increasing regulatory focus ensuring thoughtful innovation

Regulators and policymakers globally are increasingly cognizant of the technology-driven risks to market resilience and have been implementing measures to enhance the industry’s focus on model risk management and to encourage industry collaboration. In the U.S. for example, the White House executive order on responsible development of digital assets issued in March 2022 focused on consumer and investor protection and ensuring financial stability. This was followed by multiple related reports issued by the U.S. Department of the Treasury, including the digital asset, financial stability, risk and regulation report published by the Financial Stability Oversight Council (FSOC) which focused on crypto asset risk and outlined regulatory gaps and market risks that could pose threats to stability. Given significant risk events in the crypto markets of late, it is likely that legislative activity will accelerate this year.

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As we look ahead, the risks that come with any new technology implementation should not deter innovation strategies of global financial services firms. Instead, firms should be encouraged to adhere to three guiding principles as they embark on their innovation journeys, in order to ensure that their services continue to provide optimal value and maximum benefit to clients.

First and foremost, any development of digital solutions, including those covering digital assets, must begin with a strong client and industry-centric approach. Client benefits must be clear and tangible, backed by customer engagement, industry support and proven hypotheses. New or enhanced solutions should allow the industry to optimize the full value chain, or key components of it, to achieve cost and operational efficiency.

Second, any new technology initiative should provide equal or greater resilience than existing infrastructures and solutions.

And finally, given that the financial markets ecosystem will continue to change at a rapid pace, all participants and market providers must be prepared to adjust early and often, and focus on creating the most flexible long-term solution, not the only short-term solution.

conclusion PHOTO?

Without doubt, emerging technologies offer many benefits, leading to greater access to products and services along with lower costs of participation and other efficiencies for both consumers and institutions. However, today, many of these benefits have yet to be fully realized despite great promise, and we have already seen some significant, unexpected risks arise as a result of new technology implementation. Evidence to date indicates that the balance between prudent innovation and systemic risk considerations has not yet been achieved. Policymakers and regulators should act swiftly to promote the implementation of appropriate guardrails and best practices globally, and to ensure that any new technology initiative provides equal or greater resilience than existing infrastructures. The industry, market participants and regulators should continue to work together to avoid a scenario whereby in the pursuit of rapid innovation, and the desire for speed and convenience, we undermine the progress in systemic risk mitigation achieved since the last financial crisis.

Michael Leibrock

Michael Leibrock is a Managing Director in the Depository Trust & Clearing Corporation’s (DTCC) Financial and Operational Risk Management division, with primary oversight for the Counterparty Credit Risk and Systemic Risk functions. He is responsible for the analysis, approval and ongoing credit surveillance for all members of DTCC’s clearing agencies. Michael is also responsible for the identification and monitoring of potential systemic threats to DTCC and the securities industry, actively engaging with DTCC clients and regulators on systemic risk topics and producing periodic thought leadership content. In addition, Michael serves as co-chair of the Systemic Risk Council and is a member of the Management Risk Committee and Model Risk Governance Committee.

Prior to joining DTCC in 2011, Michael’s career in risk management spanned over 20 years during which he held senior risk management roles at several firms, including Chief Counterparty Risk Officer at Fannie Mae and North American Head of Financial Institutions Credit for Commerzbank A.G.

Michael holds a Doctorate in Finance and International Economics from Pace University’s Lubin School of Business and a M.B.A. in Finance from Fordham University. He is a Lecturer in Columbia University’s M.S. program in Enterprise Risk Management and co-author of a 2017 book titled “Understanding Systemic Risk in Global Financial Markets” (Wiley Finance).

Synopsis

The COVID-19 Pandemic has ushered in a heightened focus on climate change risk and resultant exposures across the corporate world. Disparate political views and evolving regulatory requirements result in uncertainty, requiring boards to establish internal standards necessary to safeguard their companies, enhance corporate culture, and serve as an innate moral compass in order to march toward a stable and sustainable future.

shepherd or the sheep: introducing climate risk frameworks

by John Thackeray

Climate risk is the defining issue of our generation, but it is the velocity of climate change which will have the greatest and most profound impact upon our lives. Climate risk is a long-term science-based, non-diversifiable risk, impacting and affecting all industries. To the corporate world, climate risk is a balance sheet risk, a profit and loss risk-- and more importantly a reputational risk. In fact, such is the influence, from this exogenous source, that reputational risk has been elevated in short order. The impact of this fast-impending influence is that banks in particular have had to up their game, in terms of their narrative, marketing, and branding.

