Talking Heads: the financial crisis

Crawling from the wreckage – Daily News at Sibos asks whether the industry will experience another Lehman Brothers-type crisis. Have market participants learned their lesson?

Eric de Nexon: head of strategy for market infrastructures, Société Générale Securities Services

If we refer to history and to the old adages, “never say never again” or “the worst is never certain”, the answer could be “yes” or “no”. And as I can’t foresee the future, I’m going to refrain from answering either way.

Regarding the second question however – have we learned our lesson? – it is easier to have an opinion. The dramatic consequences of the financial and economic crisis have led us, at a global level, to call into question some previous absolute certainties and to carry out an in-depth analysis of the crisis and its roots in order to determine the main areas of reform needed to set up a new world order for preventing a new crisis.

As a result, initiatives have been launched worldwide to implement the regulatory framework of the future: some have already been implemented, others remain in progress. I believe we are moving in the right direction but we have only covered part of the path to the target and we need to maintain the momentum. Moreover, the work is more and more likely to run into obstacles: some already have been encountered, such as excessive diversity in the implementation of the principles defined by the G20 that could result in further competitive distortions between market places and the risk of reforms gradually becoming bogged down as the crisis disappears behind us and those on both sides of the Atlantic, who favour the status quo, carry out intensive lobbying to assert their positions of self-interest.

I consider that we have clearly learned our lesson and consequently initiated, with conviction, numerous projects for implementing the required changes. The question now is: will we finally deliver the expected structure that will ensure financial stability for decades to come?

Paul Taylor: director, global matching business development, Swift

Clearly, much has been undertaken since September 2008 to improve the robustness of the financial markets, but it is also the case that much of the regulation coming into place now is targeted at fixing what was inherently wrong in 2008. In reality, the markets are not static.

And some of the measures designed to reduce risk could inadvertently increase it. Take for example the increased use of centralised clearing via CCPs. The cost and efficiency benefits of CCP use are obvious: netted transactions create a lot less operational work in terms of settlement and CCPs by and large charge fractions of a cent to clear trades. But they are not immune to failure: think of the Caisse de Liquidation des Affaires en Marchandises collapse in 1974 and the Kuala Lumpur Commodity Clearing House in Malaysia, which had to be bailed out by the government in 1987.

Clearly protection mechanisms are in place. And yes, post-Lehman, large CCPs were able to absorb much of the impact using just a portion of initial margin only, which was great. But will that always be the case?

All that said, regulation such as Dodd-Frank and the European Market Infrastructure Regulation (Emir) is now demanding adherence to some really robust post-trade processes, which should go a long way to making the markets safer. Electronic trade confirmation, trade reporting, increased collateralisation… all these practices increase control and transparency in the trade process. And the ready availability of standardised messaging and network solutions to automate these processes means that these measures that are so important to shore up market safety also can be adhered to in as cost-effective a way as possible.

New regulatory impositions are forcing the industry to act on many of the lessons from past mistakes and while it would be naïve to say another Lehman-type disaster isn’t possible, some important steps have been taken to make it less likely.

Paul Anderson: managing director, head of credit, market and liquidity risk, Deutsche Bank

When I’m asked to evaluate any proposal I start by examining a set of postulates and their probabilities and outcomes.

The human brain is irrational around risk where we cannot afford to be wrong; I’m a risk professional and quite rational, but if someone says he saw a lion in my garden, I lock the door first and look out of the window second.

We also know that crowds will stampede – a few people rush screaming for an exit and everyone else joins the panic. You can put volunteers onto an aircraft which routinely disembarks in minutes, but fill it with smoke and offer incentives for people to get down the chutes and the exits will be chaotic.

Confident extroverts will always be elected to public office over cautious introverts. And, in periods of strong growth “let the good times roll!” will be always better received than “are we sure this is wise?”.

Human innovation is incredible and people do not like being told what they can and cannot do. They will wriggle round the letter of any rule. And then I look at the current financial landscape. I see a lot of well-intentioned but complex regulation and a need for banks to hold ever increasing amounts of capital and cash against ever more conservatively accounted assets.

While I am confident that compliant banks will not fail in a disorderly manner and create major contagion in the near future, there are three inevitable outcomes of higher capital ratios: return on regulatory capital becomes more important than “do we really want to do this?”; the pressure to create shareholder value will drive some products away from regulated banks; and a period of amazing innovation.

