Risk Review: Where is the global industry today?

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RISK REVIEW

WHERE IS THE GLOBAL INDUSTRY TODAY?

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CONTENTS Welcome to the Risk Review

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Regulation | Basel IV – The unbearable standard

Page 4

Market Risk | Five icebergs in the investment floe

Page 8

Credit Risk | What is the true cost of Sovereign default?

Page 12

Operational Risk | Quo Vadis Operational Risk? Emerging Page 14

operational risk management techniques

Modelling | Top 5 Innovations in Modelling

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Innovation & Disruption | Four long-term impacts of DLT Page 18

and Blockchain

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Twitter: twitter.com/RiskMinds

Content home: riskmindslive.com

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SPECIAL THANKS & CREDITS Editor: Sophie Cater, Digital Content Manager, RiskMinds Contributors: Barbara Mack, Journalist, Dan Barnes, Journalist, Massimo Morini, Head of Interest Rate and Credit Models at Banca IMI, David Carruthers, Head of Research at Credit Benchmark, Lisa Riordan, Head of Operational Risk in Deutsche Pfandbriefbank AG, Dr. Klaus BĂścker, Head Risk Models & Analytics at Deutsche Pfandbriefbank Contact: sophie.cater@knect365.com

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WELCOME TO RISK REVIEW Where is the global industry today? As we move towards

risk managers as well as the

December’s RiskMinds

micro details of credit risk,

International conference

operational risk and modelling.

and the final part of the year there is a strong feeling

RiskMinds International brings

of anticipation in the air.

together the very best experts

The American election

in their fields to address the

looms in November; the

strategic and the technical

“Basel IV” requirements are

risk challenges facing the

within touching distance;

industry today and in the near

and innovation is shifting

future. It is our hope that this

increasingly into main

magazine will provide you with

stream thinking.

some timely, engaging food for thought between now and the

This edition of Risk Review

conference in Amsterdam this

delves into the crucial macro

December 5-9.

factors on the horizon for

ED STAPLEY EDITOR-IN-CHIEF, RISKMINDS 3


Join a panel of industry experts to discuss “Basel IV” - What It Means For Banks And For The Economy at RiskMinds International on 5th December.

Basel IV, as last year’s proposed amends to Basel III are dubbed, is

REGULATION

unworkable for banks in Canada, Europe and Japan. That is the conclusion of many practitioners who

BASEL IV – THE UNBEARABLE STANDARD

The move to standardise approaches to capital requirements under ‘Basel IV’ are a blunt weapon, say bankers. BY DAN BARNES

are seriously concerned about the rewriting of capital requirements, set under the Basel III regulation. The changes to Basel III, announced in the summer of 2015, are intended by regulators to create a standardised approach to the way banks measure their capital requirements. Iain Mackay, group financial director at HSBC, told analysts on 6 May 2016 that adding up the capital required of HSBC and all of its competitors would not cover “a small fraction” of what was needed given the potential impact of standardised internal risk based approach (IRBA), operational risk and market risk. “I think we’re all pretty much stuffed,” he said, if there were no change to the proposed rules. “On that, I’d add that if we’re all stuffed, then we’re less stuffed than everybody else, because we generate capital and we have multiple means by which we can manage capital to overcome the obstacles.” Marcus Schenck, chief financial officer at Deutsche Bank concurred in a call with analysts on 26 July 2016 when he said, “It looks like the impact [of Basel

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IV] is humongously draconian and


would essentially be a complete game

a standardised floor on it you have

“The US haven’t really implemented

changer for the banking industry on

exactly the same problem.”

things like the IRB, they are using

this planet.”

Patricia Jackson, partner and special

a different method which is CCAR,

adviser on Risk Governance for EMEIA

a stress testing approach,” says

Pinpointing the exact level of

Financial Services at consultancy EY

Jackson. “That is really based around

increased capital required is hard;

says, “People have forgotten about

the Fed’s own IRB models. So I think

consultancy EY cite an increase of 40%

the distortions caused by Basel I

geographically people have gone down

made by the Basel Committee, while

and they are just focussing on more

different routes. It’s not just in Europe,

the European Banking Federation

standardisation across countries.

it’s in Japan as well. It’s countries

put the figure at €600-900 billion at a

If you standardise at 2% capital

which have implemented the IRB

journalist briefing in August.

requirement that’s not standardising

but which have large, high-quality

it relative to the risk, if one bank has

corporates still borrowing from the

One sizes fits few

an ‘A’ quality book and another has

banks and that’s just a fact of life in

Basel IV changes several of the

a ‘BB’ quality book. So it looks like

markets outside the US.”

existing measures imposed under

standardisation but it’s a wholly un-

Basel III in order to present a

level playing field.”

standardised approach to the way banks assess capital requirements.

