Banking Study: The Benefits of Innovative Information Technology in Turbulent Times


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SAP AG and the BTA have partnered with the Frankfurt School of Finance & Management and the New York University’s Stern School of Business and Management to conduct a joint research project, which seeks to identify a number of methods and procedures in value chains and risk management approaches of banks with business models of different size and complexity of which the outcomes have been consistently superior to others, and which can, consequently, be labeled as “best practices” in this field.

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Banking Study: The Benefits of Innovative Information Technology in Turbulent Times

  2. 2. Figure 1: Contributions of process innovation and IT 6 Figure 2: Important features of management decision support information 7 Figure 3: Technology innovation in the future 7 Figure 4: Interview framework 9 Figure 5: Sector level clustering 10 Figure 6: Department level clustering 10 Figure 7: Business model 13 Figure 8: Complexity of asset/funding flows 13 Figure 9: Challenging environment 14 Figure 10: What is in-memory computing 22 Figure 11: Weighting Range 30 Figure 12: Importance of information technology 30 Figure 13: Process innovation 30 Figure 14: Importance of data 32 Figure 15: Capability of current systems and processes 32 Figure 16: Senior management decisions 32 Figure 17: Aggregation of data 33 Figure 18: New information technology 33 Figure 19: Gaps of service providers 33 Figure 20: Mobile banking 34 Figure 21: IT budget 34 LIST OF FIGURES
  3. 3. TABLE OF CONTENTS 1 EXECUTIVE SUMMARY 4 2 INTRODUCTION 8 3 FRAMEWORK OF THE BANKING STUDY 9 4 KEY DRIVERS OF CHANGE AND BEST PRACTICE PRINCIPLES 11 4.1 Key Driver of Changes in the Banking Industry Identified in the Study 11 4.2 Deriving Best Practice Principles Based on Experiences from the Crisis 12 5 MAIN TOPICS FOR DESK RESEARCH: KEY DRIVER OF CHANGES IN THE BANKING INDUSTRY 18 5.1 Changes in the Regulatory Framework 18 5.2 Developments in the Technology Environment 20 5.3 The Decisive Role of Mobile Technology for Banking in Africa 23 6 IN-DEPTH INTERVIEWS AND ELECTRONIC SURVEY: ANALYSIS AND KEY FINDINGS 25 6.1 Main Trends in the Financial Industry: Results from In-Depth Interviews 25 6.2 Changing Regulatory and Risk Management Requirements: Results from 27 In-Depth Interviews 6.3 Technology and Process Innovation: Results from In-Depth Interviews 28 6.4 Results of the Online Survey 29 6.5 Breakdown of Results for Key Markets 31 6.6 Results from a Regulators’ Perspective 35 7 BEST PRACTICE BANK 36 7.1 Creating Unique Value Together with Customers 36 7.2 Securing Compliance with Risk Management and Regulatory Requirements 38 8 CONCLUSION OF THE BANKING STUDY 46 9 AUTHORS 47 10 APPENDIX 48 11 LIST OF REFERENCES 66
  4. 4. 4 Introduction | Banking Study 1 EXECUTIVE SUMMARY Triggered by the financial crisis and the subsequent chang- es to their regulatory frameworks, banks are moving towards a new paradigm in managing risk, return, liquidity, and capital simultaneously and proactively. In doing so, they face several challenges: stricter regulation and an increasing intensity of su- pervisory control have led to substantially higher demands on their risk management infrastructure. In conjunction with higher macroeconomic volatility and a slowdown in growth in Europe, Japan, and the US, and intense competition, this has led to a protracted erosion of profit margins in many of the established business lines and locations. On the other hand, “megatrends” such as variations in customer demands and behavior, shifts in geographical, political and economic power balances, as well as demographic changes and innovations in information technol- ogies, offer new opportunities for future business. Hence, stra- tegic innovation is essential for a successful revision of current business models and to differentiate future business models from competition. As a senior executive from a leading US-Bank put it “Innovation is also not limited to leveraging next gener- ation technology capabilities. Innovation can also come in the form of strategic improvements around both talent and process management.” Innovation efforts are equally related to new products, services as well as business practices, and are mirrored by higher requirements to the technical frameworks of banks and their use of innovative IT solutions. Against this background, SAP AG and the Business Transformation Academy in Basel, Switzerland, have partnered with the Frankfurt School of Finance & Management and the New York University’s Stern School of Business and Management to conduct a joint re- search project, which seeks to identify a number of methods and procedures in value chains and risk management approaches of banks with business models of different size and complexity of which the outcomes have been consistently superior to others, and which can, consequently, be labeled as “best practices” in this field. The goal is to explore how identified best practice approach- es can be reflected in a state-of-the-art framework by leveraging the benefits of advanced and innovative information technology. Research Goals: • Analyze the current and future mega trends and challenges in the banking sector • Identify the major drivers for business transformation in the financial industry • Understand the impact of innovative technology on future business models • Describe the characteristics of a best practice bank • Explore the roles of customers and supervisory authorities in reshaping the banking value chain Setup of the Study The study consists of a thorough analysis of current drivers and innovation trends in banking, and describes how they relate to the current business challenges. A specific goal of the study is to investigate how innovative technology can shape interactions with stakeholders, enhance risk management and compliance, and create integrated global value chains. The study builds on three pillars: 1. Extensive desk research 2. A series of 20 in-depth interviews with C-level bank man- agement executives, and executives at regulatory authori- ties as well as audit firms 3. A web-based survey resulting in responses from 230 medi- um level executives from different financial institutions. The interviewees include representatives of supervisory au- thorities, e.g. the U.S. Securities and Exchange Commission and Deutsche Bundesbank, leading audit firms like KPMG and PwC, and leading banks, e.g. JP Morgan, Barclays Bank, and Deutsche Bank. Due to the composition of the respondent group, the geo- graphical focus of the investigation is mainly on Europe and North America, although some insightful contributions came from Africa, as well. Study Results The analysis reveals a clear consensus that the “originate-to-dis- tribute” business model which dominated before the crisis is now outdated. Regulators demand that banks implement a long-term sustainable business model instead of focusing on short-term profit maximization. On the other hand, there is large pressure to accelerate the process of change and business model transformation. As a senior representative from a large German bank put it “the felt perception of a two year project is to have an infinite duration. There is pressure for short term success and execution. Key for new technologies is to achieve long term improvements in a short time horizon.” Among the main challenges are low profit margins, the volatile macroeco- nomic outlook, intensified competition and rising IT costs due to new regulations. The Key Drivers for Business Model Transformation: 1. Changing regulatory and risk management requirements 2. Technology and process innovation 3. Variations in customer behavior and preferences
  5. 5. 5 Introduction | Banking Study The recent amendment of the Basel Accord on Banking Super- vision will require banks to strengthen their equity base and control their liquidity situation more stringently. As a senior ex- ecutive from a German bank put it “the stricter and increasingly extensive regulatory requirements now constitute the greatest challenge for banks.” In the context of Basel III, the supervisory authorities have raised their data requirements in terms of quan- tity, detail, accuracy, and speed of delivery. According to a senior executive from a regulatory authority, the main challenges are “automated ad hoc stress testing functionalities, correct, com- plete, granular product data, timely balance sheet data, timely and complete counterparty data for the entire bank or group. This requires bank-internal systems to be improved continuously and hence places high demands on the technology in use.” A se- nior executive from a regulatory authority made the clear state- ment that “we estimated that a great percentage of the currently implemented processes with most of the banks are insufficient to meet future requirements.” His colleague from another super- visory authority confirmed this view: “IT budgets have to signifi- cantly increase to meet the current and future requirements.” Moreover, the Dodd/Frank Act and European Market Infrastruc- ture Regulation (EMIR) will have a profound impact on the reg- ulatory landscape. One U.S. interviewee predicted that “as a result, more trades will be driven to clearing houses and other trading platforms. Margins may well compress in this process but at the same time new business opportunities will emerge, for example, in the area of client collateral management.” It is ob- vious that due to the strict margining and collateral rules which such a move implies, data management within banks will have to become more efficient, which can only be fulfilled by an inte- grated and scalable IT infrastructure. However, risk management is by no means limited to the ful- fillment of regulatory standards alone. Instead, it is increasingly understood as a key driver of competitive advantage. As Dr. Marc D. Grüter of Roland Berger Strategy Consultants put it “there is a direct relationship between the quality – i.e. the effective- ness of risk management, and the sustainability of profit devel- opment.” 1 According to this understanding, a bank’s Chief Risk Officer needs to act as a mediator between the CEO and those top-level executives responsible for market-oriented activities. Technology and Process A main challenge is the improvement of important information flows like current liquidity and risk profile which is often sum- marized by the key term Real Time or as a senior executive from a global bank phrased it: “MDs must be able to get the informa- tion they need at any time; what, where, how, and why. There must be one responsible person in the company who also needs to manage that on the level of the system.” This is supported by the statement of a German senior executive: “New corporate governance regulation states that DAX corporate board mem- bers need to be aware about all risks within their company also if it is not their resort. That can obviously only be done with a perfect IT infrastructure and predefined and explained figures or information, available at any time. The information needs to be delivered in such a way that each board member understands and values it.” But technology is not just a means for a tailored reporting pro- cess to effectively inform the management or for adapting to new regulatory requirements. Rather, according to a leading U.S. bank executive “one of the key imperatives for IT is the align- ment of technology initiatives with business priorities. The key focus areas for IT are typically improving customer experience, enabling growth, improving productivity/efficiency, and reduc- ing risk.” Another interviewee concisely concluded that “there is a lot of IT without banking, but there is no banking without IT.” Here, the key terms are big data, mobile technology and cloud computing. With regard to the former, a senior executive from a large US-Bank asserted: “By harnessing big data we will reduce costs and make our operations more transparent to ourselves and our regulators. We will develop new approaches to mitigate risk, including faster and more effective identification of fraud and other illegal and costly activities. Using big data and ana- lytics, we will provide new opportunities and services for our customers by developing tools and providing enhanced infor- mation that will allow them to make better decisions regarding their businesses. We are at the beginning of a new age of mas- sive and real-time information and analytics and if we proceed wisely, it will have a positive impact on everything that we do.” With regard to the latter, concerns regarding the potential in- security and lack of privacy protection were primarily voiced by supervisory bodies and only to a lesser extent by banks. A senior executive from Deutsche Bundesbank made the statement that “in the case of Germany, the Bundesbank sees the Cloud not as secure enough to be used in banks. Germany is complicated and conservative in this type of changes.” Variations in Customer Behavior and Preferences The key to re-building trust and improving relationships with customers lies in enhanced cooperation and communication to adjust the product and service portfolio to the needs of the cus- tomers. As a representative from a British bank stated “one of the most delicate challenges is the trust that clients have in the institutions. For customers, business transparency is an ongoing concern and money is a very sensible subject.” When dealing with information technology, challenges and opportunities are implied: A representative of a bank with a large retail segment confirmed that “the digitalization of retail banking, e.g. through mobile payment calls for a process sim- plification. It is accompanied by a strong increase in the num- ber of customer channels. Through Web 2.0 and Social Media applications, banking has become increasingly interactive. These applications are strongly used by businesses and private citizens to decide which companies they deem reliable, what products they should buy, and - a very important fact - to let others know how they were attended to.” In response, many banks have been investing heavily in applications for tablet com- puters and mobile phones with internet connectivity that enable customers to conduct a large variety of transactions en route. At least some of them also use the capabilities of social networks to attract “fans” to full-featured social network pages, seeking to strengthen the image of their brands and to have consumers share personal information. A senior executive from a large US- Bank summarized his projections for his client base as follows: 1  Source: Roland Berger Strategy Consultants, Press Release, Zurich, February 18, 2014.
