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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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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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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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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Elevated country risk has historically been associated with developing economies. The 2008 financial crisis has, nevertheless, exposed the vulnerability of many eurozone economies and, hence, a great deal of attention has been paid to the sovereign debt crisis in Europe. Greece, Italy, Ireland, Portugaland Spain (GIIPS) have found themselves increasingly mired in the distressing consequences of the negative global economic climate. With increasing uncertainty about the future of the periphery of the European Union, financial institutions are now looking to redesign their country risk framework by devoting increasing resources to the country risk analysis of distressed industrialised countries.

Key Findings

• Organisation of country risk operations – The allocation of responsibilities in the Country Risk department is organised along geographic lines. Four out of six interviewed banks divide the responsibility for various countries amongst analysts by categorising countries into geographical groupings and assigning analysts to each group. Only Bank 2 separates countries into developed and emerging markets. 
• Review of country risk framework – Although interviewed banks are clearly directing more human resources to assess the country risk associated with distressed eurozone economies, it is unlikely that they will redesign their organisational framework in order to assign a separate group of analysts to focus solely on GIIPS. 
• Limit settings – Banks have started to set lending restrictions, not only on emerging economies, but also on distressed eurozone countries. Yet, it is very unlikely that GIIPS will be downgraded to emerging market status, and banks still institute more limit settings for emerging markets than for eurozone countries. 
• Regulatory reporting – The majority of banks have not invested in additional IT infrastructure to contend with the additional reporting requirements for the distressed eurozone countries. 

Conclusion

The European sovereign debt crisis has brought about important changes to the country risk framework. Banks are devoting additional human resources to more closely monitor the rapidly unfolding events in both emerging and industrialised countries. Yet, it is very unlikely that distressed eurozone countries will be downgraded to emerging market status. Rather, banks are trying to reduce their exposure to the crisis inEuropeby setting additional lending restrictions to troubled eurozone economies.

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These days, banks must ensure that an aggregated view of risk is punctually available to all stakeholders, which further leads to greater vigilance and sensitivity to threats in ways previously unaffordable. Towards this goal, it is imperative to collect, collate and convey all risk metrics that track and present all potential hazards to senior management in a format that is easy to interpret. This purpose is served by a dashboard which, essentially, is a brief compendium of all information that managers may need in order to guide the strategic course of business.

Key Findings

• Prevalence of Operational Risk Dashboards – 84% of banks in the survey acknowledged the existence of a dashboard that summarises relevant information for senior management.

• Format – Although operational risk dashboards are prevalent, at 74% of banks that say they have them, they exist as written reports or spreadsheets, and only 26% have developed specific interactive tools. It is also notable that nearly all firms with these tools are smaller organisations.

• Duration of Use – Given the pervasiveness of written reports and spreadsheets, it is surprising to observe the extreme variation in responses shown by the survey. Understandably, banks relying on tools have largely developed them within the last two years, while no decisive trends have been observed for those that do not.

• Frequency of Reporting – As most banks do not deviate from written reports or spreadsheets, senior managers generally receive a monthly update on past performance. Banks that have developed dashboard tools, however, allow ad-hoc access to information.

• Drilling Down – The ability to explore points of interest in greater detail using dashboards is limited to a small minority of banks. At the same time, however, most respondents expressed satisfaction with the amount of detail the dashboard contains.

Conclusion

This survey illustrates that a burgeoning number of banks have introduced operational risk dashboards with the underlying format still unchanged from that of more conventional reports i.e. written reports and spreadsheets. While the benefits of interactive tools are evident to almost all firms, smaller institutions are, in general, the first to adopt them over other formats. With upgrades underway at a rapid pace, operational risk dashboards should gradually take on best practice formats featuring interactivity, real-time delivery and customisability.

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The financial crisis had a devastating effect on the financial sector and, in turn, the global economy. After the dust settled, it became clear that many firms had failed to invest enough resources to formulate effective early warning systems, which are critical in detecting the initial signs of credit deterioration and default. Although capital markets are returning to conditions suggesting that the crisis is finally subsiding, the best institutions should remain cautious. All banks should continue to strengthen these early warning indicators, which necessitates proactive and dynamic systems and metrics that are regularly updated.

Key Findings

• Strengthening Early Warning Systems – Though the banks have adopted different methodologies to strengthen their early warning systems, all the participating banks have realised the importance of early identification of deteriorating credit in insuring the bank’s longevity.

• Metrics and Forecasting – The respondents use a variety of variables, CDS spreads being the primary one, to detect credit decline of counterparties, industries and regions.

• External Data – Internal findings receive precedence over external data sources. External data, however, still plays a big part in the participating banks’ methodologies. External data is used mostly as a marker to check the consistency of internal methodologies.

• Results – All of the responding banks have processes in place to escalate risk to senior management. Only three of the participating banks, however, are confident that these results are being used to influence the setting of risk appetite and business strategy.

Conclusion

All of the four participating banks are currently rectifying the various weaknesses in the detection of credit deterioration, which the financial crisis exposed forcefully. This is being done through the strengthening of existing systems or the development of new ones. Whilst one of the participating banks is still developing its systems, another created an independent group in 2008, which is specifically tasked with managing emerging risks proactively. At the other two banks, internal credit methodologies have been strengthened over the last 36 months, which should lead to much more proactive credit risk management.