The risk requires firms to think about assigning a set of comprehensive roles, social responsibilities, and values that can be measured and be accountable to mitigate the challenges posed. Through climate change, one sees the interconnectedness of emerging risks (with the current pandemic a manifestation of both the velocity and acceleration of climate risk) ushering in a change transformation of thought, word, and deed.

how Covid-19 has informed stress testing models for climate change

COVID-19 is a dress rehearsal for climate change, a harbinger and abstract of what is in store down the road. The current pandemic is an agent of change, causing disruption and requiring firms to adapt their business models to accommodate these evolving circumstances. Such a change can be seen in the realm of stress testing and scenario design, which are the common tools used to identify, measure, quantify, and review both known and unknown enterprise risks. The data provided by COVID-19 has resulted in more realistic testing parameters to also assess the emergence of climate change.

Stress testing and scenario design have been around for a while, but what has changed in this pandemic is the need to repurpose and enhance existing models, whilst at the same time overlaying and incorporating new thinking and parameters. Common issues such as data quality, information technology, and risk management have had to be structurally addressed to ensure that the output from these test results are both meaningful and transparent to their many users. The pandemic has asked questions regarding the gathering, collection, and frequency of data utilized, requiring enhanced data sets which can be introduced and populated for climate change modelling. In particular, the data has been distorted, normal channels have been compromised, and there are more outliers than before with trends harder to discern.

COVID-19 has ignited and obfuscated the current climate change debate, with politicians from all walks of life trying to distract and manipulate the debate for short-term considerations. This political uncertainty is amplified by the fact that firms operating in multiple jurisdictions will have to cater to the differing lenses and perspectives of a constantly changing central government policy. Corporate leadership needs to be strong since it will have to navigate conflicting political and regulatory minefields. Strong governance can only be sustained by a united board willing to take a more active role to drive resiliency in the face of competing conflicts that otherwise would steer the company off course. If the way out of the current pandemic comes in the form of green shoots, it may be that the corporate world needs to take the initiative, strive to do what is right, and lead all to greener pastures.

Firms have now been forced to plan to include climate risk within their portfolio of risks, a corporate framework that includes five key pillars: governance, risk management, strategy, pricing, and metrics. The lynchpin of this framework is governance, evidenced by company boards (rather than senior management) driving and dictating change in order to set a whole new sense of social and commercial responsibility the likes of which have never been seen before. Indeed, some boards have insisted in terms of risk management that environmental due diligence be incorporated into their firms’ credit process by requiring an independent evaluation of counterparties’ environmental history and track record. Boards are having to be educated in short order, with many turning to colleagues from the insurance industry who have a wealth of experience in forecasting and dealing with the long-term implications of climate in order to expedite their thinking around strategy, pricing, and all-important metrics. It is becoming self-evident to boards that their firms’ very existence is wrapped up in the way they approach climate risk and the efforts needed to improve their continuing viability, sustainability, and resilience. For the few executive leaders who walk this path, this climate change DNA is invoking a strong culture of compliance and governance focused on quality returns and maximized customer experience.

Many firms have been forced to disclose their efforts by means of a written narrative in their financial reporting. For example, the European Commission’s Corporate Sustainability Reporting Directive (CSRD) amends and significantly expands the existing requirements for sustainability reporting. The quality of firms’ disclosures will be under the microscope, with stakeholders looking to see that the words have been translated into concrete actions. Boards and senior management will be watched with eagle eyes on how they behave, with any discrepancies possibly becoming the subject of litigation and social media scrutiny.

The messaging will be all important and could be part of the sustainable company brand. The requirements to comply with regulatory measures are exacting-- financial institutions now need to monitor their customers’ green efforts and behavior by means of covenants and warranties. These covenants and warranties are far-reaching and extend to both funding and investment decisions, in terms of research and development and capital expenditure. Lending firms are becoming more closely identified with their customers and their borrowing policies, a reflection of their climate corporate governance. This gives the opportunity for lending firms to position themselves as “green” role models and brand their lending accordingly. The more astute firms will take this onboard with performance tables being designed and produced to indicate the applicability of climate risk standards, enabling corporations to benchmark against one another.

Conclusion

Climate risk now can be seen as representing a commercial risk and, as such, institutions must both acknowledge its existence and treat subsequent exposure. Institutions that can see climate risk as an opportunity rather than a threat can strengthen and align corporate values, enhancing reputation and business resiliency. Those institutions that adopt a higher purpose with a climate moral compass are likely to experience a more coherent and collective culture. This culture change can be seen as a competitive advantage, but it must be remembered that there are costs associated with the introduction of this climate change vision. Embedding this change transformation requires a sustainable reengineering in terms of business practice and models, demanding investment in different skillsets and training.

