Do banks really understand innovation?

By Stanley Epstein – Principal Associate at Citadel Advantage

Today’s “Financial Services Club Blog” on banks and innovation ( see: http://thefinanser.co.uk/fsclub/2009/07/sibos-1-why-banks-dont-get-innovation.html ) really got me thinking. Are banks really interested in innovation or are these “innovators” just few and far between?

When we speak about innovation it is not only technology. Innovations can come about without any technological advance. There is a distinction between “product innovation” and “process innovation”. In the former, the factors of production are rearranged in new, hitherto non-existent forms – no technology needed. “Process innovation” does tend to use advances in technology or new technologies – mobile payments are a case in point.

The underlying cause of financial innovation is self interest which manifests itself through the maximization of profits. Banks seek out, through the innovative process, the most efficient, cost effective way to maximize their profits either on existing products or potential new ones. Financial innovation comes about on the basis of anticipated material gain.

My feeling is that most banks don’t care about innovation at all. If a bank comes up with a new idea or process, and other banks feel that it can tag along to the benefit of their own bottom line, they will do so. In time a whole bunch of banks will do the same simply not to be left out. This is a simple application of the “Bandwagon” effect. And what is more many of these banks will have jumped onto the bandwagon without thinking the whole issue through, be it a new product or a new process. They simply don’t want to miss out, so they will “do it” at any cost. I have seen this time and time again.

The current financial mess that we are in and its precursor, the “sub-prime” debacle, is a case in point. Everyone was doing it. Profits were great. And no one gave much thought to even trying to understand either the product or the risks? Well, no one cared, and look where we are now.

How safe is PayPal?

Just because a payment system is well used and widely known does not automatically make it safe. This thought provoking article in online “Ecommerce Journal” (http://www.ecommerce-journal.com/articles/17048_7_risks_you_take_when_you_start_using_paypal_payment_system ) highlights seven areas where users of the popular PayPal system could be at risk.

What do you think? Let’s have those comments.

Key Issues in the Management of Liquidity Risk

By Stanley Epstein - Principal Associate & Director of Citadel Advantage.

This is the second of a series of articles on Liquidity and Liquidity Risk that we shall be publishing over the next few months.

This is the second article in a series of articles on the management of Liquidity Risk. In my first article “Managing Liquidity Risk – The 2007 Crisis” I dealt with the severe liquidity problems experienced by banks worldwide, which began in the summer of 2007 and which heralded the current financial crisis. I then examined the concept of Liquidity Risk Management, and in reviewing the events of that summer I explored the reasons why many banks came under severe stress.

The crisis revealed that important issues had been overlooked and ignored. The “Basel Committee on Banking Supervision” in its 2008 review of the situation provided additional guidance in areas like;

• the acceptability of liquidity risk by banks,
• ensuring liquidity levels are maintained,
• the allocation of liquidity costs, benefits and risks to a bank’s activities,
• identifying and measuring all the liquidity risks,
• stress testing,
• contingency funding plans,
• managing intraday liquidity risk, and
• public disclosure as a means to promote market discipline.

In this article I deal with the guidance provided in February 2008 Basel Committee document entitled “Liquidity Risk Management and Supervisory Challenges”.

This guidance has been set out in the form of seventeen individual “principles”. In turn these principles have been grouped into five major categories. I will deal with category and the principle or principles that they each contain in turn.

Fundamental principle for the management and supervision of liquidity risk
This is made up of a single principle that essentially places the responsibility of the management of liquidity risk squarely on the bank. There are a number of actions that the bank needs to take to do this, such as ensuring that a strong risk management framework exists and that a bank is obligated to see that it maintains an appropriate level of liquidity to meet its trading requirements. Within the same principle Bank Supervisors are enjoined to ensure the adequacy of the individual banks liquidity risk management framework.

Governance of liquidity risk management
This section comprises three principles. All relate to the level of liquidity risk that a bank is prepared to take. This includes setting a level of required liquidity to meet the individual banks business strategy, the establishment of an appropriate management structure to manage this risk and the duty of the bank’s board of directors to review and approve all issues relating to liquidity at least annually. The third principle in this section deals with the need for liquidity costs, benefits and risks to be incorporated in product pricing and for the need for all new products to be approved with a view to understanding the effect they have on and how they are affected by the bank’s liquidity position.