  6. 6. 6 Introduction | Banking Study • “Over 25% of mobile phone users access financial services content on their phone. Financial services growth on mobile apps has increased to 53% YoY • Payingcreditcardbillsviamobilegrew30%overthepastquarter • Remote check deposit increased to 40% in past quarter • 24% of current banking customers with smartphones trans- fer money via mobile • Banks will need to continue to evolve with changing con- sumer behaviors as the predicted inflection point of mobile vs. PC banking is expected by the end of 2015.” A colleague from a leading German bank agreed with him: “Mo- bile Banking will be a main distribution channel for standard retail products with low counselling intensity.” Against this background, Vincent Piron, a partner at KPMG Bel- gium, reckons that “over the long term, social media will become enmeshed into the organizational fabric [of financial institu- tions] in much the same way that the telephone, the internet, and email did before them.” 2 However, use of technology alone will not automatically be a source of competitive advantage. Creating added value requires a lot more than pinning technologically sophisticated applica- tions onto a traditional business model. More specifically, the study reveals the three strategic needs to 1) synchronize tradi- tional and new banking channels, 2) re-design bank branches and 3) use technology to facilitate organizational learning. A colleague from a leading German bank agreed with him: “Mo- bile Banking will be a main distribution channel for standard retail products with low counselling intensity.” Against this background, Vincent Piron, a partner at KPMG Bel- gium, reckons that “over the long term, social media will become enmeshed into the organizational fabric [of financial institu- tions] in much the same way that the telephone, the internet, and email did before them.” However, use of technology alone will not automatically be a source of competitive advantage. Creating added value requires a lot more than pinning technologically sophisticated applica- tions onto a traditional business model. More specifically, the study reveals the three strategic needs to 1) synchronize tradi- tional and new banking channels, 2) re-design bank branches and 3) use technology to facilitate organizational learning. Breakdown of Result for Key Markets Regarding mega trends and future challenges driven by regula- tory and risk management requirements, the markets in Europe and the U.S. are very similar. Moreover, the assessment of pre- vailing strategic challenges and the necessary management re- sponses are comparable for these two regions. American banks have on average made better progress in recovering from the re- cent financial crisis than their European counterparts. As a con- sequence, the leading American banks have far more resources available to prepare for the necessary transformation of their business models and for strengthening their foothold in grow- ing market segments, e.g. in the newly advanced economies of Latin America, Eastern and Southern Asia, and Africa. In many the markets for which higher growth rates are expected for the near future, distribution channels for financial services differ a lot from those in established market economies. In both Latin America and Sub-Saharan Africa, the availability of ba- sic banking services via mobile phones is a prerequisite for a majority of the population to access the financial markets. In many of these regions, however, the start-up costs associated with the establishment of new banking offerings are consider- able because of substantial investments in technological infra- structure needed for the build-up of new distribution channels. Those large U.S. banks which have advanced further in restor- ing their financial health than their European counterparts can be reasonably expected to have a significant advantage in the global competition for market shares. Key Lessons Learned • Banking is all about confidence. Hence, the banks that will emerge best from the recent shake-up within the sector will be those that have access to reliable information about customer needs and concerns, and use it to make the most attractive offer through the most appropriate channel to the right individual at the most suitable time. • Carefully identifying, measuring, reporting, and steering risk is not just a regulatory duty but an integral part of the value creation process. The more this principle is put into prac- tice, the better the new regulatory framework can be turned from a burden into an opportunity. • Competent use of recent advances in information technol- ogy, like real-time analytics, in-memory computing, and (to some extent) Cloud Computing can contribute significant- ly to resolving the trilemma posed by new regulatory de- mands, eroding profit margins, and increasing client service demands. Survey Results Highlights The contributions that process innovation and IT can make are considered highest in the fields of regulatory compliance and customer satisfaction (77%). The cost reduction and revenue enhancement effects of these factors are, on average, deemed less pronoun: Process innovation and IT can help with... 0% 20% 40% 60% 80% Reducing costs Increasing revenues Improving customer satisfaction Meeting regulatory requirements 0% 20% 40% 60% 80% 100% 2  Source: KPMG International (2013) Figure 1: Contributions of process innovation and IT
  7. 7. 7 Introduction | Banking Study When it comes to supporting management decisions, respon- dents place greatest emphasis on the aggregation and compre- hensiveness of information. The availability of real-time infor- mation receives considerably less weight: Important features of management decision support information include 0% 20% 40% 60% 80% 100% Figure 2: Important features of management decision support information Simulation and stress testing Aggregation and comprehensiveness On-demand drill-down functionality Real-time analytics Among current technology innovations, mobile computing at- tains the highest average importance score, with Cloud and in-memory computing lagging far behind: A technological innovation of high relevance in th e future is... 0% 10% 20% 30% 40% 50% 60% 70% Figure 3: Technology innovation in the future Mobile computing Cloud computing In-memory technology A finding of high importance for technology providers is that while 60% of respondents expect their institution’s budget for information technology to increase over the next three years, only a small minority anticipates a budget increase of above 25% in this time span. Conclusions: Characteristics of a Best Practice Bank In spite of the considerable heterogeneity of the banking land- scape in the main target regions of this study, the survey, the in- terviews, and desk research on which it is based led to the con- clusion that there are five common traits which banks that are practice leaders in their field have in common, and could thus be described as common characteristics of a “best practice bank”. • People within a best practice bank are keen listeners and attentive observers when it comes to identifying custom- er’s needs and wishes, and strongly focused on gaining and keeping customers’ trust through product and service offer- ings of lasting value. A best practice bank encourages and swiftly responds to customer feedback, seeking to turn crit- icism into opportunities for learning and improvement, and uses technology as a means to this end. • Decision makers in a best practice bank are aware of the fact that risk management is not primarily a modeling ex- ercise under the exclusive responsibility of a group of pro- fessional fearmongers but a vital part of just about every- body’s business. A risk management executive interviewed in the research phase of the project summarized this point very precisely: “The firm’s risk management framework is intended to create a culture of risk awareness and personal responsibility throughout the firm where collaboration, dis- cussion, escalation, and sharing of information are encour- aged. Technology is a key enabler to effectively deliver on the objectives of risk management.” • A best practice bank takes the recent regulatory amend- ments as an inducement to overcome existing bottlenecks within the present IT infrastructure not by trying to enhance legacy systems in a piecemeal manner but by moving to a new, integrated framework which secures data consisten- cy and integrity. Supervisory authorities will appreciate the greater speed, reliability, and accessibility of risk-related in- formation and the qualitative enhancement of risk manage- ment processes this brings about. • Executives in a best practice bank are aware of the fact that the information on customer demands and behavior, mac- roeconomic environment factors, money and capital market developments, and internal performance and risk indicators, which it gathers in the course of its daily business, becomes one of the organization’s most valuable assets if competent- ly used. A best practice bank therefore actively draws on the capability of in-memory data processing to accelerate and facilitate access to information coming from heterogeneous sources and in various formats, thus improving the reliabil- ity, speed, and appropriateness of decisions. It also uses the potential of Cloud Computing when seeking to achieve data coherence and economies of scale in data manage- ment. Moreover, the bank closely interacts with technology providers in order to align IT concepts with bank-internal organization structures and workflows, and to maintain a common understanding of the demands on, and the oppor- tunities offered by, technology.