One source said the BIS might revise the level of advanced IRB for corporate

While Basel III is seen as a necessary

mid-cap lending to €500 million of

and important step change in the

consolidated turnover, with foundation

“The removal of internal modelling for

quantity and quality of capital being

IRB increased for the largest

wholesale exposures and specialised

held, it originally went with the grain

corporates and for specialised lending.

lending, removal of internal modelling

of the risk-adjusted capital measures

However even with these reforms,

for credit conversion factors (CCFs)

that were already in place. Where

issues would still exist with the lack of

and the CCF calibration proposed in

it was requiring much more capital,

recognition of bank risk management

the standardised framework and then

it was on a risk adjusted basis. The

practices and the capital framework, in

the floors are our members’ main

risk from proposed changes to the

the IRB framework.

issues,” says Jacqueline Mills,

internal ratings based (IRB) approach

director for Prudential Regulation at

is that the regulators are going back

Jackson says, “Some of the proposals

the Association of Financial Markets

on all of those risk adjustments.

have to be re-thought and I think that’s

in Europe (AFME).

At a practical level, requiring an

quite likely to happen with the IRB,

additional two percentage points

because the effects are so great.”

In some ways the pressure to

of capital for lending to a large

Recent media reports have suggested

standardise the approach to risk

corporate can make the process

the European Commission will take

versus capital represents a step

uneconomical, damaging the lending

a strong line to defend its banks and,

back in the approach to risk. Under

channel and given the scale of the

given the strength of feeling amongst

Basel I requirements drew very little

effect, potentially the economy.

the firms themselves it seems clear

lending. The Basel committee

Enter the draconian

be needed.

engaged in a considerable review

Understanding the potential for

of the effect that Basel I was having

reforms of these proposals will

Mills says, “We are not sure what these

before developing Basel II, and found

depend on who and how concerned

very strong positions will now mean

it was causing enormous distortions

people are about the existing

for negotiations.”

including in the United States.

approach. The imbalance EY’s

The effect of floors only adds to

Jackson observes is perhaps most

the problems by forcing minimum

notable across geographies. In the US

levels of capital on the industry.

capital markets have long been used

distinction in quality of corporate

either reform or compromise will

by corporates seeking to raise funds. Mills says, “Floors compound the

In Europe and Japan where bank

loss of risk sensitivity and even if

lending is still a major source

you improve the risk sensitivity in

for corporates to raise funds, the

the RWA framework and then stick

current regime is more punitive.

Explore the latest regulatory changes at RiskMinds International at the Regulation Summit. CLICK HERE to discover more.

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This is far and away the best

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Scott Aguais, Managing Director,

CRO, The World Bank.

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MARKET RISK

For many market observers China has been the biggest macro story; it has had a significant impact upon other

FIVE ICEBERGS IN THE INVESTMENT FLOE

emerging markets and its market

The risk landscape for many firms will be determined by several macro factors; these are top of the list.

of a similar magnitude, changing the

reforms are changing the investment landscape, from currency to equities to bonds. However, other macro issues are also shaking up the investment picture and could have repercussions economic picture and thus hitting markets. Here are the top five macro risks that analysts see looking forward. Political risk Populism is not limited to any one country. There are many movements

BY DAN BARNES

in many countries that reflect a lack of faith in existing political doctrine, parties and their policies. The British referendum to leave the European Union (Brexit) is a case in point, however various other referenda from the Colombia FARC peace deal to

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Hungary’s rejection of European Union

threaten to overturn long-standing

oil importers so the fall in prices has

(EU) migration quotas are good points

political directions make this

brought down inflation and boosted

of comparison. The effect on markets

characterisation relatively widespread.

purchasing power.”

short term, whilst in the longer term

Oil

Nevertheless, timing seems to have

economic growth can be affected.