Measurement and management of liquidity risk
This is the “meat” of the proposal. It is made up of eight individual principles. I will deal with each of these principle in turn.

• Banks must have a sound process to identify, measure, monitor and control their own liquidity risk.
• Bank must take a total active liquidity view. This means that they must manage their exposures and their funding across all their business lines, currencies and legal entities at the same time. And they also need to allow for legal, regulatory and practical limits to moving liquidity between business the various entities that make up their business.
• Banks must diversify their sources of funding and they should regularly test their ability to raise adequate funds from these sources at short notice.
• Intraday (as opposed to overnight) liquidity must be actively managed so that it can meet the bank’s obligations as they arise. Furthermore a bank needs to plan to do this under both normal and strained conditions.
• Collateral must also be actively managed and care should be taken to separate assets which are already tied-up and those that are free.
• Regular stress tests must be undertaken, using different scenarios. This is important as it will help determine if the bank can keep its liquidity requirements and usage within the previously set limits.
• The bank must have a formal emergency liquidity plan. This should also include clear lines of responsibility and escalation procedures. This plan should also be tested regularly.
• Banks are also required to maintain a buffer of unencumbered, high quality liquid assets to meet emergency situations. These assets must also be free of any barriers to their use.

Public disclosure
There is a single principle here – that a bank should disclose information regularly that will permit market participants to form their own opinion as to the bank’s liquidity and its liquidity risk management structure.

The role of supervisors
The final four principles deal with the role of the bank supervisor. Firstly supervisors need to do a regular check of the bank’s risk management structure and its liquidity position. On top of this they should be getting additional information like internal reports and current market information. If supervisors find problems they should also intervene to make certain that these problems are addressed promptly.

There is also a requirement for supervisors to communicate with other supervisors and public authorities, like central banks, both within and across national borders. This is to ensure that there is effective cooperation regarding the supervision of liquidity risk management. This communication needs to take place regularly during normal times. In times of stress this sharing of information needs to increase appropriately.

This guidance was published for initial consolation and comment. In a subsequent article I will deal with some of the “hows”, “whys” and “what to look for” in applying some of these principles.

FREE Foreign Exchange Operations Risk Guide

The Foreign Exchange Committee (FXC) is an industry level body that includes representatives of major financial institutions engaged in foreign currency trading in the United States. It is sponsored by the Federal Reserve Bank of New York.

The foreign exchange (FX) market is the largest and most liquid sector of the global economy. Operations risk affects all aspects of the financial world and FX is certainly not an exception. Best practices for managing FX operational risk is available free from the FXC. To download in PDF format use the following link - http://newyorkfed.org/fxc/2004/fxc041105b.pdf

Is faster, better?

The UK’s Faster Payment service has been highlighted in a recent new item by the BBC. More than a year after launch, the system seems to be effective in getting payments from one domestic bank to another much faster than before. But (isn’t it funny how there always is a “but”?) all is not as rosy as UK payments authorities say it is. The BBC is fretting over a number of problems like inconsistent participation, secret limits and more. Read their report and concerns at http://news.bbc.co.uk/2/hi/business/8166676.stm . Do you have any experiences with the Faster Payments service? What are your views and experiences? Share your comments with us.

What to do in a bank robbery

We tend to get very complacent about banking and risks, especially regarding what to do during a bank robbery. Perhaps many of us are fortunate in so far as an armed robbery has never been on the agenda. However, irrespective of where one may be, bank robberies are a very real issue in many places. A spate of bank robberies in the US (in Oklahoma) last week, including a firefight, brings this reality home.

What to do and why is the subject of an interesting Blog by Meghan Brennan, an Oklahoma City Personal Finance Examiner. Read what she has to say at http://www.examiner.com/x-16952-Oklahoma-City-Personal-Finance--Examiner~y2009m7d22-Banking-101-What-to-expect-in-a-bank-robbery

Personal Mentoring

Training courses can usually only go only part of the way in developing ones professional skills. Added to this is the fact that very often the training course chosen is only an approximate fit. It usually covers only 70% or 80% of the trainee’s needs. Personal mentoring is one way to overcome this sort of problem. It provides a much greater degree of training, geared to the individuals own professional and job requirements.