  8. 8. 8 Introduction | Banking Study 2 INTRODUCTION The extensive usage of leverage on bank balance sheets, es- pecially in the United States and Europe, together with regu- latory arbitrage led to one of the worst worldwide crises with defaulting banks and large state rescue packages and even bail outs of sovereign European countries. The claims and lobbying by large international banks for de-regulation opened the way for large balance sheets with little equity, creative offshore solutions and misuse of the securitization technic. After exten- sive years of development of the financial system, one small wheel, in this case the US housing market, fell and revealed the puffed up system. The domino effect turned out to be stronger than expected and finally opened the process for a complete rethinking of the regulatory financial framework. This process obviously has already started and resulted in several new or stronger regulations. For example, Basel III increased the equity needs and installed a liquidity ratio (CRD IV package – including also CRR – Capital Requirements Regulation), new proposals for derivatives like EMIR were developed over the past 12 month; the Bank Recovery and Resolution (BRR) Directive started in 2013 and the Liikanen Plan was delivered by a High-level Expert Group by October 2012. The overall target is to restructure the banking system in such a way that it can stand on its own legs even in a strong crisis. From a more general perspective, banking is the business of managing information flows as a core financial intermediary in a dense network of different market participants especially bor- rowers and investors. In today’s globalized world, financial net- works are larger and more complex and given modern technol- ogy, the information flows have become exponentially greater andfaster.Bankingisnowvirtualandtheintrinsicvalueofabank is the existing network of relationships, and fast access to all relevant information regarding existing and in the near future, ongoing funding, asset and information flows in this network, as well as the ability to manage the business opportunities and the risk inherent in these flows. Therefore, a bank is part of the core activities to be a leading operator of advanced information technology and this statement is even more meaningful as the institution’s business model becomes larger and more complex and more counterparties in the financial network are covered. In the future, a sustainable business model and attention to risk management and regulation is needed. Against this back- ground, SAP AG and the Basel-based Business Transformation Academy have partnered with the Frankfurt School of Finance Management and the NYU Stern School of Business to conduct a joint research project This project seeks to identify a number of methods and procedures in value chains and risk manage- mentapproachesofbankswithbusinessmodelsofdifferentsize and complexity of which the outcomes have been consistently superior to others, and which can, consequently, be labeled as “best practices” in this field. The goal is to explore how iden- tified best practice approaches can be reflected in a state of the art framework by leveraging the benefits of advanced and innovative information technology.
  9. 9. 9 Framework of the Banking Study | Banking Study The action plan for the Banking Study comprised three pillars. It began with extensive desk research, followed by 20 in-depth, high-level interviews of banks, regulators, auditors and consul- tancies from the USA and Europe, and finished with an online survey of the alumni network of Frankfurt School of Finance Management with 230 usable results. The interviews were jointly conducted by the Frankfurt School of Finance Management for the European area and the NYU Stern School of Business as a partner for the United States. It was important to choose the institutes as broadly as possible on a geographical as well as sector and topic perspective. The interviewees were restricted to the top to upper management of the respective institute or the specialized division, like risk management, front office or IT (see figure 4). The desk research phase paved the way for the ongoing study. The official documents constituting the new regulatory frame- work for the international banking system were examined and their likely implications determined, drawing on the relevant related publications and expert opinions from audit firms and business academics. Some of the top trends in the field of in- formation technology were sought, identified and examined by theirrelevanceforthebankingsector,combiningsomeliterature research with experiences gathered by the team while working as practitioners and advisors. In doing so, both the relationship of the bank with its current and potential customers and the way bank-internal processes and information flows are shaped by both regulatory requirements and the quest for sustainable value creation were taken into account. The first step was to identify, mostly based on desk research, the main topics for the questions to be asked. Four main subject areas, Mega Trends, Risk and Compliance, Capabilities of Pro- viders and Mobile Banking, were identified and explored using different numbers of individual questions. “Mega Trends” was intended to provide an overall impression of the importance and challenges of IT and risk management in the near future and how new topics like cloud computing, in-memory technology and big data are viewed. The section Risk and Compliance was the main section within the questionnaires and tried to focus in detail on specific tasks like the possibility to deliver real-time data or reportingingeneral,currentsetupsandneededchangestofulfill current regulatory frameworks. Capabilities of Providers were implemented to show strength and weaknesses in the eyes of the market regarding the behavior, setup and general activities of IT solutions providers. Finally, the section Mobile Banking was explicitly created as desk research showed a huge potential for all areas of internet or mobile based activity. The second step was to identify a list of potential participants over different sectors and regions. It was possible to conduct interviews with well-known institutes such as JPMChase, Mor- gan Stanley, Barclays, Commerzbank, Deutsche Bank, Deutsche Pfandbriefbank, Hessische Landesbank, DZ Bank, FMS, HSH Nordbank, ING, the U.S. Securities and Exchange Commission, Deutsche Bundesbank, PriceWaterhouseCoopers, KPMG and Booz Company. As a side project interviews were performed with the Banque of Mocambique (central bank) and the Standard Bank Africa, to gather some information from developing countries where, for example, mobile banking is more common compared to in Europe and the United States. Finally, the interviews were either carried out as a real face-to- face interview, or delivered and filled out by senior management of the appropriate division. The overall distribution of seniority levels of participants can be stated as 12.5% coming from the 3 FRAMEWORK OF THE BANKING STUDY “Frankfurt School of Finance Management is a research-led business school, covering every aspect of business, management, banking and finance. An impressive portfolio of services – ranging from degree courses to Executive 1111Education programs, from research projects to consultancy – means that Frankfurt School acts as adviser, catalyst and educational partner to companies and organizations, to individuals embarking on new careers, and to experienced executives. As a center of intellectual and practical activity, the business school formulates forward-thinking solutions for the worlds of business, finance and management, where agendas and issues are constantly changing.” (FS 2013) “Since its inception in 1900, New York University Stern School of Business has been in and of New York City. Founded as the School of Commerce, Finance and Accounting, the School initially offered training to students for careers in commerce in the burgeoning financial markets of New York City. Today, located in the heart of Greenwich Village with a campus in Westchester, Stern is one of the nation’s premier management education schools and research centers with a broad portfolio of academic programs at the graduate and undergraduate levels. With its global partnerships and engagement in NYU’s global network university, today NYU Stern is not only in and of the city, but also in and of the world.” (NYU 2013) Commercial bank Retail bank Investment bank 2nd level C-level Front office 3nd level IT Universial bank US Europe Type of Institution Topic Area Seniority Risk management Figure 4: Interview framework
  10. 10. 10 Framework of the Banking Study| Banking Study first layer of management, 25% from the second layer (senior vice president or equivalent), and 62,5% from the third layer or below (vice president/director) . Online Survey In addition to the questionnaires presented to senior manage- ment of banks or regulatory entities, an electronic field study via an online survey accessable under was con- ducted. The goal was to get broader result of the needs and opinions throughout the financial markets, across all levles of seniority. The targeted group was the alumni association of the Frankfurt School of Finance Management which consists of more than 1,500 national and international former students. The study was closed on the October 15, 2013 with usable feed- back from 230 participants. Participants were asked to answer 10 multiple choice questions and to submit their company and department names for clustering purposes. All questions were to be answered using a scale ranging from 1 (“not important/ not at all”) to 5 (“very important/to a large extent”). During the evaluation of the survey, votes for categories 1 and 2 on one hand, and categories 4 and 5 on the other, were combined to form the meta-categories “not important/negative” and “im- portant/positive” respectively. In order to enable a comparison of the different questions and subquestions, a weighted average voting factor was calculated, multiplying the vote 1-5 with the number of votes setting the NA as 0. A high number indicates a strong and clear result (See table in appendix). Analysis of the Participants The survey was built to give detailed information about the department or just general infomation about the company for which the participant works. Thus, it was possible to cluster in two ways; firstly based on the typical working field of the company and secondly based on the actual activity across all types of companies. The company level was split into Asset Man- agement, Auditing, Banking, Consulting, Corporates, Financial Services, No Information and Others, no matter which specific department the participant is working in. This can lead to some unclear situations, as consultants exist in consulting companies, but also within typical auditors such as KPMG or PwC. For the first analysis, a consultant working for KPMG was listed under Auditor as the company level and for the second analysis under Consulting. Considering Frankfurt School of Finance Man- agement, as a private university with a focus onfinancial mar- kets, it does not seem surprising that the 7% share of Corporate employees is quite small. Most of the participants are out of the Banking industry (53%), which includes every bank with a banking license. Together with the Financial Services entities, which are brokers or financial firms without a banking license, the overall targeted group Banks comprises up to 57% of the survey,a long way ahead of Auditing (9%), Corporates (7%) and Consulting (5%). However, 16% or 37 persons did not deliver information to cluster them correctly (Figure 5). Looking at the department or working area of each participant, no matter what kind of company, it is interesting to see that the strongest group are the Consultants, followed by Investment Banking, Audit, Corporate Banking and Private Banking, Wealth or Retail Banking (Figure 6). Obviously, Investment, Corporate, Private, Wealth and Retail Banking are not real departments, but it wasn´t helpful for this study to cluster further into their subcomponents. Some departments like Treasury, Sales or IT are important on the regulatory side as well, as they do exist outside of banks, which is why they are mentioned seperately. One further impovement of this clustering should be to distin- guish between sector and department fields and to state both. Nevertheless, it is important for the interpretation of the study that it reached the right people. Consultant Investment Banking Retail Banking / Private Banking / Wealth Management Audit Corporate Banking Sales IT Treasury Asset Management Controlling 12% 13% 16% 4% 5% 6% 10% 10% 12% 12% Figure 6: Department level clustering Asset Management Auditing Banking Consulting Corporate Financial Services No Information Others 53% 9% 4%2% 16% 4% 7% 5% Figure 5: Sector level clustering
