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.

To receive a free copy of this report, please send your name, job title, address and phone number to marketing@lepus.com and we will ask the sponsors of the report to email a copy to you

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.

To receive a free copy of this report, please send your name, job title, address and phone number to marketing@lepus.com and we will ask the sponsors of the report to email a copy to you

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.

To receive a free copy of this report, please send your name, job title, address and phone number to marketing@lepus.com and we will ask the sponsors of the report to email a copy to you

Since the onset of the credit crisis, there have been a number of high profile failures in the financial services industry, which have exposed glaring shortcomings in the corporate governance framework at major banks. Previously, the governance framework at banks gave undue precedence to revenues and reward at the unfortunate expense of effective risk management procedures. Moreover, there was insufficient oversight of senior management by the Board and organisational structures were too complex, which further exacerbated an already substandard framework. Now, however, significant changes are being pursued by major banks to redefine this framework and accord greater authority to Risk Managers.

Key Findings

• Committee Structure – To best respond to clients’ expectations, leverage the strengths and enhance the synergies of a multinational company, an effective governance structure must be in place across all geographies and divisions.

• Responsibility and Accountability – As is to be expected, the board approves the delegation of authority at the interviewed banks. This is in line with effective corporate governance practices as the board ultimately delegates authority primarily, and through approving further delegation of authorities, the board can ensure that decisions made are in keeping with the business strategy, culture and risk appetite.

• Transparency of Risk Information – Responses from participating banks indicate that it is commonplace in the industry for financial institutions to provide as much information as possible concerning governance and committee structures to all employees. However, industry players are setting limits as to what can be made freely available. Understandably, risk information deemed too sensitive is not distributed or made available to those it is not considered pertinent.

• Policy – Although it is a generally accepted fact that it is extremely difficult to guarantee governance policies are instilled into every colleague at an institution, banks are persisting in endeavours to make it as difficult as possible for them to be ignored.

Conclusion

Released in early 2010, the Basel consultation papers heralded significantly more prescriptive oversight of the corporate governance framework by supervisory bodies. Endeavours to strengthen this framework, however, should not be undertaken solely to avoid regulatory recrimination. Otherwise, these initiatives would simply culminate in mere box-ticking exercises no different from those that fomented the credit crisis.  It is, therefore, necessary for these changes to be driven internally, with efforts being to certify buy-in form all business lines and personnel.

To receive a free copy of this report, please send your name, job title, address and phone number to marketing@lepus.com and we will ask the sponsors of the report to email a copy to you

As banking products and processes become increasingly complex, the need for risk management solutions that can deliver on all levels has become more significant. Banks now have a wide array of vendor products to choose from, the merits of which must also be judged against the unmatched customisability afforded by in-house solutions. As banks must now fulfil increasingly complex regulatory requirements and build a robust risk management framework simultaneously, vendor strategy has become a key area of concern.

Key Findings

• Current trends – Across all areas of risk, a large number of banks are either using in-house Risk Management solutions or a combination of both in-house and vendor solutions.

• Market leaders – The survey found no clear market leader among Credit Risk vendors, however, QRM, Algorithmics and Oracle were the most popular options among respondents for Liquidity, Market and Operational Risk management solutions respectively.

• Features – Flexibility was considered the most important feature in an ideal vendor solution, followed by cost effectiveness.

• Vendor strategy – Most banks expressed satisfaction with their current risk solutions. A few, however, have started a long-term change programme to expand the capabilities of their current Risk Management solutions. Regulatory reforms have had a deep impact on banks’ vendor strategy.

Conclusion

Banks realise that having a risk solution that can be easily customised to meet specific requirements offers competitive advantage. An increasing number of banks, therefore, are opting to use vendor products and in-house solutions together, instead of relying exclusively on the former. When it comes to features, flexibility and customisation are the most important factors to users. The survey results show that the role of external consultants in the selection of vendor solutions is still important, but it diminishes sharply at tier-1 banks. Finally, regulatory authorities have also become key determinants of the vendor strategy pursued, as banks must now comply with a plethora of reforms within a short span of time.

