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