  11. 11. 11 Key Drivers of Change and Best Practice Principles | Banking Study 4 KEY DRIVERS OF CHANGE AND BEST PRACTICE PRINCIPLES In the first phase of the research study we conducted a detailed desk research analysis. The authors of the study are all experts with many years of professional banking experience. We have combined this track record with a wide range of publicly avail- able information from many sources to identify a broad set of key drives of change and for the future common accepted best practice principles for the banking industry. In a later stage of the study we adjusted our findings by conducting an empirical study, comprising in depth expert interviews and an electronic survey. We will describe the identified key drivers and best prac- tice principles below and in the following parts of the report we will show how this list of drivers and principles is justified by the results from desk research, in-depth expert interviews, and electronic survey. 4.1KeyDriverofChangesintheBankingIndustryIdentified in the Study The analysis revealed a clear consensus that the pre-crisis ver- sion of the “originate-to-distribute” business model which dom- inated before the crisis is now outdated. Banks are now in the mode of focusing on so called core business fields by reducing of their activities in former attractive segments, such as securiti- zation, correlation products, complex derivative and proprietary trading, structured solutions for regulatory and tax arbitrage, amongst others. For example, today in Germany we find high competition in traditional business fields, like SME-Financing, which were considered in pre-crisis times an activity with poor risk/return profile. In light of the absence of previous opportuni- ties, many banks in Germany have discovered the “Mittelstand” (i.e. small or medium sized enterprises) as a new core compe- tence and even accept a considerably negative PL impact to increase their market share and to drive competitors out of the market. This leads to all time low refinancing costs for SMEs in Germany but RoE-Expectations for German banks will stagnate at a poor level. From today’s point of view, there is no convincing strategy of how to fulfill regulators’ demand for banks to adopt long-term sustainable business models rather than focusing on short-term profit maximization. The main challenges include low profit margins, the volatile macroeconomic outlook, inten- sified competition, and rising IT costs due to new regulations. We expect, especially for the European banking industry, strong consolidation tendencies in the long run, with surviving entities finding compelling answers to the key drivers for change. We have identified the following three key drivers for fundamental business model transformation: • Changing regulatory and risk management requirements: Regulatory amendments crystallized as the main drivers of business model changes and require an integrated and efficient IT infrastructure as well as data management. This will necessarily increase costs while products’ margins shrink. In particular, representatives from regulatory au- thorities and auditors clearly articulated the view that the increasing degree of harmonization among different sets of regulatory requirements like IFRS, Financial Reporting Standards, Basel III and BCBS 239 creates an urgent need for banks to replace existing data and reporting silos with information systems capable of operating reciprocally with others, enabled by new data warehousing technologies. Risk management, rather than focusing only on the ful- fillment of regulatory standards, increasingly assumes the role of a key business partner and acts as a mediator be- tween the CEO and those responsible for market-oriented activities, particularly trading. In this capacity, risk manage- ment and the efficiency of the Internal Capital Adequacy Assessment Process (ICAAP) is regarded as a key driver of competitive advantage in the banking industry. Besides the role of ICAAP as a target of the supervisory review process (second pillar of the Basel framework) and of market dis- cipline (third pillar of the Basel framework), we consider the performance of the ICAAP process as a key for future business opportunities. We believe that this statement is valid for all main business models in the banking industry and covers both pure banking book institutions and trading book institutions. For example, historically the loan busi- ness in the SME segment has shown poor profitability. As a consequence of redesigning business models, many insti- tutions focus on local business and SME in particular, and stronger competition in combination with increasing cap- ital and liquidity requirements driven by Basel III will put further pressure on margins. In this environment, optimiz- ing credit processes can deliver key competitive advantag- es. Introducing simplified and automated processes across the value chain of credit related ICAAP components like Internal Rating Based Models, Early Warning Systems, Limit Management and Capital Allocation Processes and better alignment of credit processes to the specific business seg- ments enable the banks to carry out more efficient deci- sion making. This will result in an optimized cost base and enable financial institutions to capture more business due to faster credit decisions and more competitive business offerings. The effects of market discipline cause external components, like funding costs and other important factors for the lending business, to be influenced by the quality of the credit process. In the capital market business, like mar- ket making, trading desk activities, repo, securities lending or collateral transformation services, banks are faced with additional challenges, which are posed by the availability of real-time credit and market data for calculation of the
  12. 12. 12 Key Drivers of Change and Best Practice Principles | Banking Study Basel III Credit Value Adjustment Charge, or by technolog- ical processes for enterprise wide collateral management needed to optimize the use of available collateral. Success- fully dealing with these challenges means creating vital competitive advantage for costs of capital and liquidity and again leads to increasing market share. Re-engineering the different ICAAP-relevant risk management processes is a key requirement. This statement leads us to the second driver of change as it is intertwined with a broad range of technological requirements, including the existence of cen- tral data warehouses, highly automated process chains, and availability of real-time analytics. • Technology: As we have already established that technolo- gy is the main ingredient for creating competitive advantage by increasing the efficiency of the ICAAP processes, we can now apply this concept to the entire banking organization. Thanks to technological innovations, data management, workflow, and client/customer interactions are chang- ing dramatically. The interviewees, especially those from banks whose business is positioned globally, emphasized their assessment that the arrival of big data and real-time information and analytics constitutes a new era in informa- tion technology. New technologies are the key to targeting new markets and client groups with new kinds of financial services sold through innovative distribution channels. At the same time the rise of the network economy creates new competitors: Banks are faced with higher substitution of products and providers. The next two decades will be driven by demographic changes, geopolitical power shifts, the growing strength of the emerging markets, and cross border integration of value chains. Especially for banks headquartered in developed countries but aspiring a global business model, it will be a clear opportunity to participate in these developments and to create a new growth story in order to diversify the consequences of the expected consol- idation process in the mature economies, i.e. those charac- terized by stable or declining populations and experiencing a slowdown in growth. We expect fundamental changes in banking based on innovations in information technology and the accelerated creation of knowledge. • Customer centricity: Enhanced cooperation and communi- cation can be seen as the key to rebuilding trust and im- proving relationships with customers especially in the ma- ture economies. There is a lot of room for banks to evolve in the way they characterize their clients’ goals and risk tolerance. Traditional bank services fail to capture the complexity of people’s lives nowadays. Characterizing the real risks that affect people’s lives (medical, housing, de- pendent parents, etc.) and then building options to allow people to self-insure where they wish, and farm out seg- ments of that risk with stop-loss can be part of adapting financial and investment management services to changing client demographics and environments. Driven by expan- sion strategies to emerging markets the retail demograph- ics for global banks will become younger. Consequentially, market leaders will be forced to move away from the tra- ditional tools like paper-based statements and reporting, to service delivery in line with other services these client groups are accustomed to. This means banks will be forced to deliver better online services, clearer and more creative presentation of quantitative data and to offer online chat rather than telephone interactions. Using big data and an- alytics will also provide new opportunities and services for customers by developing tools and providing enhanced in- formation that will enable them to improve their business decisions. Adjusting products and services to the needs of customers with the help of new opportunities created by innovations in IT such as mobile phones, interactive digital devices, and social networks can be the guide for future growth paths. 