To receive a free copy of this report, please send your name, job title, address and phone number to marketing@lepus.com and we will ask the sponsors of the report to email a copy to you

Our latest Executive Summary, sponsored by Thomson Reuters, is the white paper “Determining Best Execution: What Role Does Transaction Cost Analysis Play?”.

The Markets in Financial Instruments Directive (MiFID) came into effect on 1^st November 2007 and brought with it a requirement for all European firms to achieve best execution for clients. Not only do firms have to achieve best execution, they must also show they have obtained best execution – or the “best possible result” for clients, which may be determined by price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of an order. 

This Executive Summary looks at the business, market and regulatory drivers for evaluating best execution at global firms and examines whether TCA is appropriate for the institutional buy-side and brokers to ensure orders receive the optimal mix of price improvement, speed and likelihood of execution.

Key Findings

• Environment – Brokers and institutional clients alike recognise the MiFID obligations on best execution are applicable to them, and are a high priority. All those who were interviewed for this paper have put together best execution policies that are reviewed annually. All firms interviewed for this paper were performing their own best execution analysis before the MiFID requirements came into force and continued to do so. Brokers also report clients are increasingly asking to view their best execution policy.

• Concerns – There are some concerns that the MiFID best execution requirements are not currently being met.  

• Establishment – TCA is more established in the US than in Europe and this is likely to lead development in the latter region in two key ways: firstly some firms expect regulators to institute a consolidated market data tape for equities trades in Europe, as already exists in the US. Individual customers of TCA services are also likely to adopt the vendor already used in their US office to ensure commonality of systems.

• Differences across the Atlantic – However key differences between use of TCA in Europe and the US are also likely to continue: MiFID covers a wider range of products than the equivalent regulation, Reg NMS, in the US, and uses broader terms to define best execution, rather than just price.

• Current use of TCA to prove best execution – TCA is viewed as playing a crucial role in meeting the MiFID best execution requirements. However it is not solely used to meet regulatory requirements.

• Desired providers/methodologies – Commonality of systems is important, so European users are likely to use the system that is used in their US offices, TCA being more established in the US.

• Return on Investment and time to market – Cost of TCA services is viewed as expensive but necessary. Despite well-documented cuts to buy-side technology budgets recently, TCA has not suffered widely, perhaps because as a risk-reducing tool it is appealing in the current risk-averse investment climate.

• Benefits of TCA – Clients do not just use TCA in order to meet regulatory requirements. It is also seen as offering commercial advantage with significant return on investment as a result of a refined trading process.

Conclusion

TCA is seen as a vital tool for brokers and investment firms alike to meet their requirements to show best execution under MiFID, and is considered to offer sufficient ROI. However it is in early stages of use and adoption and further development is hindered by a number of issues. Chiefly, the data used to analyse transaction costs is perceived as flawed. The lack of a consolidated market data tape for equities trades in Europe and the exclusion of some trading venues and dark pool data from some TCA benchmarks are seen as major limitations to the usefulness of most existing TCA services.

However TCA providers have taken steps in the right direction to correct this problem and at least two vendors now provide benchmarks calculated from the full universe of equities venues. Real-time TCA is also in very limited use in Europe currently, but its advantages are known to clients and they say they would use it when they see improvements in the data used for TCA and in their own trading technology. 

It is clear there is a sizeable appetite and enthusiasm for useful and accurate TCA, and users would not be put off paying more, or going through the disruption of switching services, to get the right service. As such there is a real opportunity for a vendor who is able and willing to respond to investment firms’ demands in this fast-growing sector. 

To receive a free copy of this report, please send your name, job title, address and phone number to marketing@lepus.com and we will ask the sponsors of the report to email a copy to you.

Introduction

The events of the past 18 months highlighted the need for banks to be more aware of the systemic risks to which they are exposed. In the wake of the credit crisis, stress testing has emerged as the tool of choice when assessing the impact of low probability, high impact events. There has been a substantial increase in regulatory demands for firm-wide stress testing as supervisory bodies worldwide decide how best to prevent future liquidity and credit crises from occurring. 

