Lepus

CVA

lepus — Tue, 31 Jan 2012 12:44:28 +0000

Introduction

The devastating losses associated with high-profile defaults since 2008 have led financial institutions to focus on improving the methods they employ to evaluate, manage and hedge counterparty credit risk (CCR). These responsibilities have been increasingly transferred to groups dedicated to managing all CCR and calculating the associated cost in the form of Credit Valuation Adjustment (CVA).

Key Findings

Pricing methodology – The majority of the interviewed banks use Monte Carlo simulation, with a minimum of a thousand paths, to generate the exposure profile. An internal study carried out by one bank suggested that the Monte Carlo error in the bilateral CVA from a simulation using 1000 paths was quite reasonable, with a standard error in the order of A$750k.
Organisation of the CVA group – Many banks are setting up dedicated CVA desks in order to attend to the increasing regulatory pressure to improve CCR management. At present, half of the banks in the research sample employ personnel dedicated to pricing and modelling CVA.
Standardised vs. advanced CVA risk charge – Of the interviewed banks, 16 intend to use the advanced internal models method (IMM) and specific risk Value-at-Risk models, but they are concerned that national regulators may prevent them from using these advanced models, preferring that banks use more standardised models.
Regulatory challenges – Banks are concerned that the Basel III proposals will make derivative products much more expensive. Uncollateralised derivatives may become limited to tier-1 banks, which are better placed than smaller institutions to overcome the regulatory and technological barriers in a timely enough manner. These “too-big-to-fail” institutions may, therefore, take a higher risk exposure position, resulting in higher systemic risk.

Conclusion

Extensive efforts have been made by regulators to address the issues that Basel II failed to combat. In particular, the introduction of the CVA risk charge and new CVA pricing methodologies will force banks to more accurately identify and hedge CCR. Yet, with the exception of some tier-1 banks and a few tier-2 banks, most of the interviewed institutions are not yet ready to meet the new regulatory requirements on CVA.

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Use of Social Media in the Financial Services Industry

lepus — Tue, 31 Jan 2012 12:32:51 +0000

Introduction

The use of social media at the workplace has generally been discouraged over the course of the last decade, as there was a belief that it was used solely for personal purposes and that it distracts employees from carrying out their responsibilities. As social media is becoming increasingly popular, however, it is revolutionising the way we are communicating and networking. Any institution that fails to leverage the benefits of social media will ultimately marginalise itself from an enormous and rapidly increasing community of users, who may well be current or future employees, business partners or clients.

Key Findings

General usage – The rise in the prominence of social media, has inevitably seen the medium permeate the professional arena, with a total of 89% of respondents stating that they use social media for professional purposes.
Preferred forms –336 respondents (93% of the total) contribute to or visit social networking sites such as facebook.com and linkedin.com at least once per month.
At the workplace – Over half of the respondents use social media at work on a weekly basis, a quarter of whom visit these sites daily. Thus, it appears that the use of social media at the workplace is quickly becoming ingrained within company culture.
Purpose of visit – The vast majority of respondents use social media at work for research or general information gathering purposes. Other job-related reasons include recruitment and networking.
Use of social media by financial institutions – Financial institutions are yet to harness the complete range of potential benefits that can be realised by the use of social media platforms, with only moderate usage, suggesting that take-up is in its infancy.

Conclusion

The current immaturity of social media within the financial services industry means that firms are not yet making the best use of this medium. At present, the way the majority of respondents are using social media has not impacted their company’s sales and revenue figures or their lead generation capabilities significantly. In the future, however, as the benefits begin to outstrip the costs in terms of a loss of productivity, the value of using social media in a professional capacity will become evident.

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Sovereign Risk

lepus — Tue, 31 Jan 2012 12:07:15 +0000

Introduction

Before the financial crisis, the danger that sovereign debt would not be repaid was associated mainly with developing economies. With a number of nations in the Eurozone having experienced ratings downgrades, however, sovereign risk is no longer confined solely to the developing world.

Key Findings

Severity of sovereign risk – The responses indicate that there is a great deal of concern about the future of the global economy, with 80% of the respondents stating that the current sovereign problems definitely have the potential to trigger a further global recession.
Regulatory response – Over half of all respondents (55%) stated that although regulators are placing too much emphasis on government debt, this is the only viable course of action available to them.
Rescue measures – The rescue package gaining most traction at present is the orderly restructuring of debt rather than a full bailout. The vast majority of respondents supported the former strategy, with 83% selecting it as the rescue measure they would prefer for defaulting EU nations.
Methodology – Though the responses vary too greatly to determine what the industry considers to be an emerging best practice, it is clearly evident that banks place great emphasis on the opinions of experienced experts, either solely, or in combination with other factors, to manage developed country sovereign risk.
CRAs – Confidence in external ratings has eroded, with financial institutions placing less weight on their proclamations than they do on their own internal ratings when assessing probabilities of default. Indeed, 61% of the surveyed financial institutions use internal assessments before consulting external ratings for discrepancies.