4.2 Deriving Best Practice Principles Based on Experiences from the Crisis The classical banking business mainly consists of taking short- term deposits and granting mid- to long-term loans. This is still the business setup especially for regional banks as private or savings banks and credit unions. International investment banks changed this business model from “originate to hold” to the “originate to distribute” approach (see figure 7) and thus changed the whole risk approach with long term influence on the worldwide real economy. Suddenly, loans were granted to persons or companies of low credit quality merely to directly sell these loans to the capital market. The main counterexample today for best practice in terms of management of information, funding and asset flows is the se- curitization technique of the pre-crisis style, which has created very complex financial intermediation chains. Securitization is the process of transforming reference portfolios of loans (or other assets) into specific forms of debt security, which can be sold to investors. Differing from traditional business models, where Banks accept deposits and utilize their comparative ad- vantages to transform deposits into loans (“Originate to Hold”) Banks became brokers in credit risk between ultimate borrow- ers and those who either purchased Asset Backed Securities (ABS) or who offered CDS insurance (“Originate to Hold”). At the same time as banks assumed the role of being investors in highly rated ABSs, the asset-side of the banks’ balance sheets usually incorporated high-rated (AAA) securities which required no significant capital reserves and low Risk Weighted Assets, but which still carried a higher premium in comparison to the banks’ own liquidity charges. Typically, this process involves a very complex intermediation chain: It starts with poor credit processes and adverse selection of assets by the originating bank, and involves shifting out the complete credit risk of the asset pool so that there is no alignment of interest with the next investor in the chain. Shin (2009) formulated the “Hot Potato Hypothesis”: Securitization allows for a “hot potato” of bad debts to pass down a chain of principal-agent problems. This continues as long there is a greater fool next in the chain and ends with the final investor who is the greatest fool. The conclusion is that “the banking system is the greatest fool” as the main final risk takers in the chain are again banks. The complexity of these
  13. 13. 13 Key Drivers of Change and Best Practice Principles | Banking Study chains is shown in the figure 8. Instead of processing information delivered by the original bor- rowerandexecutingaqualifiedcreditprocessbasedonthisdata, investors relied on externally assigned credit ratings. Higher ratings were justified by various credit enhancements including overcollateralization (i.e. pledging collateral in excess of debt issued), credit default insurance and equity investors willing to bear the first losses. Banks, in their role as main end investors intosecuritizedassets,finallytransformedtheoriginallongterm credit risk into short term refinancing and liquidity risk. The pre-crisis business model of banks was characterized by exces- sive leverage and high maturity mismatch (on/off balance sheet) in the banks and the related shadow banking system (SPVs, SIVs,andConduits).Themaximizationoflendingcapacities,sup- ported by regulatory capital arbitrage, rating arbitrage, and an extraordinary expansion of credit risk transfer instruments, re- sulted in huge financial imbalances in the form of overstretched balancesheetsorexcessiveoff-balancesheetriskexposure.This first led to rising asset prices and strong economic growth and second to credit related bubbles (housing, LBOMBO, commer- cial real estate). Finally, the acceleration of financial innovation enabled banks to transfer hedging and active trading of credit risk as a separate asset class and led to fundamental structural changes in the financial system. Wall Street underwrote $3.2 trillion of loans to homebuyers with bad credit and undocumented incomes from 2002-2007, and structured Mortgage Backed Securities (MBS) and Collat- eralized Debt Obligations (CDOs) that received high ratings and Deposits Bank BorrowerBalance Sheet: Loans Low default risk Cash Deposits Bank BorrowerBalance Sheet: Loans Low default risk Cash SPV (CDO, CMBS, etc.) Cash Cash Credit Counterpartyrisk Cash Credit Counterpartyrisk Investors Originate to hold Originate to distribute Asset flows Step 2 Loan warehousing Credit transformation (blending) Credit, maturity, and liquidity transformation Credit transformation (blending) Credit, maturity, and liquidity transformation Maturity and liquidity transformation ABS issuance ABS warehousing ABS CDO issuance ABS intermediation Credit, maturity, and liquidity transformation Wholesale funding Step 3 Step 4 Step 5 Step 6 Step 7 Funding flows Loans ABS ABS ABS CDO ABCP ABCP Repo ABCP, repo CP, repo ABCP repo Loans $1 NAV Figure 7: Business model Figure 8: Complexity of asset/funding flows, (Source: Adapted from Pozsar et al. 2010)
  14. 14. 14 Key Drivers of Change and Best Practice Principles | Banking Study could then be sold to global investors. By June, 2008 Moody’s had downgraded 90 percent of all asset backed CDO invest- ments issued in 2006 and 2007, including 85 percent of the debt originally rated AAA, according to Lucas of UBS Securities. SP reduced 84 percent of the CDO tranches it rated, including 76 percent of all AAAs. The experiences of the crisis and the numerous bank bail outs by governments, finally culminating in bail outs of different Eu- ropean countries, led to an increase and strengthening of reg- ulatory frameworks around the world. The G20 reshaped their process for regulating financial markets and banking institu- tions, adopting an even more stringent approach. The common Basel III was extended by the CRD IV package (including also CRR - Capital Requirements Regulation); new proposals for de- rivatives like EMIR were developed over the past 12 month; the Bank Recovery and Resolution (BRR) Directive started in 2013 and the Liikanen Plan was delivered by a High-level Expert Group by October 2012. The overall target is to disentangle the troubled banking sys- tem from the interrelated sovereign debt crisis. A decoupling is required of the linkage which currently exists between the Given the diversity of existing business models in terms of size and complexity, it is not possible to define a best practice bank in terms of a generic business model and risk framework. And as banks are still in the process of finding a way to mitigate the pressuredrivenbygreaterregulation,increasedcompetitionand higher costs/lower profits, it is unclear with today’s knowledge how these business model innovations will look. But we can define a list of relevant key principles as guidelines for trans- formed business models by taking into account the mistakes of recent history as well as the challenges of the future. In chapter 7 of the research study we will show that these key principles are supported by both the literature and results of the empirical study. To achieve this we will start with an abstract principle by remembering that all banks are financial intermediaries: Principle 1 (role as financial intermediary): A bank is a best practice institution if the organizational set up and technical framework enables the bank to play their business role as fi- nancial intermediary by optimal management and monitoring of information asymmetries. Monitoring of a borrower by a bank refers to collection of infor- mation before and after a loan is granted, including screening of loan applications, examining the borrower’s ongoing credit- worthiness, and ensuring that the borrower adheres to the terms of the contract. A bank often has privileged information in this processifitoperatestheclient’scurrentaccountandcanobserve the flows of income and expenditure. This is most relevant in the case of small and medium enterprises and is linked to the bank’s role in the payments system (Wambugu and Ngugi 2013, p. 473). The ability to raise bank loans serves as a positive signal if the borrower subsequently seeks funds from capital markets. Even for the traditional core business of banks, delivering lending products to clients, the core competence is to manage informa- tion flows between issuers and investors. Even though the main symptoms of the crisis are connected with excessive indebtedness and high shares of financial insti- tutions in the world’s GDP, we do not believe that part of the ideal resolution of the crisis will be for banks to roll back their business models from “Originate to Distribute” to the tradition- al “Originate to Hold” business model. New capital definition and new capital buffers, new ALM ratios and new counterparty RWAs will reduce banks’ capacity to lend and will change banks’ funding and asset composition. Since, in the future, the equilibrium price of credit will be a function of several main factors like the risk/return-profile of the financed business target but also by the cost of capital and the cost of liquidity, we believe that “Originate to Distribute 2.0” will be the next business model for banks. In our view, banks will even act increasingly as financial inter- mediaries rather than as final risk takers. Even though it is not exactly clear from today’s perspective how this will look, the new Basel III securitization rules are a step in this direction. We believe that banks will also play the role of the most important financial intermediaries, but given reduced lending capacities they will have to share the burden of credit risk with other parts of the financial markets, like the so called real money accounts (insurance or asset management industry). New regulatory rules Capital Requirements Directive (Press release CRD 2013)” Bank Recovery and Resolution Directive (BRR 2013) Report of a High-level Expert Group for possible reforms to the structure of the EU’s banking sector(Liikanen report 2012) Greater Regulation Higher competition Increasing custumer demand Higher cost of risk Eroding profits Future growth and sustaina - bility Differentiate to survive Pressure Costs/Profits Inovation Figure 9: Challenging environment sovereign ratings and the credit ratings of their banks. This linkage comes from the so called triangle situation between Governments, Central Banks and Commercial Banks. The exces- sive focus on government securities as the core of the liquidity reserve, as well as collateral for derivative transactions (both OTC and centrally cleared), creates an inherent linkage between bank debt and sovereign debt, which is due to the special status the latter is granted in the determination of regulatory capi- tal requirements. Therefore, the EU banking union is going to be based upon the pillars of (additional) Europe-wide banking supervision, deposit insurance and a bank restructuring fund. In short, pressure in the form of greater regulation, higher com- petition and increasing customer demand led to higher costs of risk (capital) and eroding profits which can only be handled by innovation (figure 9).
