Journal of Applied IT and Investment Management Vol.1, No.2

# journal SimCorp

Journal of applied iT and inveSTmenT managemenT

of Applied iT and investment management

July 2009

Volume 1 路 No. 2 路July 2009

PAUL VERDIN

Time To reTurn To growTh? REbUILDINg coNfIDENcE AND ENAbLINg gRowth gLobAL AssEt mANAgEmENt Costs, productivity, and operational risk cost mANAgEmENt IN A moRE REgULAtED AssEt mANAgEmENt INDUstRy

mitigate risk

reduce cost

1

enable growth

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July 2009

Journal of applied iT and inveSTmenT managemenT

coNtENts

CEO COmmEnt:

taking a holistic view of costs as the cycle turns

by Ceo Peter L. ravn The first issue of the Journal of Applied iT and investment management was concerned with a number of aspects of risk management in the investment management industry. That was three months ago and the market seems to have stabilised since then. but even though we may have reached a turning point in the capital markets it doesn’t mean that risk management, risk mitigation and cost issues are no longer on the agenda.

Taking a holistic view of a firm’s cost structure and its risk mitigation are both key strategic concerns. rather than just looking at ways to shave 10% or 15% off a specific activity or operation, it is imperative to understand and address the larger cost drivers of the business. in the end, it will be a much more effective way of containing cost. given the diversity of product types and the complexity of the delivery processes within an investment management firm, it is not easy to establish production and delivery costs. it takes diligent investigation to do this. yet once cost transparency is achieved, firms will be enabled to develop scalable structures that control costs while growing their businesses and help them win out against competitors. many businesses were surprised when the downturn came and by how difficult it was to cut costs. firms may go on to be surprised that they are not well placed to take full advantage when markets improve if they have not got a clear, holistic view of their cost structures. They may then be disappointed that they cannot see the scale effects that they expect.

The term ‘back to basics’ has been widely used over recent months to describe what our industry needs to do. we should not lose our grip on those basics as and when the cycle moves into a more positive growth phase, which it may now be ready to do.

Peter L. ravn (Ph.D.) is Ceo at SimCorp.

SimCorp

# rebuilding ConfidenCe and enabling growTh

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# global aSSeT managemenT: CoSTS, produCTiviTy, and operaTional riSk

5

# m&a eConomiCS in finanCial ServiCeS: The key iSSueS

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# iT and CorporaTe governanCe in The finanCial SeCTor

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# Time To reTurn To growTh?

21

# preparing for uCiTS iv

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# CoST managemenT in a more regulaTed aSSeT managemenT induSTry

29

# reduCTion of SeTTlemenT CoSTS: a poST-CriSiS riSk managemenT perSpeCTive

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# regulaTory updaTe

35

# book review

36

# reCenT reSearCh and whiTe paperS

38

Read the journal online at http://www.simcorp.com/journal ediTor-in-Chief Lars Bjørn Falkenberg, Vice President, SimCorp A/S larsbjorn.falkenberg@simcorp.com ediTorial aSSiSTanT mette Trier riisgaard, SimCorp A/S mettetrier.riisgaard@simcorp.com publiSher SimCorp A/S, weidekampsgade 16, 2300 Copenhagen S, Denmark, Phone: +45 35 44 88 00.

Journal of Applied iT and investment management is a quarterly publication, which is published and distributed globally by SimCorp A/S. Print run: 7,700.

SubmiSSion guidelineS Articles, book reviews, new reports and information on recent research can be submitted for review to editorial Assistant mette Trier riisgaard, mettetrier.riisgaard@simcorp.com. For submission guidelines, please visit http:// www.simcorp.com/journal. diSClaimer The contents of this journal are for general information and illustrative purposes only and will be used at your own risk. The articles in the publication do not necessarily reflect the view of SimCorp. SimCorp will use all reasonable endeavours to ensure the accuracy of the information. however, SimCorp does not guarantee or warrant the accuracy or completeness, factual correctness or reliability of any information in this journal and does not accept any liability for any errors or omission including any inaccuracies or typographical errors. iSSn 1903-6914. Copyright rests with publisher. All rights reserved ©SimCorP A/S 2009.

SubSCripTion Subscription to the journal is free of charge for members of the industry, associated institutions and academics.

To subscribe, please visit http://www.simcorp.com/journal. Address changes can be mailed to journal@simcorp.com.

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Journal of applied iT and inveSTmenT managemenT

July 2009

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# Rebuilding confidence and enabling growth growing funds under management in the post-crisis environment poses a range of new challenges. managers are responding to those challenges in different ways but it is clear that transparency and robust processes are likely to be key components in rebuilding confidence across the market. by richard willsher

“T

he world has changed for fund selectors and professional investors,” says phil barker, investment director and head of european business development at Standard life investments, the fund management arm of the london-listed Standard life group. “Their criteria now drive business perhaps to the larger groups. perhaps to the groups that are able to employ strong, robust processes rather than boutique fund management groups who rely on the strengths of one individual with particular skills. The buying criteria have moved on.”

The firm is looking to build its business outside of the uk, promoting funds to the institutional market across europe. barker says Standard life sees opportunities to grow due to the ‘demise’ of other competitors and because clients are now seeking more transparent products.

TranSparenCy and ClariTy “The two key words are transparency and clarity of funds as compared with pre-crisis when investors were willing to buy more complex products. now, for example, in the credit area whether it’s investment grade, high yield or government credit, investors are looking

“The two key words are transparency and clarity (…)” investment Director Phil Barker, Standard Life investments

“(…) robust and repeatable processes are key to attracting new business now, in a way that was not the case a year or eighteen months ago (…)” investment Director Phil Barker, Standard Life investments to see what is happening within the fund.

They want to be confident that their due diligence can be thorough enough to see what is in those products.”

“The same rigour also applies to understanding the investment process and within that, knowing that the systems that are used to select and monitor assets from a very large universe are robust. altogether, robust and repeatable processes are key to attracting new business now, in a way that was not the case a year or eighteen months ago,” says barker.

will be used to evaluate credit asset managers. among these it lists: • portfolio transparency and valuation; • fundamental credit analysis skills, experience and resources to ensure increased selectivity and anticipation; • fundamental investment risk management, as a complement to quantitative risk management based on modelling.

although Standard life’s offerings cover a broad waterfront of asset classes across equities, fixed income and property, a recent fitch ratings report that focuses on credit product managers echoed many of the same client concerns.

in respect of the last of these, fitch’ analysts explain, “risk management processes are being revisited in a context of heightened tail risk and are likely to be less reliant on modelling, and build in greater use of ‘what if ’ scenario analysis and stress testing outside the models.”

The emphasis on trenchant analysis is clear and implicit in this is the requirement for sound information to work with.

The rating firm’s february publication ‘Changing Trends in Credit asset management’ sets out key metrics that

whaT managerS wanT This is a theme that is taken up by helen webster who is head of products at

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SimCorp

# Rebuilding confidence and enabling growth “Sooner or later investors have to come out to play but they will only choose partners whose products and processes they can analyse, assess and understand.” aegon asset management, where she looks after product development, management and support. “what managers want is to be able to have data which they can rely on. Some companies for example, not ourselves, have moved on to prime brokerage platforms for some of their more sophisticated funds because they weren’t getting the information they needed.” in terms of fund offerings, aegon’s background has been in the wholesale end of the market. They have typically sold to fund of funds, discretionary managers, and private banks and therefore, webster says, the company has had a long-held policy of the fund being clearly defined. Their customers expect their funds to be what they say they are, rather than fudged in their focus. This ‘clean building blocks’ approach to their funds now, she believes, sets the company in good stead for addressing the needs of the current marketplace.

distrust of derivatives, concern about counterparty risk and ‘knowing where you stand’. on the other hand risk management has become a major preoccupation and derivatives provide useful tools for controlling risks within funds which investors are keen to see applied to their assets under management.

