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Euro Crisis: What Next?


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Whether the ongoing, acute Euro crisis results in a stabilized Euro, a contracted Euro or total disintegration, banking and financial services (BFS) companies must prepare their operational and IT systems to accommodate any resulting changes and limit revenue losses. We offer a remediation plan to prepare for these potentially disruptive changes that could affect systems and processes such as risk management, legal and compliance, cash and liquidity management, reporting, settlement and clearing, post-trade services, channel access, trade execution and management and many more.

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Euro Crisis: What Next?

  1. 1. • Cognizant 20-20 InsightsEuro Crisis: What Next?The Euro crisis, regardless of its eventual outcome, poses complexchallenges for the banking and financial services industry. Given theavalanche of change looming on the horizon, institutions should beginassessing the potential impact on their business and preparing forthe most likely scenarios. A ‘wait and watch’ approach will almostcertainly guarantee having to play catch-up for the foreseeable future. Executive Summary Scenario 1: Stabilized Existing Euro The impact of the ongoing economic downturn • Existing and new governments regain popular and the uncertainty surrounding the future of the support for existing or scaled-down austerity Euro have been of grave concern to executives measures. across the banking and financial services (BFS) industry. Austerity programs, and the govern- • Monetary intervention by the IMF and European Central Bank (ECB) to inject liquidity reduces ments that have enacted them, are coming under interest rates and provides stability to Euro increasing pressure to scale back or are being economies. Repayment by banks under the replaced, and there is increasing likelihood of one ECB’s Long-Term Refinancing Operation (LTRO) or more countries exiting the Euro. in three years remains a risk to future stability. In our opinion, the resolution of the Euro crisis • The purchase of sovereign debts by central will pose major challenges for BFS CXOs. These banks and/or private bondholders taking a will range from restoration of trust and limiting haircut on their holdings in low-rated sovereigns financial losses to dealing with increased liquidity helps ailing economies repay their debt. pressures, additional capital adequacy require- • Fiscal rules are implemented to realign ments, increased business risk, major systems economies to lower medium-term growth. and process changes and lower profitability. • Banks with exposure to the Eurozone continue The Eurozone that emerges following the current to de-leverage via aggressive asset sales. crisis is likely to be structurally different from the • Balance sheets improve, but profit and loss Eurozone we know today. We anticipate one of the statements (P&Ls) are hit as prices soften in a following scenarios: flooded market. cognizant 20-20 insights | june 2012
  2. 2. • Europe remains over-banked and banks remain We believe that while every effort is being taken undercapitalized; further consolidation and toward scenario 1, the most likely outcome is government intervention along the lines of the scenario 2, a contracted Euro, with one or more Bankia bailout in Spain. countries leaving the Euro. BFS institutions that are actively assessing the potential impact, andScenario 2: Contracted Euro planning and preparing for it, will be better placed• One or more countries are compelled to to weather this crisis. On the other hand, a failure leave the Euro as a result of their electorates’ to prepare will render these institutions unable rejection of austerity measures, further dete- to realign or dispose of their investments cost- rioration in their economies, escalating interest effectively and/or make the necessary operational rates and a lack of market confidence. changes in time, which could have a negative impact on their financial stability.• Agreed-upon orderly defaults and currency revaluations lead to another liquidity crunch Euro Crisis: Current Situation and significant market instability due to The financial debt crisis in Europe exposed increased counterparty risk. numerous loopholes in the European Union’s• BFS institutions exposed to exiting countries’ principles of integration, notably in the enforce- debts face substantial financial losses. ment of fiscal discipline. This problem was• All BFS institutions face a substantial impact compounded by the recent downturn in financial on their business and business processes markets and the decrease in market willingness and systems as they struggle to accom- to lend to sovereigns and the private sector in the modate changes in existing legal contracts Eurozone. and currencies and/or the reintroduction of The Eurozone