  15. 15. 15 Key Drivers of Change and Best Practice Principles | Banking Study to avoid risk arbitrage and adverse selection will force banks to share all relevant data with co-investors to enable execution of their own due diligence processes. As a consequence, banks will have to cover core functions as providers of risk data and risk management services for their clients in the future. This will force banks to re-engineer their processes in order to improve response times to clients and to allow a more rapid reaction to market developments. Improved streamlining and standard- ization of data management processes, new technologies for enabling improvements in banks’ ability to react better and faster to their customer’s needs, and enhanced client servicing platforms offering clients real-time data to manage their credit exposure will be complementary factors of success in the future. Furthermore, data management and provision for third parties will be a dominating activity of financial intermediaries. We will summarize this discussion in a second principle for being best practice: Principle 2 (use of financial innovations): A best practice bank will use also financial innovations for risk transfer to fulfill their role as key member of different financial intermediation chains. The related task to manage funding, asset and information flows has to be supported by a technical framework which is delivering full transparency for risk management departments, external and internal clients, and supervisory authorities. Driven by Basel III, the banks’ balance sheets will become smaller. Moving forward, it will be crucial for banks to diversify income streams from pure interest earnings. Especially for business with corporates, it becomes more and more difficult to separate oth- er services from the traditional lending function. Nevertheless, non-interestincomestreamsaremuchmorevolatilethaninterest earnings and banks will also face the two-sided problem of fall- ing asset prices and eroding funding sources. At the same time, information flows in the global financial markets become bigger and faster, making large, short term movements of key market data more probable. Moreover, it will become crucial to perma- nently improve the information flows inside the bank between front office departments, risk units, and senior management. In this sense, IT innovations will become the twin of financial inter- mediation and a key competence for institutions with business models related to the management of information asymmetries. Principle 3 (risk profitability): A best practice bank has a de- tailed and contemporary view on the relationship of their Risk Bearing Capacity on one hand and their profitability on the other. Best practice is to use a state of the art technical framework which takes into account the opportunities of technical inno- vations to permanently improve the timeliness and detail of all relevant information regarding risk and profitability. Besides showing how principles 1 – 3 can serve as axioms for the modern banking business, we want to highlight that the detailed definition of the meaning of “contemporary” and “detailed” de- pends on the size and complexity of the business model of the bankanditslevelofsystemrelevance.Thatisalsotheregulatory supervisory view given the principle of double proportionality between ICAAP and the Supervisory Review Process as defined in Pillar 2 of the Basel framework. The focus of the regulators is to reduce the volatility of banks’ profitability by income stream diversification and limitation of proprietary trading (USA: Volcker’s Rule). Volatility in combina- tion with interconnectedness with other financial institutions and high leverage are the fundamental reasons for the system relevance of banks. The macro prudential view of supervisors on the financial networks leads them to focus on identification and effective limitation of sources for systemic risks in banks’ business models. More important than a dual system of investment banking and commercial banking from a supervisory perspective, is the mit- igation of the “too-big-to-fail” problem. A main target of the supervisorsisthedevelopmentofharmonizedcrossborderreso- lution mechanisms. So based on actual political discussions and supported by the requirements of supervisors and tax payers, we believe that the next principle has a self-explanatory status. Principle 4 (market exit living wills resolution): The techno- logical and organizational framework for reporting fulfills all re- quirements to deliver supervisory authorities, a comprehensive understanding and analysis of complex internal and external issues of the relevant bank, facilitated by an immediate access to all relevant details necessary for a credible market exit scenario. Principle 5 (data and process management): Best Practice is to manage the information and processes required for account- ing, solvency capital calculations, treasury operations and risk, liquidity and funding management purposes in a common and consistent database for all regulatory and risk reporting require- ments. We have already discussed the fundamental issue that the pre-crisis Originate-To-Distribute business model transformed long term credit risk into short term liquidity risk. In the future, the risk of a combination of bank runs with eroding asset prices will also be a major risk. It is essential for banking organizations to view liquidity risk and funding management as an integral part of their long-term enterprise strategy. This leads us to the next best practice principle regarding liquidity and funding: Principle 6 (liquidity funding collateral management): (i) The funding base of a best practice bank is complementary to their business model (ii) Dependent on the size and complexity of their business model a best practice bank has all relevant technological requirements available for a contemporary and detailed monitoring of the alignment of the asset and liability side of their balance sheet. (iii) Dependentonthesizeandcomplexityoftheirbusinessmodel a best practice bank has all relevant technological require- ments available for real-time monitoring, forecasting and scenario simulation of relevant liquidity measures and ratios. (iv) Abestpracticebankmonitorstheavailabilityoftheirfunding sources and their significant impact on the risk profile of the organization on at least a daily basis.
  16. 16. 16 Key Drivers of Change and Best Practice Principles | Banking Study (v) The technological framework of a best practice bans ensures regulatory compliance: Basel III key figure calculation and sim- ulation coupled with comprehensive liquidity risk reporting. (vi) A best practice bank has technological capabilities available to achieve effective enterprise wide collateral management (v) The liquidity, funding, and collateral management infra- structure of a best practice bank has to ensure that the senior management has at any time and from anywhere, fast and accurate access to all relevant risk figures including liquidity risk appetite of Key Operating Entities (KOE), stress test results of KOE and liquidity limits, indicators and met- rics of KOE. Further, best practice is to implement existing technological opportunities to minimize response time to all senior management requests regarding liquidity funding risk related data and analytics. (vi) Best practice banks have an advanced early liquidity risk warn- ingsysteminplacelinkedtoseveralriskindicators.Sinceclassic risk management tools and frameworks failed to prevent the recent financial crisis, we face the requirement to move from a micro prudential to a macro prudential risk management ap- proach and to a new risk management culture. New require- ments include the calculation of regulatory capital for the mar- ket value of counterparty credit risk (Credit Value Adjustment) requiring an integrated look on different risk categories (Credit Risk and Market Risk) based on a unified data structure. Chang- ing market environments such as the emergence of significant differences between LIBOR/EURIBOR and OIS-rates require new valuation set ups for financial instruments (multi-curve valuations). Generally, the purpose of risk management is a key competitive factor and the best practice use of risk manage- ment is to increase shareholder value. Principle7(riskmanagementcapitalmanagementvaluation): (i) Regulatory, Risk Management and Business processes in a best practice bank must run together and on the same in- formation basis. (ii) A best practice bank monitors its capital structure on a reg- ular basis. In case of correlated shifts of relevant risk fac- tors, a best practice bank is able to calculate the impact on regulatory capital demand and economic capital demand, on a group level and for business areas or segments on a contemporary basis. (iii) A best practice bank has an integrated view on all business relevant risk categories (Market, Credit, Operational Risk, etc.) supported by a harmonized framework including a uni- fied data warehouse. This unified data warehouse contains all data regarding relevant risk types including product spe- cific data and legal entity views. iv) A best practice bank has implemented state of the art valu- ation procedures and risk analytics taking into account the existing structure and availability of input data (for example: product valuations in a multi curve environment). (v) Best practice regarding valuation procedures and analytics is the introduction of highly automated processes enabling decision makers to identify risk return profiles of products and counterparty relationships. (vi)A best practice bank has a powerful framework available forstresstestingbasedonflexibleandcustomizedmodules for automatic analysis of stress scenarios and ad hoc stress testing. Scenario calculations are based on timely balance sheet information. Stress testing capabilities specifically cover reverse stress tests, impact of wrong way risks and correlated shifts in systematic risk factors for ensuring a macro prudential view. The framework for stress analytics is designed to assess the impact of market dynamics on trading positions. (vii) The risk management infrastructure of a best practice bank must ensure that the senior management has, at any time and from any place, fast and accurate access to all relevant risk figures. Furthermore, best practice is to implement ex- isting technological opportunities to minimize response time to all senior management requests regarding risk re- lated data and analytics. (viii)Best practice banks have an advanced early risk warn- ing system in place linked to several risk indicators. Pre-crisis, many banks built up exposure on the banking book in complex transactions related to market risk and credit risk factors which they could not cover with their existing models and risk frameworks. The ability of a bank to play the role of risk taker by involving banking book and balance sheets capacities is very often a competitive factor and crucial for some kinds of business models. As a conse- quence, an increasing number of banks require advanced methods to measure and manage their risk on the banking book. In the past, the risk framework of a bank was very oftennotabletodeliveracorrelatedviewofallrelevantrisk factorsintimeandaspartofahighlyautomatedprocess.An advanced technical framework for risk assessment on the banking book will assist in meeting the high expectations of demanding clients as well as more stringent regulatory requirements. Principle 8 (portfolio management on the banking book): (i) Best practice banks have advanced technical frameworks available at the portfolio level to simulate the various risk factors relevant to the portfolio while taking the various dependencies into account, in order to provide all relevant information for the assessment of portfolio risk including the necessary data to run hedging strategies against se- lected risk factors. These calculations should be at a highly automated level. (ii) The timeliness and desired degree of detail of the infor- mation above depends on the size and complexity of the banking book portfolio and the business model of the bank. (iii) In addition to share and commodity prices, exchange rates and interest curves, major risk factors include, above all, the spread curves that describe default probabilities and the volatility surfaces that describe market dynamics. (iv) An essential element in the modeling of common risk factors is the assumption of distributions more appropriate than the normal distribution, in order to take the “fat tails” observable in the real markets into account.
  17. 17. 17 Key Drivers of Change and Best Practice Principles | Banking Study (v) In the design of systems, a clear distinction should be made between systems that store information (product, risk data, finance data) and systems that do calculations (risk engines, finance calculations, product valuations). Calculation results should again be stored in the readily accessible data ware- house. (vi) Trading book processes should be applied to the banking book with adequately reduced frequency and data require- ments to keep costs at bay. In order to rebuild trust and confidence with clients, regulatory authorities and politicians, it is very important for banks to pro- tect their business models and activities from the consequences of criminal actions. For the detection and analysis of fraudulent transactions, recent advances in statistical pattern recognition models, combined with advanced text and image processing methods,haveprovenveryrewarding.Clusteringprocedures,for example, can be used to group large numbers of mutually similar transactions together, so that the sudden occurrence of material behavioral deviations from previously observed patterns can trigger the activation of a warning signal. Best practice banks will use all these advances to implement maximum protection against fraudulent transactions to the fullest extent possible. Principle 9 (fraud detection, analysis, and prevention): Best Practice Banks implement state of the art technical frame- works to - identify fraudulent behavior before (significant) losses occur, - keepstepwithrapidlychangingbehavioralpatternsinthisfield, - reduce the frequency of “false alarms”, - speed up and improve the efficiency of fraud detection and prevention activities through automation, and - minimize any unwanted impacts on the core business from fraud-related activities. From a senior management perspective, there is full responsi- bility and personal liability for business strategy and the cor- responding risk strategy of the bank. During the intellectual process for understanding the crisis, it became more and more clear that for many banks especially in the German speaking area the root of the problem was not too high Return on Equity (RoE) targets. Banks in Germany became risky institutions involved in many complex transactions without sufficient investment and risk management processes, as they had inadequate business models incapable of transforming their liquidity and risk capital resources into stable and profitable business. Also, from a fi- nancial intermediary perspective, managing the risk of financial intermediation chains is best understood as an integral part of a value-oriented corporate governance. Now we want to examine the principles by which a bank can leverage their role as financial intermediary for creating unique value with customers and for establishing a long term and sus- tainable business model. We cannot forecast from today’s per- spective how the range of financial services in different business models of banks will change, but we can define general princi- ples as to how banks can, on the basis of an existing range of services in a specific client segment, generate stable returns in the long run and be successful by differentiating from their competitors.Wewillpointoutinchapter7.1thesupportfromour key findings in the interviews, which demonstrates why we see the principle below as common sense and what can be viewed as best practice in this field. Principle10(creatinguniquevalueswithclients:clientcentricity and effective use of distribution channels): (i) Best practice banks are investing in advanced technical ap- plications for modern distribution channels that enable cus- tomers to conduct of a large variety of banking transactions “on the go”. (ii) To reduce the degree of complexity for clients, best practice bankswillsynchronizetraditionalandnewbankingchannels to ensure that – - Banks request the same piece of information from a custom- er no more than once. - Banks can retrieve all existing relevant information when- ever the customer comes into contact with the bank. - Banks can recognize the customer’s demands in a rapid and reliable manner, and foster a more personalized customer experience. (iii) Best practice is the use of information technology for the strategic purpose of re-designing bank branches in an opti- mal manner. (iv) Best practice is the use of information technology to facili- tate organizational learning in order to offer superior advi- sory capabilities.