The key factor driving the use of stress testing is pressure from regulators. Supervisory authorities such as the FSA, SEC and BIS all cite stress testing as a fundamental part of the risk management framework. Most notably, the FSA has published a number of consultative papers under the title ‘Strengthening Liquidity Standards’ that focus on the use of stress testing and scenario analysis.

Key Findings and Recommendations

In a Lepus conducted research study where financial institution executives were interviewed to determine what actions are being taken to prevent future liquidity and credit crisis, it was recommended that:

• A Stress Testing Regime Be Defined – Research indicates that many banks feel that traditional historical scenarios used in stress testing have been somewhat discredited as a result of the crisis. Banks should now try to use more forward-looking hypothetical scenarios that simulate a possible future event. There has also been an increased use of ad hoc stress tests to assess the impact of certain risk factors.

• Stress Testing Should Be Implemented Organization Wide – One of the positives to emerge from the credit crisis is the increased profile of risk management. While the results of stress tests would once have been largely discarded by financial institutions, they now command far greater attention. To make the most of the stress testing process, results should be used widely across the bank. There is an increasing trend for senior management to use results as an influence on strategic business decisions. 

• A Firm-Wide, Cross Asset Class Risk Management Solution Should Be Implemented – The benefits of a firm-wide and cross asset class approach to risk management are substantial. Further to giving banks the ability to manage risk across all global entities, it can also greatly reduce the burden of regulatory reporting.

Conclusion

Regulatory pressures look certain to drive banks toward a more comprehensive, firm-wide approach to risk management. Over the coming months banks will make significant investment in their stress testing platforms to bring them in line with regulatory demand. Although historical scenarios are now deemed less credible due to the events of the past 18 months, hypothetical economic disasters and ad hoc stress tests are being used with increasing frequency. The renewed interest in stress testing from senior management will ensure that it receives the necessary support and investment to produce an accurate and useful assessment of exposure across the organisation.

Used effectively, firm-wide stress testing will become an essential tool that banks use not only to manage risk, but also as a driver of future strategic business decisions.

To receive a free copy of this report, please send your name, job title, address and phone number to marketing@lepus.com and we will ask the sponsors of the report to email a copy to you.

Emerging markets can be defined as a nation’s economy that is progressing toward becoming advanced, as shown by some liquidity in local debt and equity markets and the existence of some form of market exchange and regulatory body.

Emerging markets generally do not have the level of market efficiency and strict standards in accounting and securities regulation to be level with advanced economies (such as the United States, Europe and Japan), but emerging markets will typically have a physical financial infrastructure including banks, a stock exchange and a unified currency. 

Key findings

• Overview of the market – Key areas of emerging market territories where banks are active include the Middle East, Brazil, Argentina, Africa and particularly in Asia still too. Banks spoken to for this report commented on the importance of a presence in Dubai and also Hong Kong and Singapore.
• Popularity of risk – Due to recent events in the markets, the risk control departments in general were definitely more important than in the past. Finally staff and their influence have greatly increased as a result of the financial turmoil. This was also highlighted earlier this year in much of the mainstream press. 
• Major risk issues – There are several major risk issues that are effecting banks at the moment across the emerging markets. Across the board, banks mentioned liquidity as a key issue. Also of concern was reputational risk, which was considered of paramount importance in emerging market countries. Banks said that they did not expect these issues to change over the coming year.
• Challenges in emerging markets – Emerging market challenges were considered plentiful. In short, they are people, competition and economic climate. Another issue was attempting to prize people away from other banks and also making sure that once they worked for the company that they stayed there. Recruitment and retention was a major issue that all banks discussed as a major challenge in emerging markets.

Conclusion

Emerging markets have been and continue to be, a topical area for risk departments in major financial institutions. Back in 2003, its importance was recognised when 10 international banks adopted the Equator Principles that dealt with the thorny issue of reputational risk in emerging markets.