Conclusion

The expectation of almost half of the respondents from 49 leading banks is that the EU sovereign crisis has the potential to cause a second recession reminiscent of that which began in 2008. This position indicates that banks must invest both time and effort into developing sophisticated methodologies to model sovereign risk within developed world economies. Banks are fully aware of the seriousness of sovereign risk, with a majority of respondents expecting a series of defaults within the next three years. Unlike the situation in 2008, which was largely unforeseen, banks are preparing themselves for the possibility that their own country, or countries to which they are heavily exposed, will face the possibility of default, and the subsequent likelihood that the liquidity of assets which were once considered high quality would dry up.

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Collateral Optimisation

lepus — Tue, 31 Jan 2012 11:59:35 +0000

Introduction

Against any transaction, if given the choice, rational investors will naturally post collateral that is the cheapest to deliver. Before the credit crisis, the spreads between major return rates were insignificant, which meant that having a choice between different forms of collateral to post against a derivative trade was not particularly beneficial. Now, however, these spreads have diverged, and banks have become highly cautious about sharp swings in liquidity. As a result, collateral optimisation has become a primary concern for major financial institutions.

Key Findings

Current status of collateral operations – Traditionally, collateral operations at financial institutions have been organised within silos, and this is still the case at a large proportion of banks. There is, however, evidence of a gradual shift away from this structure, with 30% of online survey respondents commenting that collateral operations are now well-integrated.
Prioritisation of integration efforts – 71% of the surveyed banks have already integrated their collateral teams, or are currently reviewing their organisational structure. Hence, it is clear that integration of siloed collateral operations has become a high priority task.
Drivers for change – Aggregating collateral to maximise funding capacity is the most important driver for change. This is followed by improvements to cross-product risk management and regulatory requirements.
Process sophistication – As institutions have become highly wary of illiquidity and the need to make efficient use of scarce capital, the practice of passing on the funding costs of collateral to counterparties is gaining a great deal of traction across the industry. Indeed, this is already being done at 38% of the surveyed institutions, with a further 39% preparing to do in the near future. Just 23% of respondents do not deem this practice necessary.

Conclusion

There are strong differences of opinion among the surveyed banks as to what is the best method to achieve collateral optimisation. There is a variation in the approach adopted by the top and lower tier banks, and it is evident that the reason is simply the amount of available resources and the size of trading operations. Many of the tier-1 banks, as well as a significant number of tier-2 banks, are already able to, or are looking to, price collateral charges into trades and transfer them to counterparties. By ensuring that the bank does not absorb the costs of collateral, they can better prepare against a sharp drop in liquidity and use their capital more efficiently. Conversely, the lower tier banks are looking to strengthen the communication channels between Collateral Management teams, Operations, Risk Management and the business to ensure that there is a better understanding of collateral needs across the enterprise. In addition, the lower tier banks have developed, or have purchased, Front to Back Office solutions to better integrate the processes of each division.

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Credit Valuation Adjustment (CVA)

lepus — Tue, 31 Jan 2012 11:06:37 +0000

Introduction

Key Findings

Pricing methodology – The majority of the interviewed banks use Monte Carlo simulation, with a minimum of a thousand paths, to generate the exposure profile. An internal study carried out by one bank suggested that the Monte Carlo error in the bilateral CVA from a simulation using 1000 paths was quite reasonable, with a standard error in the order of A$750k.
Organisation of the CVA group – Many banks are setting up dedicated CVA desks in order to attend to the increasing regulatory pressure to improve CCR management. At present, half of the banks in the research sample employ personnel dedicated to pricing and modelling CVA.
Standardised vs. advanced CVA risk charge – Of the interviewed banks, 16 intend to use the advanced internal models method (IMM) and specific risk Value-at-Risk models, but they are concerned that national regulators may prevent them from using these advanced models, preferring that banks use more standardised models.
Regulatory challenges – Banks are concerned that the Basel III proposals will make derivative products much more expensive. Uncollateralised derivatives may become limited to tier-1 banks, which are better placed than smaller institutions to overcome the regulatory and technological barriers in a timely enough manner. These “too-big-to-fail” institutions may, therefore, take a higher risk exposure position, resulting in higher systemic risk.

Conclusion

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Data Centre Strategy

lepus — Tue, 31 Jan 2012 10:19:07 +0000

Introduction

Data centres have grown tremendously in the past decade, both in storage capacity and number. As banks deal with increasing volumes of data, challenges are arising, particularly around location considerations, cost reduction requirements and, not least, increased pressure to be environmentally-conscious. Moreover, the new regulatory framework requires banks to retain unprecedented levels of data for reporting to supervisory bodies, which significantly raises data storage requirements.