agreement to stabilize the currencies in the exiting states. Euro through the implementation of austerity• The implementation of tighter fiscal integration measures initially had a stabilizing effect in early and monetary intervention in the contracted 2012, despite the unpopularity of the measures in Eurozone builds confidence in the market, a number of countries. However, popular rejection paving the way for future economic recovery. of these fiscal policies in recent weeks has resulted in the failure of governments. ContinuedScenario 3: Total Disintegration implementation of these austerity programs has• Failure to find an effective solution, wholesale become politically untenable in certain countries. rejection of austerity measures and/or the bailouts of weaker countries by stronger The likely resolution of the Euro crisis is expected countries leads to a decision to collapse the to have a major economic impact on BFS institu- Euro. This is accompanied by a return to tions that are exposed to the ailing sovereigns. members’ currencies at their appropriate value. To understand the global impact of the Eurozone Such a scenario would have a significant impact crisis, it is important to consider the level of on the world economy and could result in a exposure of the banks of various countries to global depression, affecting all BFS institutions. Eurozone sovereigns (see Figure 1).In scenarios 2 and 3, orderly defaults have been The tremors from a negative outcome of theassumed. However, in the event of unpredict- Euro crisis will be felt by almost every country inable “disorderly defaults,” a significant financial the world and could lead to a “perfect financialmeltdown could pose challenges in aligning storm.”capital for risk-weighted assets. What Could Happen to the EuroThis paper analyzes the aforementioned The Eurozone that emerges from the crisis willscenarios in terms of the impact on operations most likely be structurally different from theand IT amid increasing concern about the fate of current Eurozone. This, in turn, will have significantthe Euro and the ability/willingness of some of the implications for macroeconomic variables andsovereigns and their counterparties to weather business models. The following section illustratesthis storm. Our analysis seeks to predict the mac- the various possible scenarios, their likelihood, theroeconomic and high-level impact on business corresponding impact and suggested solutionsand IT processes in each of the scenarios followed (see Figure 2 for summary findings).by a detailed analysis of the process impact of themost likely scenario. cognizant 20-20 insights 2
  3. 3. Banks’ Exposure to Eurozone Sovereigns 450 416.5 400 Greece Portugal Spain Italy Ireland 350 300 250 200 177.5 161.7 150.9 140.9 150 110.5 101.2 88.5 100 73.7 66.8 55.8 46.9 53.6 21.3 35.9 25.7 32.0 30.0 39.8 50 12.7 25.4 8.3 5.3 3.8 3.9 9.1 1.2 14.3 0.0 0.0 0 Germany France UK U.S. Italy Spain In U.S. $ billionsSource: Bank for International Settlements as of end June 2011Figure 1The Emerging Scenario Banking and Capital Markets:The Eurozone reforms agreed upon in December High-level Impact2011 included embracing tighter fiscal rules and The contracted Euro or total disintegrationmonetary expansion, and were a step in the scenarios will have different macroeconomicright direction to resolve this crisis. However, the and business model impacts on BFS institutions.austerity measures have not proved politically Increased sovereign risks will hamper BFS insti-tenable in key countries. tutions due to falling mark-to-market values resulting in financial losses and deterioratingGiven the current challenges faced in imple- liquidity positions as sovereign bonds are usedmenting austerity measures, the downgrade of as liquidity buffers and collateral. On the liabilitysovereign debt by ratings agencies and continued side, BFS institutions’ funding costs will rise duemarket concerns, our view is that the most likely to limited access to funds and increased counter-scenario is a contracted Euro. We predict that one party and default risks. The higher costs will beor more sovereigns will exit the Euro, which will passed on to potential borrowers through toughlead to a bleak outlook for their economies with credit standards or higher lending rates.reduced access to international bond markets,depreciating currencies, agreed-upon defaults BFS institutions will need to assess the situationand economic contraction. so as to limit financial losses, evaluate strategies for operating in these markets and evolve a riskConsequently, financial markets are likely to framework based on the changing risk perceptionexperience spikes in counterparty risk, a new and appetite which will have a cascading impactliquidity crunch and declining asset prices. BFS on operational and IT processes. Below we lay outinstitutions will be under immense pressure our view of the high-level impact on