators, such as the FSA, the Institute of International Finance (IIF) and the Federal Institution for Supervision of Financial Service (BaFin), have revised their approach to liquidity risk and put forward recommendations and regulations that banks now need to respond to.
While the specifics of the revised liquidity risk recommendations and regulations vary from country to country, the underlying components for banks remain the same. They need to:
- Identify and measure liquidity risk in both normal and stressed scenarios.
- Monitor liquidity risk to ensure that it is kept at or below the level defined, as well as a regular review of the standards set and their implementation.
- Mitigate liquidity risk, in which banks choose the appropriate tools to reduce their risk, such as diversification of funding sources and liquidity buffers.
The Evolving Remit of IT
As with any reform, change comes hand-in-hand with challenges, and the international regulation surrounding liquidity risk is now sitting high on the agenda for board members, risk managers and IT departments alike. Fundamental to this challenge is the necessity to obtain and provide an accurate and timely picture of liquidity risk that considers most parts of the business.
The complexity of putting together all of the required elements and then keeping the models tuned and relevant should not be underestimated. For liquidity risk, specifically, the prevalent issues for bank’s IT infrastructures and processes can be categorised into four main areas:
- At the heart of the analytical challenge is the necessity to have the right solution at hand for providing proper cash flow modelling, calculating appropriate liquidity buffers, measuring the influences of primary risks on liquidity, having the flexibility to define a bank’s own measures and indicators, and being able to define stress scenarios easily.
- In regards to time, banks need to ensure their IT infrastructures and processes are geared up to conduct critical calculations on a daily, and in some instances intraday, basis.
- At the heart of all processes is the data challenge, which directly affects a bank’s ability to describe the institution’s business and organisation completely, while delivering information on a daily basis when required.
- Finally, banks need to rise to the reporting challenge and ensure they have the right solutions in place to monitor the defined measures and indicators, together with collateral management and flexible ad hoc reporting capabilities.
While deadlines are tight when it comes to answerability and compliance in order to deliver monetary value, a significant co-ordination effort is required from banks that looks beyond domestic reporting requirements, such as those laid out by the FSA, and takes a global perspective. With this in mind, forward-thinking banks are looking at broader risk management solutions to support their liquidity requirements as part of a wider integrated risk management approach.
Business analytics in particular are relevant to addressing the challenges outlined above and forming the foundation of an integrated risk management strategy. A business analytics approach allows for the automated collection of appropriate data from across the business. This information is then cleansed, managed and analysed, which enables standard reporting and ad hoc reporting through the use of management dashboards. Coupled with this, business analytics further enhances the process by providing profiling and segmentation, forecasting, predictive modelling, and optimisation techniques. This level of transparency arms decision makers with an automated insight into their business, not only in regards to what happened in the past, but why it happened, what may happen in the future and how the organisation can manage its business to take into account unforeseen events, such as those that led to the current market turmoil.
There is no doubt that the global regulatory landscape has changed significantly over the course of 2009, and 2010 marks the year whereby actions will start speaking far louder than words. With regulatory requirements differing substantially from country to country, the financial industry must stand up and be counted at both a domestic and international level. With liquidity risk in particular, accuracy, timeliness and breadth will hold the key to success. The only way to achieve this, and conquer the associated challenges, will arguably be to adopt an integrated risk management approach that is supported by the appropriate analytical technology.
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