Mankind is watching and the question for the corporate world is, do you want to be the shepherd or the sheep? The choice is yours.

peer-reviewed by

Elisabeth Wilson

John Thackeray

John Thackeray is a risk & compliance practitioner and an acknowledged writer. As a former senior risk executive at Citigroup, Deutsche AG and Société Générale, he has had a first-hand engagement with US and European regulators. John holds an MBA from the Chartered Institute of Bankers and was a Lecturer in Banking, Economics and Law.

He is a frequent contributor, thought leader and speaker on risk industry insights and has published risk articles and white papers for the Professional Risk Managers’ International Association, the Global Association of Risk Professionals, the Risk Management Association, the Association of Certified Fraud Examiners, the Association of Certified Anti-Money Laundering Specialists, and the Chief Financial Officers University.

P2P lending is not about to disintermediate established banks, mainly due to the higher risk profile of typical P2P borrowers and returns sought by investors on these platforms. Platforms also differ in several other important functions usually carried out by banks, nevertheless they serve an important niche market avoided by banks.

peer-to-peer lending: financial inclusion or debt trap?

by Barbara Dömötör

The process of disintermediation is one of the most important innovations of the last decade, affecting the traditional core banking activity of financial intermediation. Alternative financing solutions are emerging, targeting individuals or business customers and offering cost efficiencies by removing the intermediary layer. In the case of peer-to-peer (P2P) lending, an online platform directly connects customers seeking credit with investors, promising lower costs for borrowers and higher returns for investors compared to bank lending.

After a rapid increase in the volume invested from 2005 onwards, the market share of P2P investments declined by 2022. A number of fintech companies have applied for and been granted banking licences, suggesting that alternative finance could be a market entry point. Future market developments depend on a number of factors, with high inflation encouraging market participants to seek high-yield investment opportunities, while declining risk appetite may keep investors away from the segment. The rationale for the business model of P2P platforms is far from obvious. The development of the technology alone does not seem to justify making the intermediary role of the banks obsolete. The empirical research in the field shows that platform clients are mainly high risk, bank-ineligible borrowers (De Roure et al., 2016) and the activity on platforms is higher in those areas that are underserved by banks (Jagtiani and Lemieux, 2018). A popular argument in favor of P2P lending emphasizes the contribution of the platforms to financial inclusion by offering financing to the subprime segment. On the other hand, the higher ex-ante probability of default, even when compensated for the lender by extremely high interest rates, results in very high ex-post default frequency. Therefore, financial inclusion by promoting the indebtedness of lower income individuals can create a debt trap for them.

In the following I compare platform lending with traditional bank financing based on four main functions used by Freixas and Rochet (2008). Thereafter I introduce the portfolio characteristics of the Estonian platform, Bondora, and conclude that platform lending is an alternative to loan sharks rather than bank lending.

function 1: asset transformation

An important element of traditional financial intermediation is the transformation of assets by size, maturity and quality. The majority of deposits collected by banks are short-term, while borrowers typically seek long-term funding. The size and risk profile also differ: investors require high quality, low risk deposits, while borrowers represent larger and significantly riskier loans.

Peer-to-peer platforms do not provide traditional asset transformation as they directly connect investors and borrowers. The maturity of investments is the same for lenders and borrowers, typically 3-5 years. However, by diversifying the investment portfolio, financing only a part of several loans, it is possible to resize and even change the risk characteristics.

Banks’ risk management is comprehensive and strictly regulated. Banks measure their credit, market, liquidity and operational risk and must meet strict capital adequacy, risk calculation and reporting requirements, monitored by banking supervision. In addition to banking regulation, deposit insurance strengthens investor protection.

Online platforms, although assisting in risk assessment by providing proprietary rating systems and automatic rejection below a certain rating, pass the credit and liquidity risk entirely to investors. Some platforms operate a secondary market where investors can sell the financed loan or even offer a buy-back guarantee, but these models are less common. Online intermediaries also face very significant operational risk; they are highly exposed to cyber-attacks.

Online intermediaries are not subject to the Basel framework, as they do not collect or create money. The regulation of fintech providers is an ongoing issue, but until now it only consists of transparency requirements and some restrictions to protect investors.

function 2: risk sharing and risk management function 3: liquidity and payment services

Banks provide a range of payment services that facilitate financial transactions and contribute to the financial liquidity of the economy.

Online platforms do not provide any additional payment services, only the settlement of the cash flow related to the credit transaction. There is no possibility of early redemption, but if the platform operates a secondary market investors can try to sell their portfolio at a cost depending on the liquidity of the secondary market.