the opera-to meet the capital adequacy requirements tional and IT processes of BFS institutions. Thestipulated by regulators. degree of impact will vary for different BFS insti- tutions depending on their business strategies,There is also a possibility of “disorderly” defaults lines of business and exposure to specificwhich could result in a “Eurogeddon” impact on Eurozone sovereigns.the world financial markets. BFS institutions willhave very limited time in these circumstances to Banking Core Processesmanage their risk and limit financial losses. Acquisition and Account Management: BanksIt is therefore essential that all major BFS institu- will need to focus on “know your customer”tions with a significant exposure to the Eurozone (KYC) and assess country risk in the client on-begin planning for the various possible outcomes boarding process. Resetting of client account andof the crisis. portfolio currencies will be required, and any rein- cognizant 20-20 insights 3
  4. 4. Potential Eurozone Outcomes Stabilized Contracted Euro Total Disintegration Existing EuroLikelihood Likely Highly Likely Unlikely but Plausible • All the Euro member • Several sovereigns opt out with • Failure to reach an agreement on states agree to tighter fis- agreed defaults. fiscal integration may lead to exit Scenario cal integration and none by major economies, trigger total Details of the members opt out disintegration. of the Euro. • Sluggish growth in short • Contraction in GDP expected in • Loss of trust and excessive finan- term in the Eurozone shrunken Eurozone and exiting cial losses will be marked by GDP economy. sovereigns. contraction. • Sovereigns on nega- • Sovereign’s monetary and fiscal • Sovereign’s monetary & fiscal poli- tive watch list of rating policies need to be reviewed. cies need to be reviewed. agencies with risk of • Sovereign ratings impact for a • Sovereign ratings impact for a downgrade. Macro- number of Euro member states. number of Euro member states. Economic • High inflation due to • Phases of severe credit crunch • Rising unemployment. monetary expansion. Impact controlled by central banks. • Increasing inflation rates. • Interest rates reduction in • Monetary intervention by central • Social unrest due to austerity mea- short term. banks would reduce interest rates sures implementation. in short term for cheaper credit • Contagion impact across the access. world’s financial markets. • Social unrest due to austerity measures implementation. • Increased focus on risk • Impact on front to back office • Impact on front to back office management and moni- trading activities such as pricing, trading activities such as pricing, toring. trading strategies, settlement and trading and hedging strategies, • Levy of additional taxes clearing in the markets settlement and clearing in the to increase the sovereign exiting Euro. markets exiting Euro. wallet. • Enhanced risk control focusing on • Major impacts on asset, counter- credit, market and sovereign risk. party and sovereign ratings. • Redenomination of accounts, • Significant focus on risk existing positions, re-calibration management and monitoring. of ATMs. • Redenomination of existing • Changes to payment processing, positions from Euro to local High-level clearing and settlement infra- currencies, recalibration of ATMs. Business structure. • Payment processing, settle- and IT • Reset of interest rates for ac- ment and clearing infrastructure Impact counts, mortgages, loans and changes. credit cards. • Reset of interest rates for accounts, • Legal and compliance implica- mortgages, loans and credit cards. tions on existing cross-border • Legal and compliance implications contracts. on existing cross-border contracts. • Valuation impact on existing • Valuation impact on existing contracts. contracts. • Monitoring capital adequacy • Monitoring capital adequacy requirements. requirements. • New regulatory reporting require- • Changes to regulatory framework. ments. • Crisis management team setup — define responsibilities, pre- and post-crisis tasks, management report- ing, plans and resolution. • Scenario planning - scenario discussions, impacts on line of businesses. • Impact analysis on business strategies. Remedia- • Operational and IT impact assessment across lines of business covering market integration strategy. tions • Contingency budgetary provisions. • Creation of detailed run-book for Euro crisis impact. • Detailed client communications planning. • Road map planning and readiness assessment.Figure 2 cognizant 20-20 insights 4