  18. 18. 18 Main topics for desk research: Key driver of changes in the banking industry | Banking Study 5.1 Changes in the Regulatory Framework 5.1.1 The Dodd Frank Act The Dodd Frank Wall Street Reform and Consumer Protection Act (Public Law 111-203 – July 21, 2010) is a U.S. federal law enacted in reaction to the recent worldwide financial crisis. It owes its name to Senator Chris Dodd and Congressman Barney Frank, who jointly created it. According to its preamble, its main objectives are “to promote the financial stability of the United States by improving accountability and transparency in the fi- nancial system”, to end ‘‘too big to fail’’, “to protect the American taxpayer by ending bailouts” and “to protect consumers from abusive financial services practices”. The Senate Committee on Banking, Housing, and Urban Affairs (Senate Committee on Banking 2010, p.1) summarizes the high- lights of the new bill as follows: • Consumer Protection with Authority and Independence: The new bill creates a new independent watchdog, housed at the Federal Reserve, with the authority to ensure American consumers are getting the clear, accurate information they need to shop for mortgages, credit cards and other financial products, and protects them from hidden fees, abusive terms and deceptive practices. • End “Too Big to Fail” Bailouts: The bill eliminates the pos- sibility of taxpayers being asked to write a check to bail out financial firms that threaten the economy. It does so by cre- ating a safe way to liquidate failed financial firms, imposing tough new capital and leverage requirements that make it undesirable to increase balance sheets tremendously, up- dating the Fed’s authority to allow system wide support but no longer prop up individual firms and establishing rigorous standards and supervision to protect the economy and Amer- ican consumers, investors and businesses. • Advance Warning System: The new bill creates a council to identify and address systemic risks posed by large, complex companies, products and activities before they threaten the stability of the economy. • Transparency Accountability for Exotic Instruments: The new bill eliminates loopholes that allow risky and abusive practices to go unnoticed and unregulated – including loop- holes for over-the-counter derivatives, asset-backed securi- ties, hedge funds, mortgage brokers and payday lenders. • Federal Bank Supervision: The new bill streamlines bank supervision to create clarity and accountability. It protects the dual banking system that supports community banks. • Executive Compensation and Corporate Governance: The new bill provides shareholders with the opportunity to in- fluence pay and corporate affairs with a non-binding vote on executive compensation. • Investor Protection: The new bill provides stronger new rules for transparency and accountability for credit-rating agencies to protect investors and businesses. • Regulation Enforcement on Banking Books: The new bill strengthens oversight and empowers regulators to aggres- sively pursue financial fraud, conflicts of interest, and ma- nipulation of the system that benefit from special interests at the expense of American families and businesses. 5.1.2 Changes in Regulation and Banking Supervision: Basel III As can be inferred from the related publications of the Basel Committee on Banking Supervision (Basel Committee on Banking Supervision 2010, 2011), the main characteristics of the new Basel III framework for banks and banking systems include the following: • An enhancement of banks’ capital bases through increased capital requirements, more rigorous capital standards and the mandatory build-up of capital buffers; • More stringent standards for counterparty credit expo- sures arising from banks’ derivatives, repo and securi- ties-financing transactions; • New provisions on liquidity management and monitoring; and • A strict limitation to the build-up of leverage as a safe- guard against the underestimation of risks due to inade- quate models or model inputs. The new global liquidity standards will demand that banks focus more strongly on the acquisition and repetition of cus- tomer deposits and lower customers’ dependence on other forms of short-term funding (e.g. interbank lending), especially for those customers for whom maturity transformation con- tinues to be a main source of income (Gomes 2013, p. 43). Furthermore, banks will have to hold a larger share of their respective asset bases in the form of instruments that are stable in value and can be turned into cash at short notice (Gomes 2013, p. 39). Banks or corporations can seek to recon- cile the need for stable funding with the goal of profiting from term transformation, which can be done by either issuing or synthetically creating long-dated floating rate debt; a point which been raised by several authors (Faulkender 2005) and (Vickery 2008). Our supposition, that credit securitization will remain an important source of funding (and capital relief) for many institutions, is supported, inter alia, by the reflections of Akseli (Akseli 2013) and the observations of Bechthold (Bech- told 2012). On the other hand, research by Härle (Härle 2010 p. 11–12) strongly supports our expectation that the new rules applying to this field and greater risk awareness on the side 5 MAIN TOPICS FOR DESK RESEARCH: KEY DRIVER OF CHANGES IN THE BANKING INDUSTRY
  19. 19. 19 Main topics for desk research: Key driver of changes in the banking industry | Banking Study of investors will strengthen the transparency requirements for such products and require originators to retain a larger stake in related transactions. Particularly in over-the-counter (OTC) derivatives trading, the joint occurrence of time-varying counterparty credit quality and exposure and the presence of “wrong-way risk”, i.e. the possibility of a negative correlation between both, currently command a high level of attention (Liu 2013). The calcula- tion of a corresponding indicator, the Credit Value Adjustment (CVA) has become part of the mandatory regulatory capital calculation under Basel III. For banks with considerable OTC derivatives exposure, effectively controlling the often highly volatile quantity and hedging against unwanted risks is a for- midable task. It usually involves the aggregation of information from a variety of asset class-specific trading systems used with different sub-portfolios on a daily basis in real time and hence constitutes a major operational and technological challenge (Delarue and Siddiqi 2013). For banks with high-volume trading desks intending to tackle this challenge, procedures capable of allocating computational demands to multiple processors will be of great benefit (Stops 2013). By allowing a faster processing of batch jobs, they will be able to supply decision makers with ex-ante information on possible transactions and help them assess the likely implications for capital requirements. The attainment of this goal, however, necessitates the consistent coupling of data from the bank’s risk management and trading operations. In more general terms, the tasks of adequately assessing the probability and severity of rare, high-impact “tail” events and realistically aggregating risk contributions from different sources allowing for nonlinearities in their dependency struc- tures continue to be at the center of interest for practice leaders in banking and supervisory authorities alike. This is evidenced by a recent whitepaper from Moody’s Analytics (Stuart and O´Connor 2013). The failures of the traditional Value-at-Risk to capture events beyond the confidence level have prompt- ed calls for a supplementation or replacement by Expected Shortfall. This number describes the statistically expected loss occurring if the threshold is actually exceeded (Yamai 2004). Extreme value theory, a branch of statistics focusing on very large deviations from the mid-point of frequency distributions, has made important contributions to the estimation of this measure in practice (Gilli and Kellezi 2006). Given the large amount of time and resources banks invest in the building and calibration of risk models, it must not be forgotten that the ongoing validation of these models based on observed data is an equally important task. Model valida- tion essentially consists of the ex-post comparison of ex-ante predictions and observed values of the variables of interest, and involves statistical appraisals of whether the deviations between the two are small enough to be considered random or so large that they call for a re-parameterization or reformula- tion of the model (International KPMG 2006). Performing this assessment is often anything but trivial since it may involve a large number of resampling rounds in order to produce valid uncertainty margins for the model output. It is estimated that a growth of global data by 40% annualized, which would lead to 44 times the volume of data by 2020. 5.1.3 Multi-Curve Valuation In the field of derivative valuation, financial institutions tra- ditionally used a single standard yield curve for discounting future cash flows and deriving forward rates. This approach im- plies that all participants in the market have the same amount of credit risk, that the firm could obtain funding at standard money market rates (LIBOR/EURIBOR etc.), and that the cred- it risk pertaining to yields for different maturities was small enough to be neglected for calculation purposes. Experience gathered during the most recent financial crisis has, however, put forth clear evidence that assuming an equal credit risk for all market participants cannot be sustained. This point can be exemplified by two cases (Samborn 2011): The spread between LIBOR rates and overnight indexed swap (OIS) rates for the same maturity widened dramatically in the aftermath of the collapse of Lehman Brothers (Sengupta and Tam 2008). Because an OIS does not require an exchange of principal, the corresponding rates are regarded as nearly risk- free, so that the LIBOR-OIS spread can be reasonably regard- ed as a strong indicator for the relative stress in the money markets, meaning that a higher spread is an indication of a decreased willingness to lend by major banks (Brown and Finch 2009). • The spreads on single currency basis swaps involving mon- ey market rates of different maturities, which used to be negligible prior to the crisis, also widened sharply. In order to adequately mirror the conditions of unequal credit risk when valuing derivatives, market participants ought to use different curves for discounting on the one hand and for projecting future money market rates on the other. • A first set of curves, which can be referred to as the “ac- crued curves”, is used to derive forward rates for different coupon frequencies. When valuing a swap with quarterly payments, the implied forward rates for valuing the float- ing leg should be calculated using an accrued curve based on three-month LIBOR/EURIBOR. • Another different curve is used to calculate the present value of all future cash flows. It should be ensured that two iden- tical cash flows occurring at the same date are assigned the same present value. To date, there is no standard definition of the exact nature of the curve to be used for discounting. • When valuing positions that are subject to collateralization, it seems plausible to use overnight index swap rates based, e.g., on EONIA, because default risk appears to be negligible. • In all other cases, constructing the discount curve on the