TranSparenCy and alTernaTiveS This paradox looks set to remain the case, at least for a while. yet if transparency is a key client concern when dealing with mainstream managers and mainstream asset classes it is an even greater concern when dealing with alternative investment providers.

“in terms of transparency and openness, i don’t think we have the same issues to address as some of our competitors in the market where there is a definite theme of ‘back to basics’.” at the same time she points out a paradoxical trend in the market regarding derivatives.

a march 2009 article published by adrian keller and dimitri Senik of pricewaterhouseCoopers Switzerland noted, “investors consider strong risk management, compliance and transparency to be as important as a good performance track record. while most alternative providers report on the investment performance and risk results, only a minority volunteer to inform on further key metrics, such as operational risks and the internal control system around the investment process and back office.”

on the one hand, post-lehmans, the drive to transparency has led to widespread

This seems to further corroborate the views of both Standard life’s phil barker

and aegon’s helen webster that transparency, clarity and robust processes are now the predominant games in town.

This, however, is hardly surprising considering the substantial sums that have been wiped off of the value of investors’ funds in the last 12 months.

The overall thrust that emerges from the views of fund managers, their advisors and consultants is that the investment management industry is in a phase of reconstructing confidence among its clients. Confidence to invest and to seek optimal returns. at the same time the pressure to invest is ever present while real returns on cash are now in many cases in negative territory. Sooner or later investors have to come out to play but they will only choose partners whose products and processes they can analyse, assess and understand. This will be the key to building funds under management post crisis. richard willsher is a London-based financial journalist and former investment banker.

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July 2009

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# Global asset management:

costs, productivity, and operational risk in recent years the costs and productivity of operations in global asset management have come more and more under scrutiny. over the last couple of years this sector has become significantly more cost conscious and many efforts are underway to drive down costs. however, increasing productivity and reducing costs affect the firms in many other ways as well; in particular, there is an increase in operational risk. it has become clear that running an asset management firm optimally requires a balance between costs and operational risk. in this article we discuss in detail the trade-offs between costs, productivity and operational risk in global asset management. by Adjunct Professor marcelo Cruz and Professor michael Pinedo,

Stern School of Business, new York university

T

he global asset management industry can be divided into two broad categories, namely, (i) institutional asset management and (ii) retail asset management. The two categories have fairly different cost characteristics, productivity metrics and risk metrics. The institutional asset management groups include the traditional investment advisory firms (for instance, ubS asset management), hedge funds and private equity funds (which may be either buyout or venture capital). This type of asset management company deals directly with large institutions and does not have to deal with the complexities of the retail business. The retail category includes all the mutual fund companies (for example fidelity and vanguard) and the pension funds (such as Tiaa-Cref). The retail category must maintain individual accounts for individual people. The retail category requires a significantly higher level of technology (such as websites and call centres) than the institutional category. This is in order to do individual account registration, maintenance, accounting and a host of other activities.

asset management in general has undergone some major changes over the last two decades. These changes took place in two phases. in the first phase, which took place from the early 90s on until 2008, assets under management have skyrocketed because of the high liquidity in the global financial markets, which was caused by abundant credit and ever-increasing personal asset prices (for instance, house prices). This phase also witnessed the formation of hedge funds, in other words, asset managers who typically have a smaller number of clients and who can take very risky positions and bets that may yield substantial returns.

These funds continue to play an important role in the financial market by exploring arbitrage opportunities. aSSeT managemenT phaSe 2 The industry is now experiencing a second phase of major changes. after the credit crunch crisis the sector has been suffering tremendously as world markets tumbled across the globe and liquidity, once abundant, became either very restricted or non-existent. even when the markets recover it is not to be expected that the

same level of liquidity and wealth will be in place. many money managers in the uS for the first time ever ‘broke the buck’, in other words, their funds’ quoted stock prices fell below one uS dollar. hedge funds that were created all over the world have been closing in droves. a sector that a few months ago thrived in a vast sea of liquidity faces today a very different reality. before the crisis most asset managers were not too worried about the costs or the risks involved since the ever-increasing personal wealth made their assets under management grow at a steady pace. errors and high costs were buried under increased revenues and profit which came from a larger asset base and high returns in the world markets.

Today the story is very different. The largest asset managers have in many cases seen their assets under management fall by 30% or 40%, not only because of the drop in asset prices that impacted their funds but also because clients withdrew funds either out of necessity or out of fear of the financial

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# Global asset management:

costs, productivity, and operational risk

conditions of their asset managers. The crisis also brought regulatory failures to light, such as the bernard madoff case which was one of the largest operational risk events in history. many investors

This new situation has forced asset managers to develop much more careful discipline around costs, productivity and risk management, concepts usually associated with manufacturing but that are starting to play a role within asset management. each of these factors has received a lot of attention in academic journals and the trade press. however, the interdependencies and trade-offs between costs, productivity and operational risk have not been analysed in depth yet. for example, it is very likely that a reduction in costs, made without proper planning, can increase the level of operational risk exposure. in this article, we study these factors and their interdependencies in more detail.

“This new situation has forced asset managers to develop much more careful discipline around costs, productivity and risk management, concepts usually associated with manufacturing but that are starting to play a role within asset management.” close to retirement lost their pensions not only because of market conditions but also because of a lack of caution and risk management from pension fund managers.

asset managers are susceptible to all forms of risks, namely market, credit and operational risks. These risks would manifest themselves in two ways: impact on client funds (in other words, indirect to the asset manager) or direct impact to the asset manager. The client funds are subject mainly to market and credit risk. market risks are due to the daily fluctuation of asset prices and credit risks are due to the possibility that some counterparties, with whom the funds do business, can go bankrupt and make financial assets worthless. Such losses would have an indirect impact on the asset manager’s revenue as losses in funds entail a smaller commission; however, most of the losses are to the fund holder. asset managers themselves are particularly vulnerable to operational risk. errors in processing transactions or a system failure can cause severe damages and impact the balance sheet of the asset manager. regular failures with regard to compliance with local regulations or very basic business ethics

Table 1. Sample of recent large operational risk losses by asset managers

FinanCial impaCt (uS$ million)

YEaR

Risk FailuRE

EvEnt

assEt manaGER

2008

failure with comply with copyright laws

reached a settlement for alleged regulatory and supervisory violations that led to employees’ improper acceptance of gifts

12

fidelity

2007

legal and compliance failure to kyC (‘know your client’)

Czech government agency reclaimed funds that were either arguably embezzled or mishandled

24

ubS

2007

insufficient hedging due to system model error

flagship global alpha fund suffering very large losses

3,000

goldman Sachs

2007

failure to comply with business ethics

alleged inside trading at ubS o’Connor

10

ubS o’Connor

2004

legal and compliance failures

improper trading – market timing and improper mutual fund trading

288

Janus Capital

2004

legal and compliance failures

Settlement for allegations that investors who traded rapidly were favoured at the expense of long time shareholders

450

invesco

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Journal of applied iT and inveSTmenT managemenT

may generate large operational losses and subsequent reputational impacts. a sample of recent losses is listed in table 1.

The most important cost factors and the related risks in the two categories of global asset management are: (i) the costs and risks with regard to human resources (that is, the employees – portfolio managers, administrators and so on); (ii) the costs and risks with regard to system development and transaction processing; (iii) the costs and risks with regard to customer contact centres and distribution channels (such as physical assets). in what follows we elaborate on each one of the cost and risk factors mentioned above. it is clear that the first factor is important for both categories of asset management firms. The second and third factors are more important for retail firms than for institutional firms. human reSourCeS: CoSTS and riSkS as a service sector firm, any type of asset manager needs to hire top-talent in order to provide the best return and service to the clients. human resource talent is needed for: (i) general management (for instance, portfolio managers); (ii) front office (sales force and others); (iii) administrative and support personnel (for example, internal auditors and iT support); (iv) research (like equity, bond and currency analysts as well as risk analysts). as is the case with many other financial firms, asset managers have to make sure that they are able to attract and retain, above all, portfolio managers with established track records and a potential to bring in clients and provide adequate returns to their funds. Such people are the face of the firm to the outside world and a basis for attracting new clients.