The cost of oil has wide-reaching

led many of those economies to be

effects from the economic impact on

hard hit, whereas the benefits are

Writing on Clinton and Trump for the

oil producing countries to the cost of

likely to take longer to feed through.

US election coming up, Kevin Logan,

industry in other markets. It is also one

chief US economist at HSBC Securities

of the most opaque markets for price

says, “Clinton is the standard bearer for

setting. Consequently, it is both hard to

the status quo and her proposals tend

predict and its effects are wide ranging.

is typically one of volatility in the

to be micro – relatively small-scale changes in numerous programs that

“A few countries that are very

can bring targeted benefits to various

dependent on oil exports that have

constituencies. In contrast, Trump is

suffered quite heavily [from the fall

the candidate of change. He advocates

this year], now the big extent to which

an extensive revamping of trade,

they suffered depends on the buffers

immigration, and tax policies. His

they built during the period of high

approach is more macro – large-scale

oil prices,” says William Jackson,

changes that would overhaul policies.”

senior emerging markets economist

Discover the key market risks at RiskMinds International on 7th December. CLICK HERE for more.

from Capital Economics. “Most Across countries the use of referenda

emerging markets should benefit

and the rise of candidates who

from low oil prices because they are

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“We have probably seen the worse

While they are facilitating debt

direct effect on investors. There is the

happen for most of the major oil

issuance in the primary market, with

potential for a bank to collapse if risk

producers, Russia’s economy seems

corporates in particular keen to take

is not properly managed as revenues

to be recovering, albeit slowly,” says

advantage of the low interest rate

continue to fall, and governments are

Jackson. “We get the sense that

environment, their ability to make

still on the hook for bailing them out.

positions of the Gulf States have

prices and take risk in the secondary

improved a bit, although there a

markets is severely reduced. In its

Central banks

few countries such as Nigeria

report ‘Capital Markets and Investment

Quantitative easing (QE) programmes

which have had a bit of a botched

Banking 2016: Time for Tough Choices

and low-to-negative interest rates

response to low oil prices and are

and Bold Actions’, consultancy

have become a cul-de-sac for central

still in recession.”

McKinsey & Co found that return on

banks, while they have aimed to

equity was flat last year at 10%, while

stimulate growth. Their acquisition of

Investment banks

European investment banks were even

government and even corporate bonds

The challenge facing investment

lower at 5%.

has hit investors; Bernstein Research found that traded volume in European

banks primarily stems from their capacity to support that levels of

With big banks pulling out of major

government bonds is down around

capital they need. Restrictions

business areas, for example Credit

12% as a result of the European Central

placed upon activity and stringent

Suisse’s withdrawal from the

Bank taking out around 8% of the

capital requirements are both

secondary European government bond

available pool of European government

a consequence of regulation.

market and JP Morgan’s withdrawal

bonds. It predicted in March that

The upshot of these rules is that

of many prime brokerage services,

corporate bonds would see a reduction

the major banks are removing

activity in the markets is reducing.

of 15-30% of the liquidity for taking out

themselves, or being removed,

The higher price of liquidity in credit

6-12% of stock. The acquisition of these

from activity of certain kinds.

markets is one clear example of a

instruments also distorts bond prices.

Global CMIB industry post-tax ROE1 analysis, based on nationality of bans

0 TOP 10

EMEA

11 144

12

10

-5

35

16

-9 -5

46

13

APAC

Tier 1 capital ratio3

-3

7

Americas

Global CMIB

Revenues / RWA

Revenues2 US$ billion

ROERWA1

-4

58

-6

282

-5

10.5

Cost income ratio4 17.4

58

12.4

13.2

100 76

53

11.8

52

12

49

12.4

min max

64

Return on Tier 1 equity (ROERMA), assuming tax rate of 30% Includes both core and non-core divisions (i.e. bad banks) for Bank of America/Merrill Lynch, Barclays, BNP Paribas, Citicorp, Deutsche Bank, Goldman Saches, JP Morgan, Morgan Stanley, UBS 3 Group level ratio 4 Includes operating expenses, litigation and restructuring expenses, one-offs, as well as costs in bad banks 1

2

Source: McKinsey CMIB Revenue Pools; McKinsey analysis; Coalition data

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A paper by economist Ros Altmann