  5. 5. Banking Processes: nominated from the original national currency into the Euro, might pose significant challenges.High-level Impact Capital Markets Core Processes Acquisition & Account Management Client Acquisition and Setup: An increased focus Reference Data Management on KYC will be required, with enhanced credit due Channel Access diligence and country risk assessment during the Legal & Compliance Risk Management client on-boarding process. Existing client data Transaction Processing will need to be migrated to incorporate changes related to reference currency such as settlement Payments, Clearing & Settlement instructions on markets exiting the Euro. Customer Books & Records Communication Trade Identification: Trade analytics and hedging Reporting strategies will be impacted due to additional currency and country exposure, which will mean Low Impact Medium Impact High Impact research and analyst teams will have to provide additional supporting data.Figure 3 Trade Execution and Capture: Margining and collateral for exchange-traded products will betroduction of a currency will require close client impacted, including re-profiling of collateral. Listedmanagement on their financial and transactional stock currency will need to be redenominated.requirements. Trade Management: Terms of confirmation andChannel Access: Channels such as branch, counterparty netting agreements may undergodirect, mobile, contact centers and ATMs will changes due to any currency exit scenario. Multi-need to be recalibrated to account for currency listed stocks netting processes will have to bechanges. Withdrawal and reintroduction of new revisited and increased trading volumes in thesecurrency notes (e.g., the Drachma) and coinage highly volatile markets will compound the opera-will be a particular challenge for banks within tional and IT challenges.countries exiting the Euro, and advance contin-gency planning will be required. Capital Markets Processes:Payments, Settlements and Clearing: Payments High-level Impactinfrastructure and systems will be heavily affectedby currency changes, and the need to reconstituteagent/correspondent banking. There is likely to be Client Acquisition & Setupa knock-on impact on European regulation suchas SEPA, despite the legally binding migration Trade Identification – Research, Analytics, Strategiesdeadline of February 1, 2014. Reference Data Management Trade Execution & Capture Legal & Compliance Risk ManagementTransaction Processing: Changes in creditpolicy, re-establishment of credit lines, implica- Trade Managementtions for trade financing and migration of existingcontracts will be major considerations. Clearing & SettlementCustomer Communication: Any changes in Other Post-Trade Servicesterms and conditions related to accounts and Product Control & Cash & Liquiditytransactions will need to be planned for and com- Books and Records Managementmunicated to clients. Client and Regulatory ReportingThe impact on pension funds could be signifi- Low Impact Medium Impact High Impactcant. For example, the potential redenomina-tion of long-term assets (such as government orcompany bonds), which had already been rede- Figure 4 cognizant 20-20 insights 5
  6. 6. Settlement and Clearing: Additional custody contracts from a legal and compliance perspec-accounts in new currencies and interfacing with tive involving multiple parties from multiple geog-new clearing infrastructures may be required in raphies. A major challenge will be to understandthe impacted markets. From the clearing house trade jurisdictions and entities ownership in orderperspective, there will be additional settlement to decide redenomination.risk monitoring requirements for incorporatingincreased country risk. Client and Regulatory Reporting: Interfaces with new local regulatory regimes and additional clientOther Post-trade Services: Processes such as reporting will be required. Client communicationcollateral management, margining and asset regarding these changes will need to be on the stocks listed in these markets willbe impacted due to currency conversion. Remediation Considering the scale of the impact on variousCommon Core Processes processes, we recommend BFS institutions takeReference Data Management: Banks will have the following actions:to incorporate the price, exchange rate, ratingsimpact and asset price listing changes. • Set up a Euro crisis management team comprised of representatives from differentProduct Control, Books and Records: Valuation lines of business. This team should drive thewill be a key consideration in the event of defaults impact assessment, budget planning, responseon existing contracts, with increased valuation planning and coordination with the lines ofand pricing complexities for structured products business and change management teams.that have underlying exposure in the impactedmarkets. Banks will need to increase focus on • Focus on scenario planning and assess the potential impact on the lines of business andP&L from these markets/products to ensure that operating models.risk models are prudently aligned and as per therisk framework. Migration of existing positions • Identify the operational and IT processes thatincluding introduction of general ledger accounts will be impacted across the lines of business.for new currencies, conversion