Compensation of such personnel is probably one of the highest costs of an asset manager. losing top talent is very costly and increases the susceptibility to operational risk as well. There is a learning curve for new people and during this period, the probabilities of errors are

higher. particularly in the uS but also in other countries, funds are often named after their portfolio managers. Typically these portfolio managers have developed such a track record and reputation that clients want to invest with them. These funds linked to a name can hold many billions of dollars in investments and the asset manager starts to become very dependent on this particular person. The risk of losing such a portfolio manager may represent a loss of revenue of many millions per year in administration and performance fees. asset managers are, therefore, exposed in a major way to key personnel risk. in the front office, sales people need to follow procedures and local regulations when selling pension and other types of funds. Several pension mis-selling cases have occurred in various different countries. probably the most infamous case of pension mis-selling was the situation that arose in britain between 1988 and 1994, after british regulators decided to allow individuals to buy pensions from private-sector providers.

The regulators determined at that time that pension investors should have a choice in the entity that would provide their pension and that it should not necessarily be their employer. They should be allowed to invest, in effect, in a retail pension fund. many who decided, or who were persuaded, to buy in a retail fund should not have done so. high-pressure tactics by commission-based salespeople led to tens of thousands of people buying products that proved to be entirely unsuitable. high fees combined with poor investment returns helped shrink the retirement savings of these investors and many found themselves locked in and unable to switch to more appropriate products without incurring very high exit fees. The result was a nightmare for investors, pension providers and the government. after a long legal process the funds were told to reimburse the investor for mis-selling these pensions. until 2008 an estimated ÂŁ11.5 billion (near uS$20 billion) had been paid in compensation for mis-selling across many asset managers that operated in this market. This experience serves to illustrate what can go wrong when, even with the best intentions, a choice is given to people who are unprepared for it. it also shows how greedy sales people can exploit unsuspecting consumers, and how something that starts out as a good idea can turn into a major

financial liability to asset managers if not properly conducted.

The back office is also subject to operational risk. for example, risk managers, auditors and accountants play an important role in any institution since they have to guard the firm against for instance rogue traders, accounting frauds and ponzi schemes (like the aforementioned madoff case). it is important that the proper due diligence is done with regard to any counterparty the firm is dealing with and it is also important that in the organisational structure of the institution the reporting lines of the traders and risk managers do not overlap.

The research arm is a very important part of any asset manager. research analysts typically are highly compensated and are supposed to produce reports with sound recommendations. however, even the research division is subject to a significant amount of operational risk. The analysts often depend in their judgments on complicated models that few people understand. it has often been the case that the assumptions underlying such models do not make sense or that the evaluation of the models has been erroneous, resulting in substantial losses.

SySTemS developmenT and TranSaCTion proCeSSing: CoSTS and riSkS Scale plays an important role in asset management. The larger the portfolio, the lower the cost per transaction. however, the optimal size of a managed fund is often a balance of various tradeoffs. for example, a larger scale is preferred because of economies of scale; on the other hand, a smaller scale is preferred because a fund is then more nimble and will have an easier time meeting its benchmarks and outperforming the competition. another aspect that has an impact on the optimal size of a fund is the error rates (operational risk), which typically is a function of the transaction frequency. it is to be expected that the probability of error increases with an increasing frequency in the rate of transactions. a larger fund, in order to meet its benchmarks, will have to take

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# Global asset management:

costs, productivity, and operational risk

bigger bets. So, for each type of fund there is an optimal size and an optimal focus. historically, several funds have reached sizes that apparently had been larger than optimal and therefore had to close entry for new customers (for instance, fidelity’s magellan).

revenue and the quantity negotiated. it is represented analytically by

financial institutions in general, and asset managers in particular, traditionally have never been as careful with costs as other industries have been. in several industries, such as car manufacturing, the error rate is extremely low and very well controlled by sophisticated quality control departments, usually the most sophisticated area within an organisation after research or product development.

The third representation of revenue, the marginal, corresponds to the variation of the total revenue in relation to the quantity sold. it is represented by:

on the other hand, in the financial services industry, the most sophisticated departments are located either in the front office or on the revenue side. financial derivatives are priced taking only market opportunity costs into consideration and rarely transaction costs; even if transaction costs are taken into account the analysis is not very deep. in the portfolio aggregation of these products, the final effects of processing are never considered. in this section, we try to briefly depict how a more sophisticated cost analysis can be developed for financial products based on a traditional microeconomics analysis. economic theory postulates that for a firm to maximise its results it is necessary that it produces such a quantity that allows equilibrium between the variation of the total cost and the variation of the total revenue. in economic terms, there are three types of revenues: total, average and marginal. The total or gross revenue is simply the result of multiplying the price p of a certain product by the quantity q negotiated. it can be represented by RGROSS = p.q The average revenue is defined as the result of the division between the total

RaveRaGe = or

p.q

RaveRaGe =

RMg =

RGROSS q q

= p

RGROSS q

assuming that the variation of the quantity and the gross revenue can be infinitesimal (nice in theory but hard to imagine in business practice), the marginal revenue can be determined by the first derivative of the gross revenue in relation to the quantity sold: RMg =

dRGROSS dq

or, for the sale of q units, we have the following relation: q

RGROSS = ∫ RMg dq o

in asset management the increased number of transactions (the ‘production’) will bring about an unexpected variable cost that is an increase in operational errors, in other words human and system factors would not perform the same when subject to a higher volume of transactions.

The relationship between the number of operational errors and the transaction volume can be estimated through multifactor models. The entire analysis of revenues, production and costs based on (micro-) economic theory is complex and there is a vast literature on the subject. we will not delve into more details in this section but strongly suggest the understanding of these relationships when developing any growth strategy. it is worth noting that perhaps the most important conclusion from these relationships is that the profit will be maximised when: CMg = RMg

The relation above says that the profit will be maximised when the marginal cost and the marginal revenue are exactly the same.

This relation will hold for all cases and should be the objective of the strategy of the firm. in what follows we present a simple example, which may help illustrate the theory above. Suppose a particular fund trades a single product with a very tight margin that is stable at 0.006% per unit trade (one unit = $100,000 notional) as seen in table 2. we can, therefore, simulate the revenue, which we do from 200,000 to 700,000 transactions processed per day. in general, the fund trader would only see the trades from the revenue side and is happy to see the revenue grow to $4,200,000 when 700,000 units are traded. This is a very general view, but revenue-generators will be very happy and would not care about the costs incurred to reach that. let us now analyse the costs. we divide the costs into two components; the processing costs and the error costs. The processing cost is expected to be stable at $5 per transaction. The error cost is $1.81 with a standard deviation of 3.89. developing a 95% confidence interval for the error cost, we find that it would be $9.43. Therefore, on average it would cost $5 to process a transaction correctly and $12.43 to do a reprocessing because of errors. we can also find a loss ratio. for this exercise we assume a simple linear model to relate the loss ratio to the number of transactions processed. The model is given by: Loss Ratio = 0.0094957 + 1.155737 x Transactions R2 = 89.12% by using the model above, we can verify that if the loss ratio is estimated to be 3.26% when the number of transactions is 200,000, the error rate climbs to 9.04% when the number of transaction grows to 700,000.