Negative rates are also a having

ranges of assets, some highly illiquid

published on 13 September 2016 found

serious consequences for the

such as infrastructure projects, others

that in the UK low rates were not

portfolio managers at pension and

more risky such as emerging markets

reflected in the retail market, with the

insurance companies who are less

investments. In 2008 economists woke

average standard variable rate mortgage

able to cover their risk exposures

up to the importance of the finance

higher in 2016 than in 2011 while savers’

with debt instruments. Consequently,

sector to the economy; ignoring it now

interest rates have fallen sharply.

investment is moving into wider

could be disastrous. Emerging markets and China

Many borrowing interest rates have risen, not fallen Date

Credit Card %

Overdraft Rate %

Standard Variable Rate Mortgage %

2-year fixed Mortgage 75 % LTV %

Aug 2011

16.73

19.38

4.11

2.69

Aug 2012

17.26

19.53

4.27

3.54

China, as by far the largest emerging market, has a sizeable knock-on impact on the rest of the emerging world. The channels through which that risk moves are important in assessing the economic impact. Slower growth in China effects China itself which is home to approximately 20% of the world’s population and is

Aug 2013

17.87

19.54

4.36

2.8

Aug 2014

17.39

19.67

4.52

2.74

Aug 2015

17.91

19.67

4.48

1.72

Aug 2016

17.96

19.68

4.33

1.52

Interest rate change over past 5 years

+1.23

+0.3%

+0.22%

-1.17%

the world’s second largest economy. It then impacts on countries which trade heavily with it such as those in East Asia and then countries which may be affected indirectly via commodity prices. “Large parts of Africa and Latin America might be affected by restructuring China if the prices of the commodity that they export

Source: Bank of England

are affected,” says Jackson. “Other emerging market countries face somewhat different risks, for example

Savers’ interest rates have fallen sharply Date

Cash ISA

1 yr fixed ISA

2 yr fixed Deposit rates

Aug 2011

2.37

2.54

3.08

Aug 2012

2.52

2.53

3.08

Aug 2013

1.26

1.74

1.93

Aug 2014

1.09

1.5

1.52

in parts of Eastern Europe what happens in the Euro Zone is absolutely key, for Mexico it’s the US.” Circling back to politics, there are clearly big risks for emerging markets that are potentially more volatile than developed markets. In Turkey and Russia political risk has been a key issue for investors, and more recently it has been for the Philippines too. With armed conflict making

Aug 2015

1.01

1.51

1.55

the Middle East highly unstable, the risks are enormous for commodity

Aug 2016

0.6

0.94

1.02

Interest rate change over past 5 years

-1.77%

-1.6%

-2.06%

consumers as well as suppliers.

Source: Bank of England

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Credit Risk

WHAT IS THE TRUE COST OF SOVEREIGN DEFAULT? BY DAVID CARRUTHERS, HEAD OF RESEARCH AT CREDIT BENCHMARK

In the world of credit risk,

observable and frequently update.

sovereign governments are the

But they are distorted by a significant,

most controversial and political

time varying risk premium, although

of all the borrower types. Unlike

this can be quantified if the analyst

a corporate, a defaulting sovereign

can estimate the underlying, ‘real

can devalue their debt or simply

world’ probability of default (“PD”).

refuse to repay. In response, they

There is no shortage of credit risk

may be temporarily locked out of

models, so the challenge is to select

global debt markets; but this phase

one set of comparable PD estimates.

rarely lasts.

The Credit Benchmark approach is to publish crowd-sourced average

The true cost of sovereign default is

estimates across multiple models,

often seen as being more insidious:

calibrated by teams of experts in

years of subsequent under-investment

IRB banks.

and difficult borrowing terms. It can

Join David Carruthers at RiskMinds International on 7th December at 15:30 to hear him speak about Estimating Liquidity Risk Premiums from CrowdSourced Credit Data. CLICK HERE to find out more.

estimates and S&P long term ratings, on the same named obligors.This risk

be difficult to avoid the vicious circle

Figure 1 shows the relationship

premium varies over time, so market-

where one default makes another

between these crowd-sourced

implied ratings need to be adjusted for

more likely. Agency credit ratings are the natural starting point for assessing sovereign risk. But agencies often disagree and the “issuer pays” business model means that they can face some very difficult political and commercial decisions. For the same reason, unsolicited ratings are often met with analyst scepticism. There are at least 50 Sovereign states who are unrated by the main rating agencies. Market implied measures (bond yields and credit default swap spreads) are popular because they are readily

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FIGURE 1


the current level of this risk premium.

