Impact of the US Financial Modernization Bill on the Requirements of Enterprise Wide Risk Management
“We’re making a fundamental and historic change in the way we operate our financial institutions.”
--William
Jefferson Clinton
November
12, 1999
(remarks
at the signing of the Financial Modernization Bill)
For more then 60 years, U.S. Financial Institutions have been severely restricted by the regulatory framework of the Glass-Steagall Act of 1930. Enacted during the depression, this well intended legislation missed its goal almost as soon as it was ratified. While providing considerable domestic “turf” protection for banks, it proved to create a serious disadvantage for US Financial Institutions wishing to compete in the global marketplace. Most non-U.S. international financial institutions were “universal banks”, with few limitations to their desire to be active in all financial markets, from banking to investment banking to insurance. The signing of the “Financial Modernization Bill” (H.R.10 & S. 900) removes most of the artificial barriers for the US Banks, and provides an even playing field for U.S. Financial Institutions as they compete with international Banks.
Broadly,
this new legislation allows banks to affiliate with securities firms and
insurance companies, affiliations not permitted under Glass-Steagall. The bill
defines a new category of Bank Holding Company that functions like an
investment bank in relation to its member subsidiaries. While the bill does not
repeal the Glass Steagall Act completely, it repeals the important Section 20
and amends Section 32, specifically allowing bank holding companies to own a
securities affiliate. In addition, holding company affiliates are permitted to
engage in insurance activities, even in states that have local anti-affiliation
statutes.
This
change in Banking Legislature comes at a time when globalization of the
investment banking industry is picking up a strong momentum. The industry seeks to expand their presence,
their representation and their activities into conventional banking
territory. The insurance industry, at
the same time, is in the middle of a major institutional restructuring, known
as demutualization. All these events will produce enormous changes in the way
the financial markets are structured and operate to the way financial companies
are organized and managed. In addition, non-financial organizations will
strengthen their in-house banking capabilities to maximize control over the
cash flows of their affiliated organizations. In the meantime, regulatory
changes and requirements (FAS 133, IAS 39) will continue to require that
financial dealings and organizational structure be more transparent to
investors and regulators.
These
changes have a significant impact on risk management. All risk - market, technology, operations, insurance event,
strategy and political - will change. The effect these changes have on the
financial condition of these institutions must be identified, quantified,
correlated and managed. As new lines of business are developed, as partnerships
are formed, as new institutions emerge, as others consolidate and merge, senior
management will face several strategic decisions that flow from the business
need to push the financial community beyond the edge of the current universe.
These
developments add dramatic new relevance to an all encompassing enterprise- wide
financial risk management infrastructure that covers all risks. This combined
industry is IT driven now, with systems taking on more and more critical
functions over time. System decisions have become survival choices rather than
the mere productivity and P&L choices of not too long ago. With the
substantial shifts, consolidations and expansions that will naturally flow from
this Financial Modernization Bill, these strategic decisions will have to be
made at a far more accelerated pace than the industry has ever experienced
previously.
Technology-based
management of operational, market and credit risk was a difficult task in the
segregated universe of Glass Steagall. Difficulties arose not just from
quantification and correlation elements, but also from much more mundane issues
like data availability, reliability and timeliness. The integration of the three
disciplines - banking, securities and
insurance – with all their products, risk profiles and correlations -- will
demand an integrated approach of seamless straight-through-processing of all
financial transactions. This means that the centralized risk control office
must be able to manage all risk components of multiple locations, multiple
portfolios at each location, and provide limit controls on any risk component,
regardless of legal entity, industry or market. This is a huge global
requirement.
And there are other factors. Consolidation under the Investment Bank Holding Company (IBHC) will introduce major integration issues. Elements of installed technology can be as much as ten years old. Even if legacy systems managed risk adequately in a single vertical market, there is no single upgrade diskette that can make a structured legacy system leap into new markets and feed the IBHC.
Legacy
systems must be consolidated or replaced, and new application layers must be
developed to meet the reporting requirements of this bill, increasing
operational risk. Initial evaluation of
in-house development approaches are likely to be prohibitively expensive, and
vendor solutions priced right will be feature poor. Even external custom development and support will come with a
price tag that could literally “break the bank.” ROI models will be weaker at the IBHC level when compared to the
returns that were available when technology was installed in each of the
vertical markets.
These
changes will make the implementation of “Best of Breed” solutions even more
difficult or perhaps even impossible. In a single industry environment, “Best of Breed” solutions provided the
comfortable appearance of vendor independence. But this approach has always
required substantial custom integration to produce global results, at a high
cost of ownership. Fragmentation, specifically on the technology side, always
creates integration problems. Every change in risk management philosophies,
every new product on the market, every new risk component will require multiple
system adjustments. It will cause delays in implementation and reporting,
create valuation risks and integration cost. With cross-industry consolidations under the IBHC concept,
the “Best of Breed” method will be very risky if not impossible to implement,
and will not achieve the intended goal: a timely, cohesive and complete risk
management framework that fairly presents the current risk profile of the
organization, under clearly defined risk parameters and assumptions.