However, it is hard to predict long-term consequences of the new framework and only fools believe systems are foolproof. That is why we cannot be certain crises won’t strike again, but at least we have made progress in limiting the damage.

Paul Simpson: head of global transaction services, Bank of America Merrill Lynch

We can’t predict the future but what we have learned from events of the recent past is that we need to expect the unexpected. Uncertainty is now the new company byword for business as usual and we can expect to see further disruptions in the future. We have all seen the speed at which different risks can strike.

The financial crisis brought about a rethink in the way risk is managed and taught valuable lessons which continue to be relevant. This is applicable for risk management across the board – counterparty, foreign exchange, sovereign, interest rate and weather to name a few. The experience taught companies that they must have a much stronger ability to survive in the most challenging worst case scenarios.

Today, companies and their treasury functions have to accommodate the risks, challenges and opportunities of doing business on a global basis. Uncertainty is always at work, underlining the need for companies to continue evolving the dynamics of their risk management policies and ensuring they are robust enough to cope. Companies now need to be in a continual state of readiness and ensure their policies and procedures are fit for purpose. To this end, there has been a radical overhaul of policies, processes and strategy to ensure match-fitness for the sternest of tests. We are increasingly seeing companies adopt risk management plans that are more holistic in nature and integrated worldwide, reflecting their enterprise-wide approach to post-crisis risk. Companies are increasingly looking to centrally manage their risk worldwide with more complete and transparent information set against stricter risk policies.

Thomas Zeeb: chief executive, SIX Securities Services

I don’t have a crystal ball, so I can’t predict if another crisis is looming around the corner. What I can say is that market infrastructures are now playing an even more important role in ensuring the stability of the financial markets. Regulators have shifted more responsibilities onto market infrastructures (for instance, OTC derivatives will be centrally cleared) in an effort to decrease systemic risk. Should there be another financial crisis, the industry will ensure that the damage is minimised.

During the previous financial crisis market infrastructures did an important job in ensuring that the impact to the markets at a fundamental level was minimised. The lines of communication between the major infrastructure providers, the global custodians and major banks remained open following the collapse of Bear Sterns and we worked closely together to ensure an orderly wind down in comparison to Lehman Brothers. In the event of another crisis, we will show the same spirit of collaboration and continue to show that infrastructures are part of the solution.

Given their increased importance, the post-trade industry has naturally been hit by stricter requirements, such as the CPSS-Iosco principles, CSD Regulation and Emir. These measures should further increase stability. To mitigate against the risk of a future crisis, it is important that post-trade infrastructures are well capitalised, have access to liquidity and employ prudent risk management standards. However, the legislation being introduced will have to be reviewed again when the consequences manifest themselves. This is inevitable because anticipating everything that could happen is almost impossible.

David Penney: executive vice-president, strategy, SmartStream

It is difficult to say that changes taking place today will prevent further financial crises; certainly that is the objective of governments, central banks and regulators. US Senator Warren believes one of the reasons for the financial crisis of 2008 was the repeal of the US Glass-Steagall Act, which had separated commercial and investment banking. So Senators Warren, McCain and others are re-introducing the act to separate the savings of ordinary citizens and remove them from the operations of riskier, speculative parts of financial institutions.

Meanwhile, there is plenty of action under way among financial services firms to ensure they can meet the demands and requirements being placed on them by financial regulators. Some institutions are at the leading edge of developments, putting in place best practices that are likely to be more widely adopted.

For example, at a leading UK financial institution a program to strengthen client money segregation, the controls around other business processes and know your customer requirements is likely to be a template for other institutions. This company is implementing intraday liquidity management; a significant challenge.

Financial institutions are being called on to prove to regulators that they have the systems and processes in place to avoid a repeat of 2008. Control continues to be a focus for both financial institutions and regulators. Underpinning this control are reconciliations, which ensure that processes are completed correctly. Automating reconciliations has become even more crucial as regulators steer banks towards real-time, intraday reporting and liquidity management.

Further to this, by linking liquidity and cash management on a real-time basis to their reconciliation operations, institutions can build an enterprise-wide solution for cash, treasury, exceptions and reconciliations management. This creates a global, real-time view of all money movements, cash and liquidity positions to support investment and lending opportunities.