This dataset covers a very large

Another advantage of this data set

Credit Benchmark crowd sourced

universe of unrated obligors. Where

is the extension of credit views to

estimates are based on contributions

at least 3 banks have contributed

additional obligors. If two countries share

from at least 3 banks, and are available

estimates, a Credit Benchmark

similar macro-economic and political

for about 90 of the 193 sovereigns

Consensus (“CBC”) credit category

characteristics, and only one is quorate,

recognised by the United Nations. A

can be published as a benchmark

then that quorate estimate can be used

further 53 estimates are contributed

for ratings. The non-quorate names

as a proxy (with a suitable confidence

by 1 or 2 banks.

can be grouped into very granular

interval) for the non-quorate country.

portfolio baskets, providing a rich set There are a number of advantages to

of benchmarks for bank loan books.

this dataset: • Monthly updates

With trends updated monthly, this

• Trends and turning points

data set can also provide early warning

• Confidence ranges for estimates

of potential credit risk changes.

• Model validation for single names

This can, on occasion, include early

• Calibration for PD models

warning of rating agency upgrades

• Aggregates and Indices

and downgrades as well.

About David Carruthers

David is responsible for researching and developing the

FIGURE 2

Credit Benchmark dataset. He previously held roles at Markit Securities Finance, including most recently as Managing Director, and as Head of Quant Research at Data Explorers. Prior to this he held senior roles at risk consultants Barrie & Hibbert (now part of Moody’s) where he was responsible for fixed income and equity portfolio risk analysis, and in portfolio management with Pimco and Murray Johnstone. David holds a PhD in Econometrics from Glasgow University and is a member of the CFA Institute.

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OPERATIONAL RISK

QUO VADIS OPERATIONAL RISK?

Emerging operational risk management techniques BY LISA RIORDAN, HEAD OF OPERATIONAL RISK IN DEUTSCHE PFANDBRIEFBANK AG, AND DR. KLAUS BÖCKER, HEAD RISK MODELS & ANALYTICS AT DEUTSCHE PFANDBRIEFBANK

A brief history of measuring

banks typically concentrated on the so-

the current debate regarding

OpRisk and AMA

called loss distribution approach (LDA).

the benefits of operational risk

Within the realm of financial risk

The underlying idea of the LDA was

measurement is long overdue. The

management, operational risk

not new, as the insurance industry had

idea to implement a single-number

measurement as a discipline on its own

been using a similar approach which

metric for operational risk, a Value-

is relatively new. The first consultative

had been originally developed by Filip

at-Risk (VaR) at a high confidence

papers, regarding the revised capital

Lundberg in 1903 to quantify the risk of

level which would be comparable and

Basel II published by the Basel

insurance claims.

acceptable as market risk standards,

Committee 15 years ago, recommended

was doubtful from the offset.

that operational risk should be

Since then, LDA type models have been

considered a new risk category in

further developed and specialised to

The main purpose of the AMA

addition to market and credit risk

overcome fundamental challenges such

approach was to technically align the

within the Pillar I framework.

as heavy-tailed loss sizes, in the hope to

operational risk charge with the other

better measure operational risks.

existing Pillar I risk capital charges.

This change triggered the rise

This approach was necessary to

of quantitative operational risk

However, despite the amount of time

fulfill the requirement that all Pillar 1

measurement, as banks were now

and effort invested by both practitioners

risks should be measured under the

allowed, and were additionally

and academics into LDA modelling,

same units in order to make the risks

motivated by the prospect of capital

internal-model based operational risk

comparable. As a result, banks were

relief, to develop their own operational

could not conclusively convince the

required to capitalise against rare but

risk measurement model. Risk

regulators that the model developed

extreme operational risk events e.g.

Management departments started to

could accurately reflect the risk

once in 1000 years.

hire operational risk quants for their

exposure to operational risk.

operational risk departments, software vendors offered tailored solutions,

As a result, in March 2016 the Basel

special operational-risk focused

committee announced that all existing

consultancies emerged and last but

regulatory approaches to operational

not least, external data consortiums

risk would be replaced by a new

gathered loss data in the hope to

standard measurement approach (SMA)

overcome one of the largest hurdle for

which for regulatory purposes makes

operational risk measurement, namely

the internal operational risk models

lack of data.

superfluous.