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In the quest for enterprise risk management, several banks have recently undertaken radical reorganisation efforts to integrate different risk teams into a more collaborative whole. However, any permutation of reporting lines and designation of roles can prove to be an expensive – and ultimately, desultory – exercise in the absence of a sound and communicable risk culture. Mitigating this situation requires a top-down approach to setting the risk appetite of the business, which can be mediated by risk factors collected through a bottom-up approach.

Key Findings

• Setting the Appetite – Banks generally follow a top-down approach that is mediated by the bottom-up perspective. Limits are initially prescribed by business heads in collaboration with senior risk officials, which are then assessed for their potential impact on the balance sheet before being presented to the board of directors.

• Methodology – As expected, stress testing and VaR are the primary methods through which limits are determined, with the confidence level generally set at 99%. The focus is on target debt ratings, future earnings and, most importantly, the capital ratio. As market risk is easily quantifiable, qualitative judgements are rare.

• Role of Stress Testing – Serving as the central measure for risk appetite, stress testing is typically conducted over an average of 10 days but varies by asset class. All risk variables, from volatilities to sensitivities, are stressed.

• Cascading the Appetite Downwards – Allocation of limits across desks are based on interdependencies. Uniquely, one bank has no specific market risk limits as it is moving towards enterprise risk management.

• Role of Past Performance – Past performance is mainly considered in terms of unutilised limits and earnings. While there are no capital penalty charges, limits are reassessed every year and may be lower if they had previously remained unused. Similarly, measures akin to the Sharpe Ratio are not key determinants, but past earnings do guide future projections for stress tests.

Conclusion

Transparency of the risk appetite setting process and seamless communication to lower levels of the organisation will be key criteria on which performance will be monitored by regulators. At the participating banks, even though the top-down perspective has gained ascendancy, the bottom-up perspective also holds considerable weight. Involvement from the C-suite is expected, but decisions are made in consultation with individual business heads and the Finance department for assessing the impact on the balance sheet. Increasingly, it is apparent that the importance of stressed quantitative measures is being appreciated throughout the organisation.

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The Dodd-Frank Financial Reform Act is the response of the United States to the deepest global recession since the Second World War. The fact that the sub-prime mortgage contagion germinated within the financial services industry, before spreading across entire economies, is reflected in the multi-faceted nature of the Act. When President Obama introduced the Financial Reform Plan in 2009, providing the foundation for the Dodd-Frank Act, he termed it the most sweeping overhaul of regulation since the Great Depression.

Key findings

• Monitoring and Prioritising Developments – Banks are fully aware that the many facets and pervasive nature of the Act will require them to develop specialised processes to implement changing requirements. Two-thirds of banks already have a specialised team devoted to implementing the many new rules and regulations. The remaining third will soon follow suit.

• OTC Derivatives – The majority of participants believe that Dodd-Frank provisions will effectively encourage institutions to clear derivatives centrally, encouraging OTC derivatives to be pushed onto clearing exchanges.

• Proprietary Trading – One of the aspects of the Dodd-Frank Act that is still some way from being finalised involves the proposals from section 619. As is expected then, this is an area where banks are still unsure as to the outcome. Over half of the participants (56%) do not know how events will play out.

• Systemically Important Institutions – Instead of minimising systemic risk, participants believe that the Dodd-Frank Act will instead increase concentration risk in the industry. It is argued that systemically important banks will gain reputational advantages, with customers and investors choosing these as they will receive government backing in times of future peril, and thus, forcing smaller banks out of the market altogether.

Conclusion

There is widespread ambiguity regarding the implications of several reforms in the Dodd-Frank Act. Ongoing political deliberations may well cause further changes to the Act, thereby leaving many banks uncertain as to which proposals will eventually be enforced and which agencies they would need to work with to ensure compliance. Nevertheless, in whichever form the final proposals appear, banks will face immense difficulties in fulfilling all stipulated requirements within the timeframe required.

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In recent times, pressure from stakeholders and regulators has highlighted the importance of enterprise risk management. Towards this end, several firms have embarked on major restructuring projects. Recent research conducted by Lepus across several industry leaders revealed that, at least within the Capital Markets division, these approaches have been pursued vigorously, but they also vary quite sharply. Whether this extends to the structure of Group Market Risk as well is a point of intrigue.

Key Findings

• Group Level Organisation – As expected, at a vast majority of banks, there is one group head of market risk, to whom various divisional heads report. A small minority of respondents stated that divisional heads also serve as co-heads at the group level.

• Alignment – At the group level, the market risk function is generally organised under one function. This is followed by institutions where this function is aligned to the bespoke nature of market risks e.g. behavioural in ALM and contractual in trading.

• Support Functions – The market risk infrastructure and analytics functions operate centrally for the group at most banks. However, this is closely followed by approaches where the functions are either aligned to asset classes and regions or they cover all risk factors for the group.

• Liquidity Risk and ALM – One may expect liquidity risk to be the responsibility primarily of a group treasury department. While a slim majority of respondents did confirm this to be the case, a comparable number of firms have fused liquidity risk with market risk.

• Counterparty Credit Risk – At most firms, counterparty credit risk formally remains the domain of credit risk. However, several responsibilities, such as exposure management and analytics have been transferred to the market risk department, while credit risk continues to issue limits.

Conclusion

This report clearly highlights the prominence of consolidated management of market risk at the Group level. Most banks have generally achieved this through central management at the Group level, further branching downward into divisions, asset classes and regions. Intriguingly, however, these similarities dissipate when considering areas such as liquidity risk management or regulatory liaison. With time, however, buffeted by the tide of regulation, such variations are expected to give way to greater homogeneity.

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