The 3 False Gods Of Financial Services
June 22, 2009
We have long proclaimed our devotion to capital adequacy, risk management and straight-through processing as the fundamental underpinnings of the financial service industry. However, as the financial crisis has proven, we now realize that we failed to properly imbed these fundamental concepts into our industries business model.
Regulators expected that provisioning capital for extreme losses would sustain financial enterprises in periods of stress and prevent them from failing. They had foregone the challenge of transforming transaction data and related operating metrics into forward looking risk exposure measures. Now, in the midst of this financial crisis, perhaps a more appropriate view of these capital measures is that it is the ruler by which an organization counts down to failure, not the system that proactively prevents it.
The problem, simply put, is the inability to measure and control the risk financial firms are exposed to. This is caused by the lack of transparency within these businesses due to the silo nature of their organizational structures and by the inappropriate incentives that fail to balance risk and return with short-term self-interest and long-term stakeholder goals. It was also wrong-headed to believe that an historical, mathematically modeled view of past losses, manifest in capital provisioning would prevent too much risk from being taken. Financial transactions entered into in real time have the potential of risk exposures cascading far beyond their notional value and certainly far beyond capital provisioned from past loss events.
The failure to aggregate basic risk management data is the root cause of this inability to monitor risk in the same real-time context as the risks that are being taken. This aggregation ability is missing because the underlying identifying data and valuation information are neither synchronized across the many silos of each business nor across the many businesses comprising the global financial industry.
Standardizing data has long been desired to facilitate the long sought after straight-through processing (STP) vision. Although the benefit of open and uniform standards is well researched and advocated by many, it still remains a distant vision as business processing applications still use proprietary codes and non-standard conventions. These actions evolved over many decades and have placed a high hurdle on financial firms in switching costs to move to open and uniform standards.
The consequence to the industry is built-in delays and high operational costs that result from additional data mapping processes and reconciliation activities. In most securities markets it takes three days for this process to run its course, with significant risk and cost consequences in the interim, notwithstanding the difficulty in getting accurate data to regulators in any meaningful time frame.
Now that regulators across the globe are both overseers and indirect owners of financial institutions, they will need better risk management tools. They will find this task challenging despite these institutions having long functioned as shareholder-owned, regulated and externally audited entities. They already realize that systemically important financial firms operate globally, making transparency a global issue for each sovereign regulator.
The history of financial disruptions points to more collaborative action through shared facilities and more standardized reporting. The current financial crisis has already resulted in proposed central counterparty mechanisms for over-the-counter derivatives, acceleration of computer tagging of regulatory filings, and in applying central matching and guaranteeing concepts to common-to-all, standardized data.