Journal of applied iT and inveSTmenT managemenT

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following traditional optimisation analysis, the maximum profit condition, CMg = RMg, will be reached, given the current costs at 427,000 units traded. if the volume is higher, we have declining profits and need to adjust our processing capacity likewise. This type of modelling also offers us conditions to verify our capacity and see how an improvement in the process (for instance, system improvement, training process and hiring employees) will benefit the organisation and increase productivity. in our example, the profit will be maximised at $190,052 when CMg = RMg =$6. Therefore, the average number of transactions was 239,815, given our current environment and capacity conditions; we would maximise our potential by trading 427,000 units per day. if the asset manager has a strategy trading more than that, it will have to take into consideration the costs as well. we also performed a simulation with these data, assuming that we were able to cut the processing costs by 20%, which means, from $5 per transaction to $4 per transaction due to economies of scale. The

modification is substantial. The maximum profit condition in this case is reached at 900,000 units per day, more than doubling our optimal capacity, as can be seen in table 3 on page 10. in another simulation, the loss ratio was cut proportionally to around 3% due to operational risk reduction by, for example, training of the employees and improving systems, and the error cost was reduced proportionally throughout the table. The maximum profit condition was reached at around 600,000 units per day.

Therefore, the simple fact that we reduced the operational risk in a business unit made our optimal capacity increase by 40%. we had a dramatic productivity gain by managing the operational risk more effectively. See table 4 on page 11 for more information.

There are several other factors that affect the costs and the risks of transaction processing. Transaction processing can be outsourced (however, usually not off-shore, but preferably to a firm relatively close by so that any form of operational risk does not increase by too much). another important factor is manual versus automated transaction processing

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(for instance, SwifT). automated transaction processing clearly has a higher productivity than manual transaction processing. however, automated transactions can only be done with regard to the more standard, plain vanilla transactions, not with regard to the more complicated esoteric transactions. even though one would like to think that automated processing is more reliable and less susceptible to operational risk than manual processing, it is not clear that this is actually the case. for example, automated transactions are still subject to typographical errors; typographical errors often cause substantial costs to managed funds.

CoSTS, produCTiviTy and operaTional riSk in CuSTomer ConTaCT CenTreS There are various channels through which an asset management firm can interact with its customers, namely: (i) (ii) (iii) (iv) (v)

branch network (‘bricks and mortar’) websites call centres sales force and broker/dealers correspondence and mailings of statements.

Table 2. Cost structure for a fund

Quantity

profit

REvEnuE

maginal profit

Revenue

0,47

1.230.000

1.200.000

marginal revenue

average revenue

total cost

total mg. cost

total avg. cost

6,00

6,00

5,31

1.089.158

5,53

5,31

1.061.503

5,31

COsts

processing cost

1.000.000,00

Error cost

61.503,20

marginal error cost

1.025.000,00

64.157,88

0,531

200.000

138.497

205.000

140.842

0,308

210.000

143.133

0,46

1.260.000

6,00

6,00

1.116.867

5,54

5,32

1.050.000,00

66.867,06

0,542

220.000

147.551

0,44

1.320.000

6,00

6,00

1.172.449

5,56

5,33

1.100.000,00

72.448,89

0,558

230.000

151.751

0,42

1.380.000

6,00

6,00

1.228.249

5,58

5,34

1.150.000,00

78.248,69

0,580

240.000

155.734

0,40

1.440.000

6,00

6,00

1.284.266

5,60

5,35

1.200.000,00

84.266,46

0,602

250.000

159.498

0,38

1.500.000

6,00

6,00

1.340.502

5,62

5,36

1.250.000,00

90.502,21

0,624

260.000

163.044

0,35

1.560.000

6,00

6,00

1.396.956

5,65

5,37

1.300.000,00

96.955,92

0,645

270.000

166.372

0,33

1.620.000

6,00

6,00

1.453.628

5,67

5,38

1.350.000,00

103.627,61

0,667

280.000

169.483

0,31

1.680.000

6,00

6,00

1.510.517

5,69

5,39

1.400.000,00

110.517,27

0,689

290.000

172.375

0,29

1.740.000

6,00

6,00

1.567.625

5,71

5,41

1.450.000,00

117.624,90

0,711

300.000

175.049

0,27

1.800.000

6,00

6,00

1.624.951

5,73

5,42

1.500.000,00

124.950,50

0,733

310.000

177.506

0,25

1.860.000

6,00

6,00

1.682.494

5,75

5,43

1.550.000,00

132.494,08

0,754

320.000

179.744

0,22

1.920.000

6,00

6,00

1.740.256

5,78

5,44

1.600.000,00

140.255,62

0,776

330.000

181.765

0,20

1.980.000

6,00

6,00

1.798.235

5,80

5,45

1.650.000,00

148.235,14

0,798

350.000

185.152

0,17

2.100.000

6,00

6,00

1.914.848

5,83

5,47

1.750.000,00

164.848,09

0,831

400.000

189.805

0,09

2.400.000

6,00

6,00

2.210.195

5,91

5,53

2.000.000,00

210.194,95

0,907

427.000

190.052

0,01

2.562.000

6,00

6,00

2.371.948

5,99

5,55

2.135.000,00

236.948,08

0,991

450.000

189.009

(0,02)

2.700.000

6,00

6,00

2.510.991

6,02

5,58

2.250.000,00

260.991,11

1,016

500.000

182.763

(0,12)

3.000.000

6,00

6,00

2.817.237

6,12

5,63

2.500.000,00

317.236,54

1,125

600.000

153.925

(0,29)

3.600.000

6,00

6,00

3.446.075

6,29

5,74

3.000.000,00

446.075,27

1,288

700.000

103.289

(0,51)

4.200.000

6,00

6,00

4.096.711

6,51

5,85

3.500.000,00

596.711,15

1,506

10

Journal of applied iT and inveSTmenT managemenT

July 2009

SimCorp

# Global asset management:

costs, productivity, and operational risk

each channel has its own capabilities and cost structure and is subject to its own set of operational risk factors.

These different channels and contact centres, of course, have a strong interaction with one another. each type of channel has its own advantages and disadvantages in its interaction with the client, whether the client is a pension fund or an individual investor.

The branch network usually entails a significant real estate cost. a network of branches is useful if the asset manager is a

retail one. a branch may be useful in attracting new customers by facilitating the first face-to-face contact. later an investor may communicate with the asset manager through one of the other channels. if the asset manager is an institutional one, then an extensive network of branches is usually not required. an asset manager may be content with having a small number of offices only in big cities. The operational risk at any given branch may depend on the likelihood of the occurrences of for instance floods, earthquakes and blackouts.

both types of asset management firms have to make considerable investments in technology in order to provide their customers with internet access or access to operators. however, the website of a retail firm typically has to be more elaborate than that of an institutional firm. retail firms typically also have large call centres in order to enable their customers to have access to operators. websites as well as call centres have to be designed in such a way that they can handle peak traffic, since overload of a system may cause crashing of internet

Table 3. Cost structure for a fund – reducing processing costs to $4 per transaction