of balances,account entry processes and data warehouse(s) • Estimate the size of the change for budget alignment and resource planning.will pose additional challenges. • Plan the roadmap for delivery with criticalCash and Liquidity Management: Cash and paths identified.liquidity management functions will have to bemanaged for nostro accounts in new currencies. • Develop the market integration strategy.Defaults and a credit crunch will lead to greater • Plan the delivery and implementation.focus on effective cash and liquidity management • Assess readiness.functions. Such extensive changes will pose significantRisk Management: BFS institutions will need to delivery and testing challenges and require sig-review their risk framework for the identification, nificant coordination with external third partiesmeasurement and management of risk. Credit, for seamless transition. This might prove chal-market and operational risk will be key focus lenging as third parties will also be in the midstareas. There will be significant changes in the risk of managing the impact of the Euro crisis on theirmodels, with the need to reevaluate/re-hypothe- businesses.cate models (with no historic data to reference), BFS Institution Readinesslimits and monitoring, collateral and margining,mark-to-market (MTM) calculations and realized BFS institutions have been closely monitoring theP&L losses, credit lines and loan drawdown Euro crisis situation but we anticipate a variablefacilities and capital flight from peripheral level of mobilization across the industry. Failureeconomies. More frequent stress testing is also to conduct the required “as-is” analysis and tolikely. determine the impact of the evolving scenarios on its finances, business models, processes andLegal and Compliance: There will be a substan- systems will leave a BFS institution unable totial impact on cross-border loans/derivatives respond effectively to the scenario that arises. cognizant 20-20 insights 6
  7. 7. Impact of No/Late Action? and mitigating the risk, the choice of partnerBFS institutions that do not prepare sufficiently will be a crucial decision. Institutions must lookfor the Euro crisis will face significant risk and for partners with experiencecompliance issues and possible financial losses. in the Eurozone and a track A resolution of theAmong the potential issues: record of helping institu- tions with regulatory change Euro crisis needs• An incomplete view of their positions in management. Deep domain renewed political sovereign debt, contracts with underlying and analytical expertise will and concerted sovereign debt and their exposure to European across banking and capital counterparties will undermine their ability to markets, scalability, agility, effort to implement assess assets in their portfolios across their responsiveness and crisis politically acceptable lines of business. management expertise are fiscal rules together some of the other attributes• Failure to identify impacted contracts with that the ideal third-party with other measures complex legal entity structures may lead to legal issues and significant financial losses. services provider will possess. aimed at boosting• Setting aside additional capital requirements Conclusion growth to reduce the corresponding to risky assets, managing this A resolution of the Euro deficit and debt. exposure and potential defaults will pose sig- crisis needs renewed political nificant financial challenges. will and concerted effort to implement politi-• Inabilityto operate effectively and be cally acceptable fiscal rules together with other compliant with the new regulatory regimes in measures aimed at boosting growth to reduce the the landscape that follows the Euro crisis. deficit and debt.• Increasedoperational risk due to increased The crisis has caused uncertainty for BFS insti- manual intervention. tutions operating in the Eurozone. With unknown timescales and high risks, these institutions needMoving Forward to be prepared to protect themselves againstThe Euro crisis is likely to force significant the risk of government and bank defaults anddisruptive changes upon BFS institutions, with counterparty bankruptcy, and limit the impact ofboth short- and long-term implications depending process and systems change.upon the scenario that plays out. A contractedEuro (or worse, total disintegration) will have an BFS institutions must focus on the imminentextensive impact on each institution’s processes changes and direct sufficient resources to assessand systems, requiring additional resources the likely scenarios. The outcome is uncertain,and experience to plan and deliver the changes but it is imperative that they plan ahead to bein a cost-effective manner to meet the likely able to meet any eventuality. Those that do so willtimescales. not only be prepared for any disruption caused by the crisis, but will also be in a strong position toTo meet these challenges, some institutions will benefit from the changing to partner with services providers. Whilethis will ensure benefits in terms of identifying For BFS institutions, now is the time to act. cognizant 20-20 insights 7