To cater for this Citadel Advantage, recently launched its newly developed CAPMen Program (very sophisticated sounding, but simply standing for the “Citadel Advantage Personal Mentoring” Program).

This program is a new service designed specifically to provide non-judgmental and professional support to those in senior management or aiming to reach senior management positions who need an in-depth competency in the areas of “Payments & Settlements” and “Operations Risk Management”.

The “CAPMen” program offers a depth of “Payments & Settlements” and “Operations Risk Management” experience and an insightful approach to the challenges of industry practices, allowing senior and other staff to develop their professional skills and knowledge for the benefit of banks and other institution as they moves into the future.

“CAPMen” Mentoring utilizes the full range of Citadel Advantage’s experience and its specialized professional courses to provide coaching, guidance and advice on a one-to-one basis, assisting the professional, set new goals, broaden their vision and build new strategies. “CAPMen” mentoring also helps develop personal management skills such as creative thinking, decision-making, problem-solving, and effective use of resources.

The CAPMen Program is available in a series of different levels – Blue, Silver and Gold. These level allow for an increasing mixture of personal training, mentoring and additional consultations and allow the selection of the option that is the most suitable for specific banks.

For more information you can contact me at stanley@citadeladvantage.com

Risk management education and training for the banking industry

A key lesson of the current economic and financial crisis is that the role of risk management within banks must be reinforced. The natural reaction of the banking industry, hard-hit by unforeseen extreme losses, is either to minimize the role of risk management or, to make the situation worse by repeating the same errors as before.

Risk management can only succeed by increasing risk management education within banks not just to risk managers but to a much wider and senior audience.

Do you really know how vulnerable your bank or organization is to;

• Corruption and bribery?
• Theft of physical assets or stock?
• Money laundering?
• Financial mismanagement?
• Regulatory or compliance breach?
• Internal financial fraud or theft?
• Information theft, loss or attack?
• Vendor, supplier or procurement fraud?
• IP theft, piracy or counterfeiting?
• Management conflict of interest?

Find out how your risk management should be protecting your bank’s future by attending our course “RISK MANAGEMENT - CASE STUDIES FROM THE 2008 CRISIS” in Johannesburg, South Africa on 25, 26 & 27 August 2009.

Key issues covered include;

• How the crisis can be traced to a failure of Operational Risk Management.
• Emergence of Operational Risk Management (Governance, Risk and Compliance) as a focus point for bank survival.
• Understanding the Human Dynamic – how greed and fraud fit into this catastrophic financial disaster.
• Understanding Operational Risk – The Big Picture.
• Positioning the organization to successfully manage the ever-present Operational Risk problem in banking.
• The critical issues in successful Operational Risk Management.

Request a Course Brochure and full courses details by e-mailing us at courses@citadeladvantage.com stating Risk Management in the subject line.

And if you register two or more participants from the same organization the second and subsequent participants’ get a 50% fee discount!

Mobile banking services in Kenya

The use of Mobiles for banking and financial services continue to proliferate at a rate that is hard to keep abreast of. Standard Investment Bank in Kenya has added to this with the introduction of a new value added short message service (SMS) to its clients, which provides for mobile trading on the Nairobi Stock Exchange.

Click on the Blog Post to get the details.

Remittances in Focus

Remittance flows to developing countries are expected to decline by 7.3% in 2009, according to World Bank estimates released at the July 13-14 International Diaspora and Development Conference in Washington DC. According to the World Bank, remittances are relatively resilient because, while new migration flows have declined, the number of migrants living overseas has been relatively unaffected by the crisis. However, sources of risk to the outlook include uncertainty about the depth and duration of the current crisis, unpredictable movements in exchange rates, and the possibility that immigration controls may be tightened further in major destination countries.

Click on the Post Title to link to the article.

Download the CA DIGEST here!

We have just published the new edition of the CA DIGEST.

Download it by clicking the Post Link.

Whats the lead story? Why there is no need for a Basel III plus all the latest on Payment Systems, Operational Risk, Remittances and much, much more.