REvEnuE Revenue

profit

200.000

338.497

205.000

345.842

1.230.000

6,00

6,00

884.158

4,53

4,31

820.000,00

210.000

353.133

1.260.000

6,00

6,00

906.867

4,54

4,32

840.000,00

1.200.000

marginal revenue

average revenue

total cost 861.503

total mg. cost 4,31

total avg. cost

COsts

Quantity

4,31

processing cost 800.000,00

Error cost

marginal error cost

average error cost

64.157,88

0,531

0,313

66.867,06

0,542

0,318

61.503,20

0,308

0,308

220.000

367.551

1.320.000

6,00

6,00

952.449

4,56

4,33

880.000,00

72.448,89

0,558

0,329

230.000

381.751

1.380.000

6,00

6,00

998.249

4,58

4,34

920.000,00

78.248,69

0,580

0,340

240.000

395.734

1.440.000

6,00

6,00

1.044.266

4,60

4,35

960.000,00

84.266,46

0,602

0,351

250.000

409.498

1.500.000

6,00

6,00

1.090.502

4,62

4,36

1.000.000,00

90.502,21

0,624

0,362

260.000

423.044

1.560.000

6,00

6,00

1.136.956

4,65

4,37

1.040.000,00

96.955,92

0,645

0,373

270.000

436.372

1.620.000

6,00

6,00

1.183.628

4,67

4,38

1.080.000,00

103.627,61

0,667

0,384

280.000

449.483

1.680.000

6,00

6,00

1.230.517

4,69

4,39

1.120.000,00

110.517,27

0,689

0,395

290.000

462.375

1.740.000

6,00

6,00

1.277.625

4,71

4,41

1.160.000,00

117.624,90

0,711

0,406

300.000

475.049

1.800.000

6,00

6,00

1.324.951

4,73

4,42

1.200.000,00

124.950,50

0,733

0,417

310.000

487.506

1.860.000

6,00

6,00

1.372.494

4,75

4,43

1.240.000,00

132.494,08

0,754

0,427

320.000

499.744

1.920.000

6,00

6,00

1.420.256

4,78

4,44

1.280.000,00

140.255,62

0,776

0,438

330.000

511.765

1.980.000

6,00

6,00

1.468.235

4,80

4,45

1.320.000,00

148.235,14

0,798

0,449

350.000

535.152

2.100.000

6,00

6,00

1.564.848

4,83

4,47

1.400.000,00

164.848,09

0,831

0,471

400.000

589.805

2.400.000

6,00

6,00

1.810.195

4,91

4,53

1.600.000,00

210.194,95

0,907

0,525

427.000

617.052

2.562.000

6,00

6,00

1.944.948

4,99

4,55

1.708.000,00

236.948,08

0,991

0,555

450.000

639.009

2.700.000

6,00

6,00

2.060.991

5,02

4,58

1.800.000,00

260.991,11

1,016

0,580

500.000

682.763

3.000.000

6,00

6,00

2.317.237

5,12

4,63

2.000.000,00

317.236,54

1,125

0,634

600.000

753.925

3.600.000

6,00

6,00

2.846.075

5,29

4,74

2.400.000,00

446.075,27

1,288

0,743

700.000

803.289

4.200.000

6,00

6,00

3.396.711

5,51

4,85

2.800.000,00

596.711,15

1,506

0,852

800.000

830.856

4.800.000

6,00

6,00

3.969.144

5,72

4,96

3.200.000,00

769.144,16

1,724

0,961

850.000

836.465

5.100.000

6,00

6,00

4.263.535

5,89

5,02

3.400.000,00

863.534,59

1,888

1,016

900.000

836.626

5.400.000

6,00

6,00

4.563.374

6,00

5,07

3.600.000,00

963.374,31

1,997

1,070

950.000

831.337

5.700.000

6,00

6,00

4.868.663

6,11

5,12

3.800.000,00

1.068.663,31

2,106

1,125

1.000.000

820.598

6.000.000

6,00

6,00

5.179.402

6,21

5,18

4.000.000,00

1.179.401,60

2,215

1,179

Journal of applied iT and inveSTmenT managemenT

SimCorp

access or excessive waiting times at call centres. it is not easy to forecast peak traffic, since traffic intensity may not only depend on the time of day, but also on random exogenous events such high volatility in the equities markets. websites as well as call centres are, in general, subject to what is referred to as technology risk. a server going down may bring an entire system down and a website may then not be able to provide its customers with internet access. The system may also be subject to for instance hacking and phishing. The institution, in order to satisfy its clients, has to keep its website up-to-date continuously with regard to content as well as with regard to security.

The cost of a client doing a transaction via the web is clearly significantly less expensive for the company than the cost of a transaction via a call centre. on the

The most common transaction for call centres is actually an address change. on the web, the participant himself could do this but there must be an audit routine supporting it to make sure it is not a fraudulent address change.

here makes it easier to balance workloads between two or more sites, monitoring the follow up of call centre people on their commitments to service. The performance characteristics, reliability and quality of service of call centres typically depend on the workload.

The higher the workload, the more productive the operators are, but, on the other hand, the higher the operational risk, the lower the quality of service.

Call centres require a great deal of sophisticated metrics and monitoring in order to be managed well. among the metrics are such items as time waiting for call pickup and efficiency in assigning calls to multiple locations. a good system

There are good reasons for diversifying call centres into various locations and even countries. Time zone variation is useful for locations offering 24/7 service. obviously, for instance weather and earthquake risk support the use of diverse

other hand, a client who does his/her transactions via the web typically has a higher frequency of doing transactions than a client who does his/her transactions via a call centre. however, it is still in the interest of the company to direct as many transactions as possible to its website where the participant himself can enter the necessary information.

July 2009

11

Table 4. Cost structure for a business unit - reducing the cost of errors

Quantity

profit

200.000

195.077

REvEnuE Revenue

1.200.000

marginal revenue

average revenue

total cost 1.004.923

total mg. cost 5,02

total avg. cost 5,02

COsts

processing cost

Error cost

1.000.000,00

4.923,20

marginal error cost

average error cost

0,025

0,025

205.000

198.837

1.230.000

6,00

6,00

1.031.163

5,25

5,03

1.025.000,00

6.163,38

0,248

0,030

210.000

202.542

1.260.000

6,00

6,00

1.057.458

5,26

5,04

1.050.000,00

7.458,06

0,259

0,036

220.000

209.789

1.320.000

6,00

6,00

1.110.211

5,28

5,05

1.100.000,00

10.210,89

0,275

0,046

230.000

216.818

1.380.000

6,00

6,00

1.163.182

5,30

5,06

1.150.000,00

13.181,69

0,297

0,057

240.000

223.630

1.440.000

6,00

6,00

1.216.370

5,32

5,07

1.200.000,00

16.370,46

0,319

0,068

250.000

230.223

1.500.000

6,00

6,00

1.269.777

5,34

5,08

1.250.000,00

19.777,21

0,341

0,079

260.000

236.598

1.560.000

6,00

6,00

1.323.402

5,36

5,09

1.300.000,00

23.401,92

0,362

0,090

270.000

242.755

1.620.000

6,00

6,00

1.377.245

5,38

5,10

1.350.000,00

27.244,61

0,384

0,101

280.000

248.695

1.680.000

6,00

6,00

1.431.305

5,41

5,11

1.400.000,00

31.305,27

0,406

0,112

290.000

254.416

1.740.000

6,00

6,00

1.485.584

5,43

5,12

1.450.000,00

35.583,90

0,428

0,123

300.000

259.919

1.800.000

6,00

6,00

1.540.081

5,45

5,13

1.500.000,00

40.080,50

0,450

0,134

310.000

265.205

1.860.000

6,00

6,00

1.594.795

5,47

5,14

1.550.000,00

44.795,08

0,471

0,145

320.000

270.272

1.920.000

6,00

6,00

1.649.728

5,49

5,16

1.600.000,00

49.727,62

0,493

0,155

330.000

275.122

1.980.000

6,00

6,00

1.704.878

5,52

5,17

1.650.000,00

54.878,14

0,515

0,166

350.000

284.167

2.100.000

6,00

6,00

1.815.833

5,55

5,19

1.750.000,00

65.833,09

0,548

0,188

400.000

302.965

2.400.000

6,00

6,00

2.097.035

5,62

5,24

2.000.000,00

97.034,95

0,624

0,243

427.000

310.850

2.562.000

6,00

6,00

2.251.150

5,71

5,27

2.135.000,00

116.149,78

0,708

0,272

450.000

316.314

2.700.000

6,00

6,00

2.383.686

5,73

5,30

2.250.000,00

133.686,11

0,733

0,297

500.000

324.213

3.000.000

6,00

6,00

2.675.787

5,84

5,35

2.500.000,00

175.786,54

0,842

0,352

550.000

326.664

3.300.000

6,00

6,00

2.973.336

5,95

5,41

2.750.000,00

223.336,27

0,951

0,406

600.000

323.665

3.600.000

6,00

6,00

3.276.335

6,01

5,46

3.000.000,00

276.335,27

1,005

0,461

700.000

301.319

4.200.000

6,00

6,00

3.898.681

6,22

5,57

3.500.000,00

398.681,15

1,223

0,570

800.000

257.176

4.800.000

6,00

6,00

4.542.824

6,44

5,68

4.000.000,00

542.824,16

1,441

0,679

850.000

226.930

5.100.000

6,00

6,00

4.873.070

6,60

5,73

4.250.000,00

623.069,59

1,605

0,733

900.000

191.236

5.400.000

6,00

6,00

5.208.764

6,71

5,79

4.500.000,00

708.764,31

1,714

0,788

950.000

150.092

5.700.000

6,00

6,00

5.549.908

6,82

5,84

4.750.000,00

799.908,31

1,823

0,842

1.000.000

103.498

6.000.000

6,00

6,00

5.896.502

6,93

5,90

5.000.000,00

896.501,60

1,932

0,897

12

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# Global asset management:

costs, productivity, and operational risk

locations. a call centre can be off-shored and/or outsourced. many financial firms in the u.S. have off-shored their call centres to india. The cost differential with regard to the salaries of the operators still seems to be significant. after making the decision whether or not to off-shore its call centres, the institution still has to make the decision whether or not to outsource its call centres. The outsourcing may be done with regard to the setup of the call centre and/or with regard to its management. The setup of a call centre is typically outsourced to companies that specialise in such operations. if the call