Although the Basel Committee did not

AMA modelling – Failure by design

provide specific details regarding the

In the author’s view, the digression

advanced measurement approach,

from AMA comes as no surprise, and

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Dr. Klaus Böcker will be speaking at RiskMinds International on 8th December at 12pm about Operational Risk – Intuitive Vs. Rational/Analytical Approaches. CLICK HERE to find out more.


However, this approach overlooked

About the authors

some crucial characteristics of

Over emphasising the usefulness

operational risk data e.g. it is

of historic data may lead us into a

particularly heavy-tailed and that

false sense of security as historic

Lisa Riordan is Head of Operational

the pattern changes with time. This,

data only provides us with events

Risk in Deutsche Pfandbriefbank

combined with the limited availability

which have already been observed.

AG where she is responsible for the

of internal data, complicated with

Operational risk is concerned with

development and implementation

the already difficult task of model

both known and possible unknown

of Operational Risk processes and

calibration, makes the estimation of

risks. Loss distribution models cannot

governance. She is an experienced

reliable results difficult. As a result, the

be expected to reflect the future risk

conference speaker and her recent

opinion of many regulators is now that

when only using historic data, as the

effort has been on the bank-wide

model results are not reliable enough

collection lags behind the reality of

implementation of frameworks

to be used successfully to compare

the speed of ongoing changes in the

supporting SREP requirements.

capital requirements across the

environment of the banking industry.

Prior to Deutsche Pfandbriefbank she worked in Credit Suisse for 8

industry and therefore there should be no surprise at the request to remove

Both authors have experience in risk

years where her main focus was on

AMA for operational risk.

quantification and management

business process reengineering.

of operational risk, and under no Where to go from here?

account intend to discredit the

But what does this mean for

quantification of operational risk and

the future of operational risk?

promote the management simply by intuition alone. However, we would

It is generally accepted that the

hope that the debate would result in

advanced measurement approach

the opportunity for banks to further

was not just about a method for

develop management of operational

Dr. Klaus Böcker is responsible

quantification, but also resulted

risk, while focusing on the essence of

for market risk and operational

in an improvement in the overall

the risk disciple.

risk methods, counterparty credit risk and XVA calculations at

management of operational risk such as the development and

Eventually, we would hope that any

Deutsche Pfandbriefbank AG.

implementation of structured

new approach would encourage the

He is conducting research in

qualitative frameworks. This

unification of both the management

various fields of finance where

encouraged an enhancement in

and measurement of operational risk

he has authored and co-authored

the maturity of operational risk

where they become complimentary

several articles that have been

within the banking industry, which

rather than opponents, even if the

published in recognized finance

was necessary and valuable in the

benefit may only be seen in the

and mathematical journals. In

development of the risk disciple.

internal management of operational

2007, 2008 and 2010 he won the

However, these benefits do not

risk rather than the regulatory figure.

prestigious PRMIA Institute’s

create a strong enough argument

Award for New Frontiers in Risk

to have AMA in its current state.

Management. Klaus is editor of the two-volume book “Rethinking

Currently AMA seems to promote

Risk Measurement” (2010) and on

the belief that mathematical and

the editorial board of the Journal

loss–data driven simulation

of Risk Management in Financial

techniques are superior in

Institutions.

comparison to the “softer” management approaches which include expert opinion. In fact, many banks have strived to improve their AMA estimates at the expense of developing the scenario-based approaches.

15


MODELLING

Since the late 1800s, technology has served as an essential driver

TOP 5 INNOVATIONS IN MODELLING

of innovation, internationalization, and modernization in the financial sector. The very early days of intercontinental trading were spurred on by the advent of the transatlantic cable system. In fact, the term “cable” came to mean the GBP/USD currency pair rate – a foreign exchange term of art that endures today. After moderate development through the early 20th century, technology started to take off in the post war era; by the

BY BARBARA MACK

1980s, SWIFT communications, DOT systems, and electronic exchanges were at the heart of the market side. And there was explosive growth in credit cards, ATM machines, and mutual funds on the retail side. As the Internet took form and online trading, banking, and financial communications technologies spread across the entire sector, from enormous asset managers to the smallest hedge funds, there have been waves of creation and disruption in FinTech. One steady mantra has been disintermediation; disaggregation is another. But for all the activity aimed at being faster, cheaper, better, there has not been a consistent move towards with centralization or decentralization. Exchanges have consolidated and broken up, as have numerous large firms, some rendered by the not-so-invisible hands of regulators. In the wake of this turbulence (and exacerbated by the financial crisis), there has been a sustained push towards the next era of financial technology – with much of it centred on start-ups. So what exactly are these brash young firms doing? What kinds of innovation are underway and how will this all play out over time?