This is the type of control that institutions can use to detect in advance when problems might arise. Automated controls are now coming together to form a real ability to sense and respond to issues before they become crises. As regulators introduce step changes in how financial institutions must work, requiring an immediate response rather than days later, these automated business controls will be key to future operations.

Chris Pickles: head of industry initiatives, global banking and financial markets, BT

2008 was just the beginning of the recognition of a much larger problem – like the ripple on the glass of water in the film Jurassic Park. In 2007 financial institutions had been saying that they didn’t need all of these new regulations because they had everything under control. Then the world drove over a cliff, showing that everything wasn’t under control at all. It also showed that neither the regulators nor the financial institutions had adequate transparency of the market or of their businesses – otherwise they would probably not have driven over a cliff.

In the wake of 2008, financial regulation today has three main drivers: better risk management, greater transparency and the customer comes first. Financial institutions have become expert at building complexity and then separating that complexity off into separate silos that don’t communicate with each other, thereby increasing risk and reducing transparency. Too often the customer hasn’t had enough voice in this – except for the invoice.

The industry is still learning lessons from 2008, but the largest firms are taking serious corrective action as a result of that education. The “disasters” to come are less likely to be on the same global scale. However, for the medium-sized bank or broker, for the small investor and the retail banking client, the serious problems are not yet over. Failure, merger and acquisition of individual institutions is more likely as the pressure and cost increases of achieving compliance with new, stricter regulations that are policed and not just issued.

Too many financial institutions still hope that by delaying regulatory change their problems will go away, as they had usually done in the past.  Without that effective policing of regulations, we’ll all be back in the dark days of 2008 very quickly indeed.

Stewart Macbeth, chief product development officer, Deriv/Serv

If the collapse of Lehman Brothers represents the defining moment of the 2008 financial crisis, its legacy may prove equally pivotal in preventing the next financial meltdown. The resulting efforts to re-regulate the OTC derivatives market have focused in large part on the development of tools to help regulators and market participants better understand risk concentrations before they explode into a full-blown crisis.

Of Lehman’s many lessons, it showed that regulators need timely access to comprehensive, aggregate and accurate data on global OTC derivatives activity so they can identify and monitor exposures and, if necessary, respond quickly when a crisis occurs.

The G20 mandate to report all OTC derivatives trades to a trade repository was the primary policy vehicle for ensuring that regulators and the market never again faced the type of misinformation that led to widespread market panic stemming from derivatives exposures – real or perceived – in 2008.

Significant progress has been made to improve the transparency of the global OTC derivative marketplace since then. Mandatory trade reporting to repositories is under way in the US and Japan, with similar mandates in Europe and elsewhere set to go live in the next 12 months.

But many challenges remain. Foremost among them is the on-going divergence of global reporting and data standards, which is leading to a proliferation of repositories globally – with little ability to aggregate data across jurisdictions and service providers. Moreover, impediments to data access and sharing may impact their ability to provide a global view of the marketplace while the on-going commercialisation of the trade repository function could disincentivise repositories from interoperating.

Trade repositories hold enormous potential to serve as a powerful weapon in preventing the next financial crisis, but policymakers globally need to act swiftly to resolve these issues in order to achieve the highest level of market transparency.

Neil Vernon: product development director, Gresham Computing

Financial institutions have faced their fair share of crises and the past several years were unarguably the worst. It seems like the dark clouds are clearing but the industry shouldn’t be too complacent. Instead of just navigating through the regulatory tape of today, financial organisations need to ensure they cover off any gaps in their operations.

One loophole still exists which could bring down an institution: the affirmation of internal trades where one division of a bank trades with another. Sounds quite mundane, but ask some of the major banks that have recently suffered billions of dollars in losses just why the rogue trades took so long to come to light.

If a trader takes a position and starts creating internal fictitious trades with other parts of the bank to cover up losses, there is no confirmation exchanged. Surprisingly, regulators aren’t focused on the internal infrastructure – they expect banks to have procedures in place. Regulators only stumble on this if they’re already in the bank doing audits.

Banks must step up internal efforts so they don’t become a victim of rogue trading. They need to have a handle on every part of the business otherwise they could be exposed to cracks in the fault lines leading to a final collapse.