The cost characteristics as well as the risk metrics are very much influenced by the training and the monitoring of the call centre employees. for instance, some call centres in the financial services world require very extensive training and licensing which can cause lots of operating problems if there is not a good compliance system in place. also, there should be some monitoring on how difficult questions are answered or shepherded on to another operator. one factor that is very important is the turnover rate of the operators; in other words, the number of operators leaving each year. This turnover rate has a high impact on costs, productivity and operational risk. new operators have to be trained and are less productive in their initial period; their error rate is, of course, also higher than that of more experienced operators. The training period is costly as well.

“The salary and incentive structure has to be designed in such a way as to ensure that the sales force does the proper due diligence when it interacts with the clients.” centre is a large operation, then the management of the call centre may be kept in-house. outsourcing and/or offshoring is done differently in the uSa than in europe, for various reasons. The number of languages the call centre of an american firm has to deal with tends to be smaller than the number of languages a european call centre has to deal with.

The set of languages that have to be dealt with in north america is usually different from that in europe. nowadays, the telecom technology is sufficiently advanced to allow call centre operators to work from home, with all the necessary access to company databases and have flexible hours. So a call centre manager, who suddenly sees a peak in incoming traffic, can mobilise a number of part time workers and bring them online within half an hour.

The relationship between the sales force or broker/ dealers and the asset manager has to be designed very carefully. The salary and incentive structure has to be designed in such a way as to ensure that the sales force does the proper due diligence when it interacts with the clients. Two aspects of such interactions require scrutiny: first, a representative of the asset manager has to present the products and its terms and conditions of business in a correct manner and has to verify the appropriateness of the asset manager’s products and conditions with regard to any given client. he or she also has to verify the creditworthiness of the client. The salary structure of the sales force should not be based only on one up-front commission for any new client but rather on a more long-term commission structure that rewards a long term relationship with a client.

Correspondence and statements, sent either by regular mail or by email, has a significant influence on the operations of the other contact centres. if all clients receive their statement on the same day, say, at the beginning of the month, then the call centres and websites will immediately be subject to a sudden peak in demand. any peak in demand will immediately increase the error rate. it is therefore preferable that mailings to clients are, as much as possible, spread out over time. This has to be done of course with client consent.

ConCluSion it is clear that asset managers have to invest continuously in their human resources as well as in technology. both areas represent major cost components and are subject to various forms of operational risk. as seen above, a reliable productivity/cost analysis cannot be done without a thorough analysis of the operational risk involved. Costs, productivity and operational risk are strongly intertwined. for a firm to optimise its investments and operations, all the possible factors and trade-offs have to be taken into account. Such an optimisation process may not be particularly easy. michael Pinedo is the chair of the Department of information, operations and management Sciences at the Stern School of Business at new York university. his research interests focus primarily on operations in financial services. marcelo Cruz is an Adjunct Professor at the Stern School of Business at new York university. he is the author of the well-known book ‘modelling, measuring and hedging of operational risk in Financial Services’ (published by wiley).

Journal of applied iT and inveSTmenT managemenT

SimCorp

July 2009

13

# m&a economics in financial services: the key issues

mergers and acquisitions (m&A) in the financial services sector accelerated in the 1980s and 1990s. This was a consequence of regulatory and technology changes, together with the search for scale and scope economies on the part of financial firms, in addition to the search for a larger geographical footprint in the case of many firms. The result has been substantial consolidation among financial services firms which can be defined as those operating in commercial banking, insurance, asset management and securities. The process continues in the financial crisis of 2007-09, in many cases encouraged or forced by governments in the course of financial bailouts, and we can expect another m&A boom after the current financial hurricane blows over.

by Professor ingo walter, director of SimCorp StrategyLab

T

Figure 1. worldwide financial service merger volume, 1986 – 2008

he m&a data are impressive. figure 1 shows the total volume of m&a transactions in the financial services industry over two decades, from 1986 to 2008. much of the volume is in the banking sector, followed by the insurance industry and investment banking. worldwide, 75.4% of the deal-flow was in-market (similar firms acquiring similar firms) and the balance was crossmarket (for instance, banks acquiring insurance companies). The in-market proportion was higher in the uS (83.9%) than in europe (67.3%) during this

period due to regulatory barriers that effectively prohibited uS cross-market deals until they were liberalised in 1999. figure 2 shows the m&a volumes specifically for the asset management industry, much of which involved the acquisition of asset managers by commercial and universal banks as well as investment banks and insurance companies. The league tables of the world’s largest and most rapidly growing asset managers depicted in figure 3 shows the wide variety of firms involved – banks, insurers, broker-dealers and independent asset managers. indeed,

% 100

Banking Insurance

80

Securities

60

Asset management

40

there are substantial differences in the structure of the asset management industry geographically – for example, figure 4 shows the importance of independent asset managers in the uS, which is absent in europe.

Several basic questions arise in connection with the use of m&a as a tool for strategic development. is bigger better? is broader better? who wins? who loses? how does the result affect the stability and efficiency of the financial architecture?1 what are m&a deals supposed to achieve? The key questions are how a transaction is likely to affect each of the following variables: revenue gainS The classic motivation for m&a transactions in the financial services sector is ‘market extension’. a firm wants to expand geographically into markets in which it has traditionally been absent or weak. or it

20 0

1986 - 1988

1989 - 1991

1992 - 1994

1995 - 1997

1998 - 1999 2000 - 2001

2002 - 2003

2004 - 2005

2006 -2007

2008

1 For a detailed discussion, see ingo walter (2004), mergers and Acquisitions in Banking and Finance, new York: oxford university Press.

14

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# m&a economics in financial services: the key issues

wants to broaden its product range because it sees attractive opportunities that may in addition be complementary to what it is already doing. or it wants to broaden client coverage for similar reasons. any of these strategic moves is open to ‘build’ or ‘buy’ alternatives as a matter of strategic execution, and buying may in many cases be considered faster, more effective and/ or cheaper than building. done successfully, such growth through acquisition should be reflected in both the top and bottom lines in terms of the firm’s market share and profitability and maximises what practitioners and analysts commonly call ‘synergies’.

Total Figure 2. merger and acquisitions activvity in the asset management industry (1985 – 2008, millions of uS$ and number of transactions)

Total asset managers

Total asset managers

global target

2,066,952

u.S. target

1,019,545

european target

672,664

other target

374,743

Total

are important when an institution can service a particular client or supply a particular service more efficiently in one geography as a result of having an active presence in another geography. Third, product-driven linkages exist when an institution can supply a particular financial service in a more competitive manner because it is already producing the same or a similar financial service in different client or arena dimensions.

economies of scope attributable to crossselling arise when the all-in cost to the buyer of multiple financial services from a single supplier – including the cost of the service, plus information, search, These come in three forms. first, clientmonitoring, contracting and other driven linkages may exist when a financial transaction costs – is less than the cost of institution serving a particular client or purchasing them from separate suppliers. client-group can, as a result, supply revenue-diseconomies of scope could financial services either to the same client arise, for example, through agency costs or to another client in the same group that may develop when the multi-product more efficiently in the same or different financial firm acts against the interests geographies. Second, geographic linkages of the client in the sale of one service in order to facilitate the sale open-end mutual fund managers of another, or as a result of internal informationtransfers 23,306 185,164 2,002 considered inimical to the 7,511 68,499 765 client’s interests.