16


Here are some of the main areas

a crowd-sourcing model to pull capital

of activity in reshaping business

together for start-ups and new ideas.

models and pushing the boundaries of finance today.

Credit Ratings and Fraud Prevention

Payment Systems No matter what is

Drawing on advances in machine learning and

going on in the broader

big data, new products in analytics

economic environment,

and forecasting can help consumers

there is always demand

track their own spending habits and

for technology that can streamline

banking and lending institutions make

payment processes. Early examples

better decisions on creditworthiness,

include PayPal and, more recently

behavioural patterns, and more.

Square, but there are many other names emerging in the FinTech space

Virtual Currencies

these days. Some will be flashes in the

Much has been written

pan and others may truly change the

about bitcoin mining,

way that transactions are processed

from the promise of

and validated around the world.

digital currencies to the perils of a decentralized, somewhat shadowy

Wealth Management

world (e.g. the Silk Road saga).

Retail customers

However, the Blockchain technology

have greater access to

underlying the bitcoin phenomenon

information and portfolio

has the potential to reach far beyond

monitoring tools than ever before.

the digital mines and deep into the

The keen interest in lowering fees

daily transaction, contracting, and

and increasing self-sufficiency have

clearing processes of the world’s

opened up the market for automated

largest financial entities.

wealth management platforms. Sometimes called robo-advisors, the

“In my end is my beginning,” wrote

product offerings come in many stripes

T. S. Eliot in the Four Quartets. The

and sizes. Although they may not

eloquent banker-turned-poet might

displace human advisers in the near

well appreciate that on the heels

term, they can augment the effort to

of a global financial crises, many

understand what is happening in one’s

phoenixes are rising.

portfolio and in the market as a whole. Funding Platforms One of the more recent areas of innovation entails the rise of

Join the RiskMinds International modelling summit on Wednesday 7th December.

online platforms that help small businesses, entrepreneurs, non-profit

CLICK HERE

organizations, and even special private projects to gain access to capital. Some funding platforms focus on debt

BARBARA MACK

to uncover the line-up

and rely on credit markets or crowdfunding to raise money. Others focus purely on equity offerings, again using

17


OIL PRICE

FOUR LONG-TERM IMPACTS OF DLT AND BLOCKCHAIN BY BY MASSIMO MORINI, HEAD OF INTEREST RATE AND CREDIT MODELS AT BANCA IMI

CLICK HERE to join Massimo at RiskMinds International on 5th December at 9am to join him on a workshop about DLT & Crypto Currencies.

Custody Looking at Bitcoin, we can say for sure that there is one area where DLT has

It is difficult to predict where

a strong impact: custody, in the sense

technology will have most impact

of the “bank account” business and

on the financial industry. No one

similar businesses. There is no need

predicted that when mobile phones

for custody of digital assets when they

were introduced among the most

are registered in an immutable ledger,

impacted industries, photography was

public or in any case shared by all

affected the most. At the same time,

players interested in a given currency

not many people would have imagined

or asset. The account or custody

that even in the case of massive

business changes dramatically with

spread of mobile phones, we would

DLT. It does not necessarily wipe out

still have landlines because they give

intermediaries or custodians: if we look

us broadband internet access. This

at Bitcoin, we see that intermediaries

is particularly true when, like the

of all kind are flourishing, and many

case of DLT (the Distributed Ledger

players offer “wallet” services. This

Technology arising from Blockchain),

is the case even if, as we will explain

one is considering not a single

in the RiskMinds workshop that I am

technology but a mix of technologies

chairing on 5th December from 9am,

applicable to different use cases, some

there is no real “wallet” in Bitcoin, but

of which already stand out.