Mobile Money Summit

There was some interesting stuff at the recent Mobile Money Summit in Barcelona. More than a billion people worldwide lack bank accounts, but do have mobile phones. This creates a dramatic opportunity to achieve greater financial inclusion. It is really worthwhile to follow events at the summit. Have a look at http://www.mobilemoneysummit.com/presentations.shtml or click through on the title of this post.

You have to register to get access. However this is free, and it is certainly worth the effort.

Managing Liquidity Risk – The 2007 Crisis

By Stanley Epstein - Principal Associate & Director of Citadel Advantage

This is the first of a series of articles on Liquidity and Liquidity Risk that we shall be publishing over the next few months.

The whole question of Liquidity Risk Management has become very topical of late spurred on by the initial liquidity crisis in 2007, which occurred in the early stages of the subsequent financial collapse. More and more frequently I find myself being asked the same question or a variation of it “what is the best way to ensure that my bank’s Liquidity Risk Management is on a sound basis?”

The subject is vast. And depending on exactly what you are trying to achieve, so too are the answers.

Before even attempting to paint a broad picture as to the key issues to be addressed in ensuring sound Liquidity Risk Management, I would like to take a step or two back – and explain some of the key principles and issues the surround liquidity management.

Liquidity in the first instance depends on the exact use that the word is being put to. Let me explain. In a pure sense liquidity is defined as the ease and certainty with which an asset can be converted into cash. Money, or cash on hand, is the most liquid asset. Market liquidity on the other hand is the term that refers to an asset's ability to be easily converted through an act of buying or selling without causing a significant movement in the price and with minimum loss of value of the underlying asset. Accounting liquidity is a measure of the ability of a debtor to pay their debts as and when they fall due. It is usually expressed as a ratio or a percentage of current liabilities.

In banking and financial services, liquidity is the ability of a bank (or other financial organization) to meet its commitments when they fall due. Managing liquidity is a daily process (in fact in today’s real-time world, this has become a real-time process too) requiring bankers to monitor and project cash flows to ensure that adequate liquidity is maintained. In a banking environment that liquidity may be needed to fund customer transfers and settlements or to meet other demands generated by the banks business with its clients (advances, letters of credit, commitments and other business transactions that banks undertake).

There are many other definitions of liquidity too. Suffice to say that the brief summary above should serve to explain the concept and to illustrate the notion that there are many variations of this.

Almost every financial transaction or financial commitment has implications for a bank's liquidity. Liquidity risk management helps make certain of a bank's ability to meet cash flow obligations. Remember that this ability can be severely affected by external events and the behavior of other parties to the transaction. Liquidity risk management is critical because a liquidity shortfall at a single bank can have system-wide repercussions, called systemic risk. The inability of one bank to fund, for example, its end-of-day payment system obligations could have a knock-on effect on other banks in the system, which could lead to financial collapse. Indeed, the central bank, as the lender of last resort, stands ready with a safety net to help out individual banks (or even the greater “system”). We witnessed this on a massive scale over the past two years in the U.S., Europe, Asia and elsewhere. However getting this assistance often carries an almost impossible price – reputation. Banks that get themselves into this sort of trouble pay a terrible price in terms of the loss of confidence amongst members of the public, investors and depositors alike. Often this price is so high that the stricken bank does not recover.

The market chaos that began in mid-2007 brought into very sharp focus the importance of liquidity to the effective functioning of financial markets as well as the banking industry. Before the crisis, asset markets were buoyant and funding was readily available at low cost. The sudden change in market conditions clearly showed just how quickly liquidity can disappear and that the lack of liquidity (the correct term is illiquidity) can last for a very long period of time indeed.

So we arrive at the summer of 2007. From August onward the worldwide banking system came under severe stress. To make matters worse developments in financial markets over the previous decade had increased the complexity of liquidity risk and its management. The result was widespread central bank action to support the functioning of money markets and, in some cases, individual banks as well.

It was pretty clear at this point that many banks had failed to take account of a number of basic principles of liquidity risk management. Why? Well in all probability, in a world where liquidity was plentiful and cheap, it didn’t seem to matter much.