8,413 60,575 478 7,382

56,090

european acquirer

759

u.S. acquirer

u.S. target

1,019,545

8,413

60,575

478

897,352

7,733

u.k. target

374,743

7,382

56,090

759

28,500

205

Cont. european target

171,147

4,939

377,109

4,222

60,481

473

open-end mutual fund managers

Total

european acquirer

u.S. acquirer

u.S. target

60,575

478

7,996

40

11,088

370

u.k. target

30,427

208

12,186

155

58

15

Cont. european target

38,072

557

17,196

465

1,200

43

in addition to the strategic search for revenue synergies through m&a transactions, financial services firms will also seek to dominate markets in order to extract economic returns. by focusing on a particular market, merging firms could increase their market power and thereby take advantage of monopolistic or oligopolistic returns. market power allows them to charge more or pay less for the same service. in many countries however, regulatory constraints tend ultimately to limit increases in market power. The key

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Journal of applied iT and inveSTmenT managemenT

strategic issue is the likely future competitive structure in the different dimensions of the financial services industry. it is an empirical fact that operating margins tend to be positively associated with higher concentration levels (as are cost-to-income ratios). even without the complexities and integration costs that arise in mergers and acquisitions, it is often difficult for major financial firms to accurately forecast the value to shareholders of initiatives to extend markets, build market power, and achieve cross-selling successfully. This is one reason why m&a transactions systematically benefit the seller far more than the buyer in the financial services sector.

CoST gainS expected bottom-line gains attributable to m&a transactions are related to lower costs due to economies of scale and scope, or improved operating efficiency, usually reflected in improved cost-to-income ratios.

15

“even without the complexities and integration costs that arise in mergers and acquisitions, it is often difficult for major financial firms to accurately forecast the value to shareholders of initiatives to extend markets, build market power, and achieve cross-selling successfully”.

Figure 3. Leading asset managers

RAtE of gRowth

sIZE

asset managers, december 2006

total assets

manager

us$ trillion

asset managers, fastest-growing firms % increase of assets under management, 2001 – 2006 0

2.45

barclays global investors (great britain)

1.81

State Street global (united States)

1.75

aXa (france)

1.74

Capital group

allianz (germany)

1.71

fidelity investments (united States)

1.64

generali group

Capital group (united States)

1.40

deutsche group ag (germany)

1.27

vanguard group (united States)

1.17

blackrock group (united States)

1.12

Crédit Suisse (Switzerland)

1.09

if economies of scale prevail, increased size will help create financial efficiency and shareholder value. if diseconomies prevail, both will be destroyed.

Jpmorgan Chase (united States)

1.01

mellon financial* (united States)

1.00

legg mason (united States)

0.96

bnp paribas (france)

0.82

northern Trust

first, scale economies should be directly observable in cost functions of financial services suppliers and in aggregate performance measures. many studies of economies of scale have been undertaken in the banking, insurance and securities industries over the years, and the consensus seems to be that scale

ing (netherlands)

0.79

natixis (france)

0.77

hSbC

aig global investment (united States)

0.73

Crédit agricole (france)

0.70

aviva (great britain)

0.70

Source: pensions & investments/ watson wyatt

100

200

300

400

blackrock group

ubS ag

whether economies of scale exist in financial services has been at the heart of strategic and regulatory discussions about optimum firm size in the financial services industry. Can increased average size of firms create a more efficient financial sector? does increased size, however measured, by itself serve to increase shareholder value?

July 2009

bank of america natixis

barclays global investors aig global investors aviva goldman Sachs group old mutual State Street global aXa prudential

franklin Templeton fortis massmutual finalcial vanguard group wellington management

*now bank of ny mellon

Source: watson wyatt

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# m&a economics in financial services: the key issues

economies and diseconomies generally do not result in more than about 5% difference in unit costs. inability to find major economies of scale among large financial services firms is also true of insurance companies and brokerdealers. for most banks and non-bank financial firms, except the very smallest, scale economies seem likely to have relatively little bearing on competitive performance. This is particularly true since smaller institutions are often linkedtogether in cooperatives or other structures that allow harvesting available economies of scale centrally. alternatively they may be specialists that are not particularly sensitive to the kinds of cost differences usually associated with economies of scale in the financial services industry. megamergers are unlikely, whatever their other merits may be, to contribute very much in terms of scale economies. most serious discussions of scale economies in financial services focus entirely on firmwide scale-effects, although the really important scale issues are encountered at the level of individual financial services.

There is ample evidence, for example, that economies of scale are both significant and important for operating economies and competitive performance in areas such as global custody, processing of mass-market credit card transactions and institutional asset management, but are far less important in other areas; in private banking and m&a advisory services, for example. unfortunately, empirical data on cost functions that would permit identification of economies of scale at the product level are generally proprietary and therefore unavailable. Still, it seems reasonable that a scale-driven strategy may make a great deal of sense in specific areas of

financial activity even in the absence of evidence that there is very much to be gained at the firm-wide level. and the fact that there are some lines of activity that clearly benefit from scale economies while at the same time observations of firm-wide economies of scale are empirically elusive suggests that there must be numerous lines of activity where diseconomies of scale exist.

Second, cost economies of scope mean that the joint production of two or more products or services is accomplished more cheaply than producing them separately. ‘global’ scope economies become evident on the cost side when the total cost of producing all products is less than producing them individually, while ‘activity-specific’ economies consider the joint production of particular services. on the supply-side, banks can create cost savings through the sharing of transactions systems and other overheads, information and monitoring cost, and the like. Costdiseconomies of scope may arise from such factors as inertia and lack of responsiveness and creativity that may come with increased firm size and bureaucratisation, ‘turf ’ and profitattribution conflicts. These can increase costs or erode product quality in meeting client needs, or there can be serious cultural differences across the organisation that inhibit seamless delivery of a broad range of financial services. % 100

Third and most important are operating efficiencies that are not related to either scale or scope. That is, financial firms of roughly the same size and providing roughly the same range of services can have very different cost levels per unit of output. There is ample evidence of such performance differences, for example, in comparative cost-to-income ratios among banks, insurance companies and investment firms of comparable size, both within and between national financialservices markets. The reasons involve differences in production functions, efficiency and effectiveness in the use of labour and capital, sourcing and application of available technology, and acquisition of inputs, organisational design, compensation and incentive systems; in other words, in just plain better management. empirically, a number of studies have found very large disparities in cost structures among financial firms of similar size, suggesting that the way they are run is more important than their size or the selection of the business that they engage in. The consensus of studies conducted in the united States seems to be that average unit costs in the banking industry, for example, lie some 20% above ‘best practice’ firms producing the same range and volume of services, with most of the difference attributable to operating economies.

Figure 4. owners of asset managers, 2008 (%)

Stand-alone

80

Specialist-finance owned

60

Insurer-owned

40 20

Bank-or-private bank-owned

0

Bankassuranceowned

Europe

United States

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Journal of applied iT and inveSTmenT managemenT

diverSifiCaTion, bailouTS and ConfliCTS of inTereST one of the arguments for financial-sector m&a deals is that greater diversification of income from multiple products, clientgroups and geographies creates more stable, safer, and ultimately more valuable institutions. Symptoms should include higher credit quality and lower cost of financing than faced by narrower, more focused firms. Certainly, the failure of any major financial institution that is the product of mergers could cause unacceptable systemic consequences.