only a registry of the transactions that allows to see the “unspent transaction amounts” controllable by different private keys. Yet this business is much thinner with DLT: there is no longer the implicit lending to a bank which is typical of bank accounts, neither the

“The beauty of technological innovation is that the possibilities are endless.” 18

typical safety and management issues associated with custody of financial assets. Financial institutions are not necessary unhappy of this: it goes in the direction of narrow banking, a philosophy of banking characterized by smaller balance-sheets that was proposed over 10 years ago. Counterparty risk The Ethereum Blockchain and its smart contracts are, for all accounts, “robot counterparties” (a much fairer


name than “smart contracts”). They own money and they make transactions, following what is written in their management computer code. Since they are the real counterparty when we are using smart contracts on Ethereum, they are already changing our definition of counterparty risk, which is another area where we expect impact. In a transaction like buying a bond, the traditional counterparty risk is when you transfer the bond but then the other party does not pay the price, or the other way around. A smart contract can prevent it, by making the transaction atomic: a service or a transfer will be executed simultaneously to the corresponding payments, since the smart contract will hold one leg of the transaction until the other one has been paid by the counterparty. The same effect applies to transfer of collateral for derivatives; the smart contract can make cash flows and corresponding collateral exchange be simultaneous, preventing big misalignments between collateral and exposures. Smart contracts can also provide various actions in case a counterparty does not fulfil its obligations, and additionally DLT can shorten the clearing and settlement times, further reducing counterparty risk. While this does not mean we eliminate counterparty risk, the whole concept changes alongside the creation of different risks. Since the counterparty is a piece of code, it can be exploited by clever hackers, as seen in TheDao case! From the

Disruptive Innovation & The Future Of Risk Management. 8th December at RiskMinds International

Ethereum fork to CORDA smart

Regulations, market supervision,

contracts, that appear very differently

and compliance

to Ethereum’s insights in the recent

The above is already visible in some real

R3 white paper, start-ups are already

use cases. At the opposite end of the

working on solutions to the new risks

spectrum, in the sense that we will most

while strengthening the advantages

certainly wait years before seeing this

of the old risks. This is another topic

in practice, is the impact that DLT can

we will analyse in detail during the

have on regulations, market supervision,

RiskMinds workshop.

and compliance. In the last few years, regulators have committed to give the

Reconciliation and settlement

largest possible visibility to financial

Reconciliation and settlement disputes

transactions, such as derivatives. For

are likely to be impacted too, leading

example, when making a transaction,

to important changes to a system still

parties need to ‘send’ the details of

based too much on “consensus-by-

the transaction to a repository that

reconciliation”, a principle which is

will check correspondence with the

very old and brings risk, delays and

transaction sent by the counterparties.

capital consumption.

On a Blockchain, these steps are automatic when the transaction is

Contracts

written in the shared ledger: a unique

The impact on reconciliation and

representation, coinciding by definition,

settlement disputes is likely to be

will be visible to all nodes with the

impacted: contracts, also in their legal

necessary authorisation. It is possible

sense. Smart contracts are not only

that when regulators consider this,

interesting for automation, but also for

they will become strong promoters of

increased precision: we already have

distributed ledger technology, and will

templates for financial agreements,

ask Blockchain to be public or at least to

and financial contracts are already

be given the privilege to see everything

translated by parties into software

happening on private Blockchain. All

running on IT systems. Making this

compliance jobs may experience a

part of the contract is an avoidable step,

radical change in such a context.

that will make regulatory compliance easier. The contract stops being two

Having said this, and looking at past

pieces of papers to be implemented

history, I suspect that at least one of the

and represented in separate ways

above areas will be impacted differently

but become a unique manager of the

from expected, and that at least one

transaction signed (cryptographically)

area that will be strongly impacted is

by the interested parties. The smart

missing from the above list. The beauty

contract can be much more detailed

of technological innovation is that the

than current contracts, incorporating

possibilities are endless. We will explore

the algorithmic details of complex

all of these possibilities in the RiskMinds

contractual features and also legal

workshop, alongside case studies and

requirements and ISDA standards.

ways in which you can adapt your

Again, this is not going to be the end

business to the prospective changes.

of law supervision on contracts, or the end of “plain English” in contracts; the legal framework embedding smart contracts, and the way to address possible problems, must become much clearer than they are now, and this will

MASSIMO MORINI

keep lawyers busy for a long time.

19


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