Key Findings

Data centre strategies – All of the surveyed institutions have a defined data centre strategy, which is typically the responsibility of the IT Infrastructure or Architecture departments. The strategy is reviewed at least once a year at a vast majority of the institutions. There are formal Data Infrastructure teams that tend to be located centrally, with only a negligible minority of institutions aligning them to business divisions. The data centre strategy is typically executed by a designated Data Infrastructure team at almost all institutions.
Trends in IT investment – Of the institutions surveyed, 52% have seen a significant rise in IT expenditure on data centre upgrades over the last three years, whilst another 24% have seen a slight increase. It is only at the banks with less prominent investment banking operations where investment has either remained flat or has decreased. Institutions that have spent significant sums over the last three years will see falling investment over the next three years as the projects embarked upon have now been completed.
Number of data centres – The preference for many banks is to retain at least one data centre in a central location. The number data centres based in financial centres varies by bank, although tier-1 investment banks tend to have a larger number of data centres in the central location than smaller banks.
Disaster recovery systems – Of the surveyed institutions, 21% have disaster recovery systems right alongside the primary systems. Most institutions, however, have disaster recovery systems within the same data centres but not alongside the primary systems. A further 32% of institutions have even set up separate data centres dedicated solely to disaster recovery.

Conclusion

The business models followed by financial institutions vary considerably, which also influences the data centre strategy pursued. Nevertheless, all institutions share the objective of cost reduction and increasing efficiency. Many firms have recently made significant investment in their data centres, whilst those that have not done so yet, expect a rise in budget for investment over the next three years. With concerted efforts to reduce latency and surging data storage requirements for regulatory reporting, data centres and the approach banks adopt towards them will be a key determinant of future performance.

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Over-regulation in the Financial Services Industry

lepus — Tue, 31 Jan 2012 10:14:50 +0000

Introduction

Although there is an understanding amongstindustry practitioners that regulators needed to act quickly and firmly, there is a perception that regulators have attempted too much in too little time.Essentially, it is believed by some that under pressure to act, regulators have made a series of proposals without fully understanding the implications these will have on theindustry and on the wider economy. There is absolutely no doubt that reform is needed, but regulators must ensure that they are finding the correct balance between protecting the taxpayer and allowing an efficient market to prosper.

Key Findings

Response from banks – A majority of the banks have responded to the great increase in regulation by establishing specialised regulatory teams or having reorganised the existing teams.
Information required by regulators – All of the responding banks commented that the amount of information that regulators are requesting has at least doubled over the last 36 months.
Investment in technology – All of the responding banks commented that they have already invested, or expect to invest, in additional technology to meet demands that have specifically come from the increase in regulation rather than from the business.
Changes expected in the industry – Three respondents were comfortable in predicting that the industry will become more risk averse, with the number of risk professionals increasing, products becoming less complicated and the markets becoming less volatile.

Conclusion

Essentially, the majority of respondents do not think theindustry is being overly regulated, with each confirming that extra regulation is beneficial to the stability of theindustry and the global economy. Each respondent admitted, however, that the extensive nature of regulation is a considerable burden to banks. Another issue raised across the interviewed sample is the fact that neither regulators nor banks themselves know how the sum total of a number of reforms will ultimately affect specific areas of theindustry, as many proposals are still to be finalised. It is expected that these effects will be more readily understood in time, and compliance projects will dynamically realign as the reforms become more defined and well understood and the consequences become clear. One thing that is certain is that the role of regulatory teams at all financial institutions will continue to be a demanding one for the foreseeable future.

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The Three Lines of Defence Model

lepus — Tue, 31 Jan 2012 10:11:23 +0000

Introduction

Financial crises always reveal glaring shortcomings in the prevailing risk governance framework in the banking industry. Nowadays, regulatory authorities and internal stakeholders at banks are scrutinising these internal governance frameworks with renewed firmness. Compliance with their expectations necessitates the clear delineation of all governance policies, so that individual departments remain cognisant of their roles. In this regard, the 3 Lines of Defence (3 LOD) approach is particularly appealing due to its uncontested simplicity and the way it very neatly ascribes distinct responsibilities to vital organisational functions.