  8. 8. About the AuthorsVirender Kumar Kalra is Consulting Manager within the UK Capital Markets Practice of CognizantBusiness Consulting. Viren has 17 years of experience primarily in the capital markets domain in businesstransformation and application development projects. He has worked as Project Manager and LeadAnalyst with several large to medium-sized banks operating in the buy-side and the sell-side. He special-izes in the investment banking and brokerage, wealth management and private banking domains andhas extensive experience in analysis and design of front to back trade processes, regulatory reporting,wealth management and asset servicing functions. Viren has a bachelor’s degree in mechanical engineer-ing from the Delhi College of Engineering, Delhi University, and a post-graduate degree in managementstudies from the Sydenham Institute of Management, Mumbai. He can be reached at Edwards is Assistant Vice President and the UK Head of the Banking and Financial Services Practicewithin Cognizant Business Consulting. Alan has more than 30 years of experience in banking andfinancial services, including 15 years of management consulting experience in strategic IT effectiveness,payments, banking and securities services. Before joining Cognizant in mid-2011, Alan was with Fujitsufor 10 years where he was most recently the UK Head of Private Sector Consulting. Prior to this appoint-ment, Alan was the UK Head of Financial Services Consulting. Alan’s earlier consulting career was withDMR Consulting for four years, latterly as the UK Head of Management Consultancy. Alan worked for 12years with The Royal Bank of Scotland in business analysis, project, program and portfolio management.He began his career at Rank Xerox where he worked for three years in IT systems development. Alan hasa bachelor’s degree in chemistry from Imperial College, London and an MBA with distinction from CASSBusiness School. He can be reached at Renardson is Assistant Vice President within the Program Management Practice of CognizantBusiness Consulting. Chris has over 20 years of investment banking and consulting experience gained ina variety of strategic, commercial and delivery-oriented back-office roles. He has worked for both U.S. andEuropean houses, including Credit Suisse, NM Rothschild and First Chicago. Most recently he was GlobalHead of Fixed Income and Equities Operations for ABN Amro. Chris has delivered major transformationprograms including global replatforming for treasury and cash equities, in-sourcing of back-office FX/MMoperations, offshoring, and clearing and settlement consolidation. He has spent the past 10 years drivinga commercial agenda for operations through initiatives focused on cost transparency, sourcing, groupshared services and partner/JV opportunities. Prior to joining Cognizant, Chris was Managing Directorfor Braxxon Consulting Limited, a management and systems consulting firm, specializing in financialmarkets. Chris has a bachelor’s degree in history and politics and a diploma in management studies. Hecan be reached at CognizantCognizant (NASDAQ: CTSH) is a leading provider of information technology, consulting, and business process out-sourcing services, dedicated to helping the world’s leading companies build stronger businesses. Headquartered inTeaneck, New Jersey (U.S.), Cognizant combines a passion for client satisfaction, technology innovation, deep industryand business process expertise, and a global, collaborative workforce that embodies the future of work. With over 50delivery centers worldwide and approximately 140,500 employees as of March 31, 2012, Cognizant is a member of theNASDAQ-100, the S&P 500, the Forbes Global 2000, and the Fortune 500 and is ranked among the top performingand fastest growing companies in the world. Visit us online at or follow us on Twitter: Cognizant. World Headquarters European Headquarters India Operations Headquarters 500 Frank W. Burr Blvd. 1 Kingdom Street #5/535, Old Mahabalipuram Road Teaneck, NJ 07666 USA Paddington Central Okkiyam Pettai, Thoraipakkam Phone: +1 201 801 0233 London W2 6BD Chennai, 600 096 India Fax: +1 201 801 0243 Phone: +44 (0) 20 7297 7600 Phone: +91 (0) 44 4209 6000 Toll Free: +1 888 937 3277 Fax: +44 (0) 20 7121 0102 Fax: +91 (0) 44 4209 6060 Email: Email: Email:©­­ Copyright 2012, Cognizant. All rights reserved. No part of this document may be reproduced, stored in a retrieval system, transmitted in any form or by anymeans, electronic, mechanical, photocopying, recording, or otherwise, without the express written permission from Cognizant. The information contained herein issubject to change without notice. All other trademarks mentioned herein are the property of their respective owners.