The coming year in the emerging markets sector looks to be an interesting one but future initiatives will be minimal as the financial industry treads more carefully in the wake of the crisis.

To obtain a free copy of this section in full, please contact us at marketing@lepus.com with your name, job title, firm, phone number and email.

The sub-prime contagion and the subsequent credit crunch have been essential in driving banks to reconsider their risk management practices and methodologies. What makes this crisis unique, amongst other things, is the unprecedented volatility that we have seen during 2008. More importantly, this volatility was not limited to any particular asset class, but was evident across the board. Various risks were simply not captured, deemed plausible or accounted for. This has resulted in great pressure both internal and from the regulatory entities all over the world. A lot is still uncertain, i.e. the direction which risk will take and exactly what the different regulatory bodies will require and impose upon the banking industry.

Key findings

• Organisation of market risk – There is a somewhat similar approach at the banks spoken to where market risk is a combination of a control function and a business facilitation unit. This is of no surprise given that business and risk go hand in hand. There is need for the business and risk to have frequent dialogue and well established communication channels.
• Strategy – the participating banks were asked to indicate whether or not they have integrated between their market and credit risk functions. Once again, there is no one size fits all as far as the integration of these two areas is concerned. However, it is important to note that all of the banks spoken to see the merits of such an undertaking and there has been some progress, such as closer communication between the two areas.
• VaR – The most recent and ongoing crisis has highlighted that banks should not rely on one any one single risk metric or tool. The role of VaR has certainly changed, and all of the banks spoken to have raised the importance of stress testing and scenario analysis.

Conclusion

The organisation of market risk is paramount, and this is definitely more so the case in these volatile and turbulent markets where there is a need to prove to investors, regulators and senior management that processes and methodologies are robust and comprehensive. Some of the main challenges being faced were highlighted to be data and quality issues, general contractions across the markets, regulatory pressures and liquidity issues. The role of VaR has changed and VaR as a tool has been under immense scrutiny. The banks spoken to supplement their VaR tool with other metrics/tools, mainly stress testing and scenario analysis. At most of the banks spoken to VaR was not the primary tool in the first place, and there may even be less reliance on this tool in the future.

To obtain a free copy of this section in full, please contact us at marketing@lepus.com with your name, job title, firm, phone number and email.

Much has been said about risk divisions, particularly in the wake of the brutal financial meltdown last year. However, risk divisions are upping their game in changing the methods of how they do business. Though banks may not agree on which areas of market and credit risk should overlap at present, the move to integrate the two is definitely on the cards for the future.

Integration of credit and market risk has been on the cards for a long time. There are many reasons for this that shall be expanded on in this report. However, in light of the financial furore at the end of last year, banks have been forced to reassess the way they manage risk and consequently they have begun to look more seriously at aligning the activities and responsibilities of credit and market risk.

Key findings

• Overview of the market – Current regulation is conceptually based upon the distinction between market and credit risk. However, some risk factors may also influence both market and credit risk.
• Benefits of merging credit and market risk – Banks said that they had noticed a decline in the number of firms that now had separate credit and market risk divisions. The key benefits of amalgamating the two divisions are cross fertilisation, blend of skills, and greater communication between the divisions.
• Systems silo – While the divisions are often merged, banks have stressed that they still have a separate system dedicated to credit risk calculations and another separate one from market risk calculations. Systems innovations are not likely to change imminently in order to keep up with these changes. 

Conclusion

There has been significant progress made in the merging of credit and market risk divisions in financial institutions in recent times. However, there is still work to be done in this area. It is by no means complete. For those firms that have merged the divisions, they still have separate systems and skill sets. As one commentator said, it is all very well wanting to merge the two divisions but there is no distinctive system to support the two methodologies at the moment. From research Lepus conducted, it is clear that such a development is all a long way off.  

To obtain a free copy of this section in full, please contact us at marketing@lepus.com with your name, job title, firm, phone number and email.