  20. 20. 20 Main topics for desk research: Key driver of changes in the banking industry | Banking Study basis of very liquid instruments (e.g. swap rates) seems appropriate. Bloomberg, for example, uses 6-month-EURI- BOR-based swap rates for the Eurozone and 3-month-LI- BOR-based swap rates for the U.S. as standards. 5.2 Developments in the Technology Environment 5.2.1 Cloud Computing In many areas of the banking business and particularly in the fields of risk management and regulatory compliance, a key con- cern for decision makers is the ability of IT systems to handle an increasing amount of information in a performance and cost-ef- ficient way. One concept that shows considerable potential in this context is cloud computing. According to the U.S. National Institute of Standards and Technology (Mell and Grance 2011), “cloud computing is a model for enabling ubiquitous, conve- nient, on-demand network access to a shared pool of config- urable computing resources (e.g. networks, servers, storage, applications, and services) that can be rapidly provisioned and released with minimal management effort or service provider interaction.” The main ways in which cloud computing can help financial in- stitutions improve their business can be summarized as follows (Nikam et al. 2012; Christmann and Falkner 2011): • The application of cloud computing releases users from the necessity to operate the corresponding facilities locally and on their own, enabling them to pick and choose services from one or more providers as needed. • The enhanced flexibility supports a faster development of new products and enables a swifter response to new de- mands from outside the organization. • Cloud computing enables an organization to exchange a huge, upfront capital expenditure for smaller, ongoing op- erational charges as it does not require any large ex-ante investments in new hard- and software. • Given that the responsibility for operating the technology rests with the provider, using cloud services can enable banks to achieve a high level of data protection and fault tolerance, as well as improved back-up and disaster recov- ery facilities at reasonable costs. It thus enables an organi- zation to focus more exclusively on its core business rather than dealing with IT-related details. While outsourcing IT operations to the cloud, it should be kept in mind that fully realizing these potential benefits requires a high degree of reliability from the provider. By outsourcing IT operations to the cloud, many, only mod- erately efficient and potentially underutilized computer centers and server rooms can be replaced by a few, highly optimized computer centers which are operated in a par- ticularly energy-efficient manner. This is likely to reduce energy costs and the carbon footprint of the organization. It should be kept in mind that fully realizing these potential benefits requires a high degree of reliability from the provider. Organizations seeking to move some of their IT operations to the cloud are strongly recommended not to base their provider selection on cost savings alone, but to look for a partner with clear evidence of comprehensive expertise in the management of enterprise data processing centers. Suppliers must give highest priority to data security (e.g. by encrypting all stored and transmitted data) and data integrity, have a proven ability to withstand denial-of-service, virus, and malware attacks from outside, and boast a record of very high availability (e.g. 99.9% during working days) as well as a watertight disaster recovery plan. A clear process of identifying problems and developing resolutions must be in place, and the service-level agreement between client and provider must cover all important details about availability, customer support, response times, and per- formance benchmarks (Trappler 2010). From a regulatory point of view, cloud computing is a form of outsourcing. As a consequence, the same supervisory require- ments that apply to “traditional” forms of outsourcing also apply here. Banks using cloud computing services are obliged to un- dertake a comprehensive due diligence of all related elements (Olaoye 2012). This involves carrying out an identification and assessment of the nature, scope, complexity and risk content of all activities and processes entrusted to external providers. Particular attention is required in cases where processes related to the fulfillment of the risk measurement and reporting duties prescribed under the Basel rules are dealt with. The legal re- sponsibility for the timely, complete, and accurate performance of these activities necessarily remains with the bank, since risk management is a core business activity that cannot be entrusted to an outside party. As a consequence, the use of cloud comput- ing will require the bank to monitor these processes closely and regularly to ensure their conformity to regulatory provisions. Moreover, outsourcing must not restrict the relevant bank su- pervisors in the performance of their duties (Basel Committee on Banking Supervision 2005). 5.2.2 Big Data Big Data has been used very often in recent years. The develop- ment of the internet and the upcoming of social media have mas- sively increased the overall amount of data that can be used for business.Itisestimatedthattodaytheamountofdatagenerated every 12 hours is as much as it was from the start of humanity until2003(SAP/FCW2013).McKinseyGlobalInstituteestimated in their “Big Data” field study in 2011 a growth of global data by 40% annualized, which would lead to 44 times the volume of data by 2020 (McKinsey Global Institute 2011, p. 16). Obviously, the speed of generating data is increasing exponentially and in an unstructured format, which means it does not reside in fixed fields, e.g. free-form text, as in the body of emails. This is
  21. 21. 21 Main topics for desk research: Key driver of changes in the banking industry | Banking Study a problem as the majority of business solutions need structured data (SAP/FCW 2013) like relational databases or spreadsheets. Traditionally,companiesbasedtheirbusinessdecisionsontrans- actional data (structured) stored in databases but today most data is non-traditional (not structured) and can be found, for example, in weblogs or social media. Technological progress has made the storage of data and computing capacity much cheaper and has opened the possibility for collecting any potentially interesting data (Dijcks 2013, p. 2). In general, big data includes and can be clustered into: • Traditional enterprise data, e.g. customer information • Machine-generated /sensor data, e.g. trading systems data • Social data, e.g. twitter blogs, Facebook Big Data is not only a matter of size but also of velocity, vari- ety and value. Twitter, for example, produces social media data streams of over 8 TB per day and this information facilitates valuable connectivity for a better customer relationship (Dijcks 2013, p. 3). The challenge is to find useful information within this large amount of data. IT is the only way to fulfill this task and therefore is essential for future business. 5.2.3 The Importance of Mobile Technology and Social Media Mobile banking, i.e. the performance of account transactions, payments, credit applications and other banking transactions through a mobile device, has experienced fast growth globally (Bećirović et al. 2011). The Portio Research Mobile Factbook 2013 (Portio Research Ltd. 2013) predicts that the worldwide mobile subscriber base amounted to nearly 6 billion by the end of 2011 and can be expected to experience a compound annual growth rate of more than 7% in the time span 2013–2016, with markets in Asia/Pacific and Africa leading the way. It seems justified to assume that mobile banking, coupled with micro-fi- nance, is one of the great trends that will shape the future of the financial services industry in emerging economies. In the take-off phase of mobile banking that many emerging economies currently experience, the main emphasis is on en- abling access to the most elementary functionalities offered by mobile banking systems, which can be summarized as follows (Bećirović et al. 2011, p. 91): 1. Accumulation of currency in accounts that can be accessed using mobile devices. 2. Conversion of cash into and out of the stored value account. Thismaybeachievedbyvisitingabankbranch,aretailstoreof the mobile network provider, or even an independent retailer who works as an agent for the transaction system. 3. Transferofcurrencybetweenaccountsusingmobiles,e.g.viaSMS. It should be obvious from these findings that accuracy of infor- mation provided, the speed and reliability of services delivered, and their 24/7 availability are key success factors for financial institutions wanting to participate in the projected growth of this market segment. In much of the industrialized world, where the nearly ubiquitous prevalence of mobile devices sets a limit to further growth in the subscriber base, qualitative changes in the technological capa- bilities and the usage patterns of mobile devices are among the most important factors calling for attention by decision makers in banking. The continual integration of mobile and web-based tools and processes along with highly interactive online communication strongly impacts the way banks conduct their business. Both businesses and private citizens have increasingly opened up to the opportunities created by IT innovations. They use mobile phones, interactive digital devices and social net- works to share and find out which companies they deem to be best, reliable and trustworthy and which products to buy, and they often even use social media to let others know about their customer experience (Bansal 2013). By intensifying the commu- nication with customers, banks also get relevant information to improve their product and service portfolios. Twitter produces social me- dia data streams of over 8 TB per day and this information facilitates valuable connec- tivity for a better customer relationship. A large number of banks have made considerable efforts to provide web-based functionalities for mobile computers and smartphones, putting customers in a position to perform a large multitudeoftransactionswhereverthereisamobileconnection. While a considerable number of banks already use social me- dia as an engagement tool, some of them have recently begun to market their products and services through these channels with the help of targeted advertising techniques, website traffic analytics and conversion rate measures to gain new insights into the preferences and behavioral patterns of customers (see Camhi 2013a). At the same time, it has to be kept in mind that the mere use of technology in isolation does not automatically create value. Rather, the significant challenge is to employ these instruments in a way that improves the customer experience. In this context, three key drivers of success arise: The first one is the seamless integration of new and pre-existing platforms and channels: The variety of banking channels and platforms has undergone a rapid expansion. As this trend is likely to continue, processes are going to become increasingly contexts. Banks will need to enhance their back office support systems in order to make sure that customers are served with the same high quality standard regardless of whether they ap- proach the bank through a “traditional” or “new” communication channel (Hamprecht and Brunier 2011). Ideally, a client advisor willneverneedtoaskforthesamecustomer-relatedinformation twice, because the bank’s customer relationship management