Many of the banks that carried the greatest exposure did not even have an adequate framework that satisfactorily accounted for the liquidity risks required by their individual products and business lines. Because of this, incentives at the business level were out of alignment with the overall risk tolerance of these banks.

Many of these banks had not really considered the quantity of liquidity they might require to meet contingent obligations because they simply dismissed the notion of ever having to fund these obligations as being highly unlikely.

In a similar vein many banks saw as highly unlikely too, any severe and prolonged liquidity disruptions. Neither did they conduct stress tests that took account of the chance of a market wide crisis (that is one that affects the whole industry rather than just a single other participant) or the depth or duration of the problems. Banks also did not link their plans for contingency funding to the results of their stress tests. And to add insult to injury they also sometimes assumed that irrespective of what happened their traditional funding sources would remain available to them.

With these events still fresh in the minds of banks and bank regulators the BIS (Bank for International Settlements) based “Basel Committee on Banking Supervision” published a document entitled “Liquidity Risk Management and Supervisory Challenges” during in February 2008.

The crisis had revealed many of the critical issues, outlined above, that had patently been overlooked. Based on this, the Basel Committee has conducted a basic review of its earlier “Sound Practices for Managing Liquidity in Banking Organisations”, which had been published in 2000. In their new document their guidance has been significantly expanded into eight key areas. These key areas cover the following principles;

• banks need to determine how much liquidity risk they are prepared to accept,
• banks must keep a level of liquidity commensurate with their needs,
• the costs of liquidity must be allocated to the banks business activities,
• all the liquidity risks must be identified and measured,
• tests that simulate extreme conditions must be developed and used,
• liquidity contingencies must be planned for,
• intraday liquidity risk must be managed, and
• open disclosure is supported as a method for sustaining market discipline.

So what is this new guidance all about? I will be covering Basel Committee’s advice on these key issues and the subsequent industry response in more detail in a series of subsequent articles.

Online Scams Jump as More Africans Go Online

New technology comes at a price. This interesting article in PC World is a warning that all is not gold at the end of the technology rainbow (Remember to click on the Post Title to view). Mobile payment developers and banks who are venturing into this area for the first time should take note.

European Commission sets out technology-driven action plan for derivatives trading

I am always concerned when we try to solve our problems (or simply wish them away) by invoking “technology” as the panacea. So seeing the headline “European Commission sets out tech-driven action plan for derivatives trading” on an e-mail alert from Finextra brings to mind all the previous misguided attempts to solve everything by throwing technology at it.

(Please click on the Post Title to read the article)

We have previous attempts to manage operational risk by “mining” historic loss data (which often did not exist in digital form anyway) and using this as an indicator of the future losses or the over reliance of VAR. Interestingly, Pablo Triana in his book “Lecturing Birds on Flying: Can Mathematical Theories Destroy the Financial Markets?” aptly compares VAR to a passenger airbag that works only 95% of the time; unfortunately the other 5% includes the time when the driver is involved in an accident.

In dealing with Money Laundering we really threw the baby out with the bathwater when we abrogated the requirement to “Know your customer” from a real personal knowledge of who your customer was and what his business really was about to the technologists black box and the modern alchemist’s book of formulae and often erroneous suppositions.

I most certainly agree that derivatives and credit default swaps have created a web of mutual dependence that makes it difficult to understand, disentangle and contain risk in the immediate aftermath of a default. I am all for using technology to improve the situation.

However, I do really fear that unless we really have a clear understanding of the derivative practices and processes and the potential implications, throwing all this technology at it could end up as a huge waste of money.

David Alexander on Ponzi Fraud

South Africa has its own Ponzi scheme too. A 2 billion rand (USD 257 million) scam that has ensnared many investors, including some well known local businessmen. Please click on the Post Title to link to a transcript of a radio interview that local fraud expert David Alexander did yesterday on South Africa’s Moneyweb Radio.

David Alexander is the Guest Expert at the CIT-Advantage Seminar in Johannesburg on 25/26 & 27 August 2009 on “RISK MANAGEMENT - CASE STUDIES FROM THE 2008 CRISIS”. David Alexander’s unique combination of business experience and insights into scams, fraud and social engineering through personal exposure has equipped him to provide unique insights and cutting edge, innovative social engineering, scam, fraud and economic crime solutions.