The new face of risk management

Regulations aimed at transparency across financial markets may be making things simpler for the regulators, but they are making life more complex for banks.

“It’s an unexpected reality,” says Sven Ludwig, senior vice president, risk management and analytics EMEA, at SunGard. “Business is basically replying to massive regulation on a daily basis, and the concept is good, but as a bank you can do less because you are more constrained by capital adequacy concerns.”

The upshot is that banks will have to be “more picky” about their trading strategies and this in turn is leading to a refocussing of risk management towards more of an enterprise risk approach that looks right the way through a trade cycle and takes customer profitability into account.

In a recently published white paper, Impact Study 2015 – survival guide for banks: the battle of sophistication, Ludwig writes: “The materialisation of significant changes within the banking system is on the horizon. While it is common knowledge that banks have to change, there is no common knowledge about how the financial markets are evolving. Though many industry participants are under the impression that the banking industry is becoming simpler, the opposite is the case. Moving forward we foresee a battle of sophistication.”

What this means in practice is a restructuring of business and IT along new lines (see panel) and a refocus on how risk measurements can allow the bank to use capital to maximum efficiency: “Banks can’t generate more profit by growing anymore: they can only do it by optimising every flow – and that includes clearing and settlement, where LCH Eurex and the rest charge differently based on cleared volume, so the choice of clearing venue becomes important. Central clearing may make things better but all of these things make life less easy.”

“Every wrong decision hits you twice,” he says. “First it costs capital and you might make a loss, so you have to factor in everything – funding costs, initial margin impacts, maybe tax impacts … and the calculations are not single-business dependent: you can’t get rid of risk, you can only transfer it, so there are circular effects in different parts of the enterprise. Lots of calculations are portfolio-based and customer relations are important – you can price differently for each customer.”

The other need of regulators is comparability – their need is to look across the market and spot trouble before it happens.

This, in its turn is creating a monoculture, says Ludwig. “To what extent do you sacrifice internal models to a standard approach? Better risk management focussed on internal models is vanishing. It is also driving the business models of each bank in the same direction.”

In the whitepaper he writes:

“The regulators’ focus on simplicity, transparency, and comparability is driving the financial markets to monocultures and is driving changes in risk management (Ludwig, 2014). However the impact is not as simple as that. The historical discretion in the risk weighted asset (RWA) determinations in line with business models and risk assessments vanishes. The primary knock-on effect will be notably visible in the capital markets business, leaving banks to choose whether to invest or exit. No exit and no investment implies a bank’s decision [is] in favour of a role of a pure but loss- making intermediary.”

For banks that want to remaining in the capital markets business have to take at least one of the following approaches: lower cost processing costs by investing to achieve operational efficiency, exit the business or engage with a partner providing the processing excellence. “The focus on lean operations will create increased requirements for business process outsourcing, with particular emphasis on OTC transaction processing.”

“People have to ask themselves ‘what is my core competency? Can I be a business utility, or do I use one of the business utilities that are emerging?’” he says.

The other route is increasing sophistication, which has even more complications for bank IT teams:

“The battle of sophistication creates new data requirements from sources across the organisation. Banks have to establish data management and IT infrastructure which allows providing required source data before the time of inception of any business activity. On the capital markets’ side the required speed of sophistication and complexity will require a new IT layer above today’s typical trading solutions. The layer will house a flexible and open valuation and simulation engine proving a consistent life-time impact on all types of constraints.”

The “third dimension” in all of this is that the traditional risk categories – market risk, counterparty risk and so forth – are becoming less important than a transition towards risk functions where strategic risk, risk reporting and risk operations take a more prominent role.

To do this will mean that the complexity of the IT architecture will force banks to “extend their technological breadth”, adopting a new type of data and process management.