In the past, Risk Management was
viewed almost exclusively from a financial product perspective. The future will
see a strong trend towards the integration of all risk aspects, including
credit, technical, production, operational, insurance and strategic components.
Industry and production specific risk ingredients, especially in the corporate
world, will play a much stronger role in Financial Risk Management. Aspects
such as competitive risks, operational efficiencies, quality control, personnel
competence, the need and the capability to adjust to changing market
environments will become important risk components.
The need for sophisticated
monitoring of the correlation between risks and performance will increase
substantially. Integrated enterprise-wide trading/risk management systems will
be used more and more to support strategic business decisions. For example,
Value at Risk (VaR) measurements will be used to determine optimal allocation
of risk capital across affiliated companies within the Holding structures.
Liquidity Risk Models (LRM’s) will gain a strong influence in the proprietary
trading and hedge management environments. Risk adjusted performance will be
used as the main base for product and personnel performance analysis.
Credit risk, traditionally complex, will be even more so in this new environment. The credit component of traditional fixed income, forex, and money market products
are complicated by credit-enhancing instruments. These instruments, such as derivative contracts and settlement agreements, as well as advances in theoretical constructs such as replacement risk and market volatility metrics require that global solutions across industries be sophisticated enough to comprehensively manage and control credit risk, real-time, in the new environment. Mark–to-market exposure calculations, yield curve constructions, NPV measurements, and volatility pricing calculations must be supremely reliable. The system must calculate portfolio effects from the IBHC perspective on correlated positions and perform margin accounting for those counterparties who supplement their credit lines with collateral.
Outside
credit data must be consolidated in real-time with the internal credit
calculations to deliver credit checking and reporting, 24 hours a day. Full credit exception reporting must flow
immediately to the IBHC. And finally,
the system must be fully compliant with all Basle credit and settlement netting
records.
Financial Risk Management will
continue its progress towards integration into the overall activities of the
organization. The financial standards – including insurance - will spill over
into the corporate world. In-house banking structures will be implemented in
large multinational corporations. The trend to view all activities of the
organization under the financial risk management perspective will improve the
effectiveness of these processes. They will become a major driving force behind
the coming integration process for organizations, which currently still have
very fragmented operations. To be successful in this endeavor, fully integrated
enterprise-wide global risk management systems are the only viable long-term
solution.
At Wall Street Systems ®, this
global view has always guided our development efforts. The Wall Street System ® is the leading
integrated enterprise-wide global trading and risk management system, used by 6
of the 30 largest Multinational Corporations and Insurance Companies, and more
than 20 of the largest International Financial Institutions in the world. The
system covers the full spectrum of financial products with true real-time
straight-through-processing. We have a track record of successful system
integration in response to mergers and acquisitions, and we have successfully
handled divestitures of affiliated companies as well. Our development efforts
have been focused on the ability to reflect a true global holding structure
across different industries, and we believe we are well-positioned to support
the coming dramatic changes in the financial industry.
As IBHCs are formed,
there will be a strong demand for global systems, installed on-site, at each
office of each IBHC subsidiary. This is
our core business. Because of this, we
are positioned, more than most, to immediately add the required features and
functions to our global cross-industry risk management and reporting
capabilities. We are, in fact, ready
with a product right now.
But
this traditional strategy isn’t broad enough to serve the needs of smaller,
geographically dispersed entities at a reasonable cost. In order for us to bring the strength of our
technology to this market, are leveraging our technological assets through
Internet delivery.
Our
product matches the market’s need for scalable solutions at a reasonable cost,
available through a delivery channel that is suitable for global entities both
large and small. Through this channel,
we deliver the same trading and risk control functionality regardless of
activity levels.
Internet
delivery addresses the cost sensitivity issues associated with installation and
development. With this delivery
mechanism, and with dedicated, experienced technology partners, we can deliver
the required functionality, at a functional depth appropriate to the size and
complexity of any institution.
The
ideal backbone software for such an
offering is a product that is a fully developed, real-world tested single
transaction processing engine with full analytical support. That engine must have the capacity to handle
high volume service requests coming from Internet-based clients.
With
just such a fully-developed engine at the core of our business, we have worked
with our existing clients and other interested parties to develop a scalable
Direct Trading environment that can be enhanced with additional features as
needs increase. Our mission is to
connect outside customers to Treasury/Trading and deliver spread-adjusted
prices onto browser terminals that are already installed one the customer’s
desk. Fundamentally, operational risk
is reduced through a reliable straight-through-processing infrastructure.
Wall Street Systems ® provides
the best, if not the only platform capable to successfully manage all risk
components related to the financial developments and performance of
International Financial Institutions and large Multinational Corporations in
the next Centennial.