By Jeroen Van Doorsselaere, Vice President, Global Risk & Finance, Wolters Kluwer
While the EU reform package will be a challenge to implement and a drain on capital, banks that embrace the message to integrate operations and systems will become better businesses.
Just because you have to do something doesn’t mean you won’t like it.
Financial supervision is intended, first and foremost, to make banks safer. But a significant aspect of the new wave of regulations, displayed amply in CRD V, the legislation through which the European Union is implementing final Basel III guidelines, is the potential to make banks more effective businesses.
There are certainly elements of the latest version of the Capital Requirements Directive and Capital Requirements Regulation (CRR II), the other main component of the comprehensive EU reform package, that bankers won’t like at all. High on the list are a probable need for additional capital and an accompanying hit to profitability, and the impact on resources from complex, overlapping sets of calculations and analyses that the directive mandates. But their attitudes may change once they realize that the required adjustments, when optimally executed, will permit firms to use capital more efficiently, perhaps recouping all of the shortfall that would otherwise flow through to the profit-and-loss statement, while also enhancing safety and stability.
CRD V, which has staggered implementation deadlines for various components and goes fully into effect on 1 January 2022, will compel banks to compile data in greater detail and with more standardized analytical methods. It will cover market risk via protocols like the Fundamental Review of the Trading Book (FRTB) and Interest Rate Risk in the Banking Book (IRRBB); credit risk, with changes to risk weightings on various types of assets intended to make assessments more sensitive to financial and economic developments; liquidity risk related to market movements and to the ability to secure funding as economic and financial conditions change; risks arising from changes in derivatives contracts, via the Credit Valuation Adjustment (CVA) and its associated capital charge, and operational risks, among others.
Other facets of the framework that will require additional capital include the output floor, which sets a minimum capital requirement when using internal models for certain risks, relative to what would have to be set aside to cover the same risks under a standardized approach, and a higher leverage ratio for global systemically important banks (G-SIBs) as a buffer against model risk and the tendency toward procyclicality: the addition of leverage as a lending cycle matures.
As burdensome as the individual components will be, the primary implementation and compliance challenge will stem from the need to conform to a broad underlying theme: interdependency. CRD V requires firms to engage not in a series of isolated calculations and forecasts, but in an intricate web of interrelated ones. A bank must assess each risk in the context of others it faces. Estimates of risks derived from calculations under IRRBB and especially counterparty credit risk (CCR), for example, will be used to quantify a range of other risks.
These interdependencies can only be addressed successfully by integrating functions like risk and finance to craft a single perspective across an institution. That, in turn, calls for an integrated finance, risk and reporting (FRR) solution designed around a unified data repository. Such a system ensures accuracy, consistency and uniformity of information that comes from diverse sources and is intended for use in calculations of multiple risks for diverse purposes by any of several departments. Ideally the system will trace the provenance of each item from its origin point through intermediate stages in which it might have been altered, and reconcile any discrepancies with data derived from other sources.
The alternative – bringing together independently generated datasets at the end of a series of analytical processes – is doomed from the start. It requires a range of idiosyncratic and often incompatible rules and practices, and systems to execute them, producing myriad variations on a theme, perhaps with some repeated, redundant ones thrown in, potentially requiring repeated rounds of reconciliation.
Unification after the fact is more error prone, time consuming and expensive, made all the more ineffective when it comes to CRD V compliance by the emphasis on risk interdependencies. Even if a bank uses the best version of each system for each function, rather than an integrated solution, it heightens the risk of inaccuracy from multiple reconciliations due to the increasing likelihood that discrepant results will arise from inconsistent data and not from the application of different methodologies.
Establishing a common source of clean, verified data that can be examined consistently from multiple angles to create a better understanding of risk relationships assures that compliance is achieved most effectively. That would be enough – if compliance were all that mattered. But bankers have businesses to run. Fortunately, the same fully integrated solution provides clear operational benefits, too, allowing conditions to be assessed faster, more precisely and with greater sensitivity to changes in the commercial environment. More important, when pressed into service to address what-if, rather than what-is, questions, it can prove invaluable in strategic planning and decision-making, and help institutions to become more proactive in assessing risks and opportunities, rather than just reacting to developments.
CRD V calls on each bank to estimate the impact that various operating scenarios – from benign to acutely stressful, common to rare – would have on credit risk and therefore on capital requirements, via key metrics like the liquidity capital ratio and net stable funding ratio, and on a range of other factors, notably expected shortfalls from market-related events under FRTB and net interest margin under IRRBB, that are reflected in the P&L statement. This will have to be done not just for the institution as a whole, but at desk and portfolio levels, as well.
A system set up to fulfill those compliance mandates can serve as a sophisticated business tool to forecast the effects of certain decisions – acquiring or dropping particular portfolios, say, or expanding or scaling back in an activity or country – on the capital budget, cash flow, return on equity, and so forth under a range of hypothetical macroeconomic backdrops. So an institution will not just be installing a solution that will keep regulators off its back, but one that will enable it to become a more effective competitor and a shrewder consumer of capital.
The challenge of planning for CRD V and implementing a solution – not just the technological components but the human ones, too – must not be underestimated. Having two and a half years until the deadline does not mean a firm can wait two years or so before it gets down to business. The reforms are comprehensive, and preparing for them requires a similarly thorough, collaborative effort, including an evaluation of existing systems and organizational structures and processes, with input from leaders in finance, risk, compliance and other key functions.
Even so, it’s important to remember that when a bank and its data management capabilities are optimally configured for CRD V, little additional effort will be required to leverage them for use in business intelligence. The heavy lifting has been done already. Merely by understanding a solution’s full potential, getting staff up to speed and making any necessary structural or operational adjustments, firms essentially get two vital tools for the resources of one. What is ostensibly a solution for regulatory compliance can earn money, not just cost money, especially for banks that implement it sooner rather than later, acquiring a head start up the learning curve and a first-mover advantage over slower competitors. As formidable a task as gearing up for CRD V is bound to be, there’s a lot to like about that.