Key Findings

Approach to the three lines – Most of the seven participating banks follow the standard 3 LOD model, with the business as the first line, Risk as the second line and Audit as the third. Some banks extend the first line to embedded Risk teams as well.
Lines of review and control – As most banks follow a standard 3 LOD model, Group functions are generally reported to by divisional and business unit level functions. The first line is responsible for developing its own controls, while the second line oversees the business.
Divisional and Group functions – All banks have their own way of allocating responsibilities between divisional and Group functions for areas such as Risk, Finance and HR.
Assurance, Finance and policy setting – At almost all participating banks, Assurance is officially within the remit of the third line, but all lines also conduct their own independent reviews. Finance roughly falls in the second line but only informally so. Policy setting is also vested in the second line, but consultations with other lines also take place.
Risk appetite – Like policy setting, the risk appetite is also defined collaboratively by the first and second lines, but is ratified by the Board, which resides outside the 3 LOD model.

Conclusion

The financial industry is increasingly showing greater appreciation of a strong internal governance framework. Towards this end, the participating banks have categorically adopted the 3 LOD model. Encouragingly, a vast majority of banks have successfully cultivated a strong understanding of the model by their employees, indicating that good governance is being duly prioritised.

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Forward-looking Analysis of Credit Risk

lepus — Tue, 31 Jan 2012 10:08:26 +0000

Introduction

In the aftermath of the events of the past three years it has emerged that the Early Warning Indicators (EWIs) which were employed by the banking industry were either insufficiently robust or were ignored by banks. One of the key elements of the post-crisis reform of the banking industry, both from within and externally, has been the implementation of more extensive and stringent systems to analyse and mitigate the various forms of risk.

Key Findings

Strengthening of EWIs – Banks have been assiduous in bolstering both their systems of forward looking analysis and the rigorous use of EWIs. Incorporating ever-increasing numbers of metrics, they are continually trying to refine the models used to forecast credit risk events.
Ratings relevance – The ratings and analysis produced Credit Ratings Agencies (CRAs) such as S&P are certainly taken into account when modelling for credit risk. It is the internal bank ratings systems, however, which take precedence and become the deciding factor in the event of a data conflict.
Fluctuating time horizons – The use of differing time horizons by different banks to forecast risk projections is a function of the business lines operated byindividual banks. Banks whose primary focus is retail banking tend to use longer time horizons for their forecasts, whilst those with a joint commercial focus tend to use shorter time horizons due to the heterogeneity of their loan portfolio.

Conclusion

This report focuses on EWIs for credit risk in particular, which affects all portfolios held by a bank and is arguably the most difficult risk type to manage effectively. It is clear from the events of the past 36 months that there is a very real need for banks to develop not only robust stress testing frameworks but if a bank wishes to survive the forecast economic turmoil, stringent procedures and processes must be implemented to incorporate dynamic and powerful metrics into their EWIs.

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Credit Risk Stress Testing

lepus — Tue, 31 Jan 2012 09:54:31 +0000

Introduction

Stress testing has become the primary indicator of a bank’s ability to withstand tail events and maintain sufficient levels of capital at all times. Although banks generally do acknowledge the importance of stress testing, the stress testing frameworks, in many cases, are still immature. One reason for this is the difficulty gauging the impact of macroeconomic shocks on risk factors in sufficient detail. This is especially true within credit risk, given that credit events normally gestate over a long period of time and their effects can be felt for similarly extended periods.

Key Findings

Stress testing framework – Most banks use hypothetical macroeconomic scenarios defined by the Economics department for credit risk stress testing. The impact of macroeconomic variables on risk factors such as exposure at default, loss given default and probability of default is analysed using regression analysis. Some banks also use scenarios defined by the European Banking Authority (EBA). Stress tests are normally conducted every quarter.
Reporting – The results of stress tests are reported to the risk management and senior management committees and regulatory bodies, at least. One bank has also set up a Board sub-committee to specifically focus on stress testing. Most banks also present a summary of these results to the Board of Directors, typically every quarter.
Stress scenarios used – The stress scenarios typically consider a period of between one and three years, by which time the full impact of credit risk events is assumed to have materialised. They consider a sustained fall in global GDP of around 2 to 3 percent every year.
Credit risk in the trading book – All institutions use hypothetical macroeconomic scenarios, historical shocks or sensitivity analysis to stress test counterparty credit risk. These tests are typically conducted daily. Most institutions do not have formal procedures for stress testing wrong way risk, and are, in fact, still working on measuring wrong way risk accurately.

Conclusion

Since 2008, the use of stress tests to inform the risk appetite has been gaining traction. These encouraging trends also extend to credit risk stress testing in particular. All of the interviewed institutions have established a robust stress testing framework, based on forward-looking hypothetical scenarios that are used to test all risk types. Nevertheless, several challenges still need to be resolved. Whilst the stress scenarios are reviewed regularly by all institutions, it has been difficult to incorporate the anticipated extreme market conditions into the stress scenarios. Stress testing of counterparty credit risk and wrong way risk also remain important areas for improvement.

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