Therefore the institution is virtually certain to be bailed-out by taxpayers – as has happened in the case of comparatively much smaller institutions in the united States, Switzerland, norway, Sweden, finland, and Japan during the 1980s and 1990s and again in the global financial crisis of 2007 - 09. Consequently, too-bigto-fail (TbTf) guarantees create a potentially important public subsidy for the kinds of large financial organisations that often result from mergers.

The potential for conflicts of interest is endemic to multifunctional financial services firms. The conflict of interest issue can seriously limit effective strategic benefits associated with financial services m&a transactions. for example, inside information accessible to a bank as lender to a target firm would almost certainly prevent it from acting as an adviser to a potential acquirer. entrepreneurs may not want their private banking affairs dominated by a bank that also controls their business financing. a mutual fund investor is unlikely to have easy access to

“Taken together, the evidence suggests limited prospects for firm-wide cost economies of scale and scope among major financial services firms.”

the full menu of available equity funds though a universal bank offering competing in-house products. These issues may be manageable if most of the competition is coming from other universal banks. but if the playing field is also populated by aggressive insurance companies, broker-dealers, asset managers and other specialists, these issues will prove to be a continuing strategic challenge to the management of a bank.

July 2009

17

conglomerate represent an ownership interest in a broad range of businesses as do shares in a closed-end mutual fund.

Summing-up Taken together, the evidence suggests limited prospects for firm-wide cost economies of scale and scope among major financial services firms. operating efficiency seems to be the principal

“(…) while larger size may make a firm too big to fail or ‘systemic’, recent experience during the financial crisis shows this as hardly an unmixed blessing.”

finally, it can be argued that the shares of multi-product firms and business conglomerates tend to trade at prices lower than shares of more narrowly-focused firms, all other factors being equal. There are two basic reasons why this ‘conglomerate discount’ is alleged to exist. The first is the argument that, on the whole, conglomerates tend to use capital inefficiently due to management discretion to engage in value-reducing projects, cross-subsidisation of marginal or loss-making projects that drain resources from healthy businesses, together with misalignments in incentives between central and divisional managers. a second possible source of a conglomerate discount is that investors in shares of conglomerates find it difficult to ‘take a view’ and add pure sectoral exposures to their portfolios. investors may avoid such stocks in their efforts to construct efficient asset-allocation profiles. This is especially true of highly performancedriven managers of institutional equity portfolios who are under pressure to outperform cohorts or equity indices. So the portfolio logic of a conglomerate discount may indeed apply in the case of a multifunctional financial firm that is active in retail banking, wholesale commercial banking, middle-market banking, private banking, corporate finance, trading, investment banking, asset management and perhaps other businesses. Shares in a financial

determinant of observed differences in cost levels among most types of financial institutions. demand-side economies of scope through cross-selling may well exist but are likely applied very differently to specific client segments and can be vulnerable to erosion due to greater client promiscuity in response to sharper competition and new distribution technologies. and while larger size may make a firm too big to fail or ‘systemic’, recent experience during the financial crisis shows this as hardly an unmixed blessing – quite apart from the conglomerate discount that may adversely affect the share values of large and complex financial firms. ingo walter (Ph.D.) is director of SimCorp StrategyLab, Seymour milstein Professor of Finance, Corporate governance and ethics and serves as the Vice Dean of Faculty at the Stern School of Business, new York university.

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# Governance, risk and compliance in the financial sector an it perspective in light of the recent financial crisis The recent financial crisis has brought renewed attention to governance of companies in the financial sector. Questions are being raised as to how we ended up in the current situation in a sector already heavily regulated and under tight scrutiny by financial authorities as well as market participants. Some of the answers must be found in the sector’s culture for corporate governance.

by Kjell Johan nordgard

T

he new millennium is still young – not even nine years old. Still, during this time, the world has already experienced two major market crises. The burst iT bubble in 2000 and the ensuing corporate scandals among giants like enron, Xerox and worldCom cost investors billions of dollars and sent shockwaves through the economy. The situation sparked a mistrust of the commercial system in general, and gave rise to the Sarbanes oxley (SoX) act in July 2002. SoX sets new standards for all public uS companies in order to ensure sound corporate governance and hence protect investors from losses incurred by bad management and controls, hidden risk and exposure or outright fraud. The need for common guidelines for corporate governance is however a global phenomenon, and SoX compliance was quickly adopted as a common benchmark for governance worldwide.

however, despite the SoX initiative, the world found itself in turmoil again in 2008. This time though, the scenario was different. whereas the situation that led to the SoX legislation came on the back of the collapse of an overrated iT segment followed by revelation of cheating, fraud and bad management amongst leading blue chip companies, this time the crisis struck at the very foundation of the capitalist system – the institutions in charge of ensuring availability of capital and funding of corporate activity.

The crisis started amongst the financial institutions with sudden collapses of big international banks like bear Sterns, lehman brothers and merrill lynch as well as leading insurance groups like aig and uS mortgage lenders fannie mae and freddie mac. it spread like fire across the entire international capital marketplace and the financial system was brought to the brink of melt down. liquidity was frozen by banks out of fear of losing out on counterparty default, and the mechanisms for funding of commercial activities thereby basically came to a standstill. The entire corporate world was soon embroiled in a deep and spiralling crisis.

“The crux of the problem in the banking sector was that banks, already heavily geared and heavily exposed to the real estate sector, increased their gearing and their asymmetrical exposure through a combination of securitisation and regulatory arbitrage.”

overeXpoSure and TranSparenCy So how could this happen in a market which is already heavily regulated by directives like basel ii, Solvency ii, uCiTS iv and ifrS, just to mention a few?

The crux of the problem in the banking sector was that banks, already heavily geared and heavily exposed to the real estate sector, increased their gearing and their asymmetrical exposure through a combination of securitisation and regulatory arbitrage. Securitisation is in essence a very sensible construction, its purpose being to transfer risk from those responsible for raising funds over to the vast universe of private investors. in this case, securitisation was achieved by packaging loans as collateral for complex structured instruments like collateralised debt obligation (Cdos), collateralised loan obligations (Clos) and collateralised mortgage obligations (Cmos). The collateral for these vehicles was corporate bonds and mortgage loans, many of them so-called subprime loans associated with high yield and high risk. Through a number of intermediaries who all charged lucrative fees for their contribution to the party, these loans, as if by magic, ended up on the shelves of the investment banks as aaa rated investment products in the shape of Cdos.

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to all levels in the organisation. and it really starts even one step before that, because information, according to russell ackoff, acclaimed systems theorist and professor of organisational change, is ‘data that are processed to be useful’. a sound corporate governance policy therefore needs to ensure:

This is however where the securitisation process failed. rather than distributing these products to the mass-market, the banks kept around 50% of them for themselves. So the securitisation stopped half way. The packaging succeeded but the distribution stopped. The risk was not transferred but kept on the books of the banks. in addition and in order to circumvent the basel ii solvency requirements, banks offloaded Cdos to different kinds of Special purpose vehicles (Spvs). To give these Spvs credibility, the offloading was however supplemented with liquidity and credit enhancements issued by the banks. Such enhancements are credit light in basel ii terms and the construction therefore effectively allowed the banks to increase the gearing by a factor of 5 compared to what basel ii would have allowed if the Cdos had been kept on the banks’ balance sheets. The problem was that the credit and liquidity enhancements meant that the risk in case of a collapse still would sit with the bank. what the banks effectively did was to write a put option to the market: “if the Spv fails to make its payments, we’ll cover for it”.

one can only guess why the carrousel then was allowed to continue spinning at higher and higher speed. The explanation is most likely that the markets lost control through a lethal cocktail of weak corporate governance, short-term greed and lack of transparency and understanding of true risks and exposures. The big international banks operate in departmental silos, each with their own performance goals. with the new structured instruments, Cdos, CdSs, abSs and so forth it is difficult enough for a single department to decompose and assess the true exposures associated with these constructions. when you then add it up across several departments in different geographical locations, it becomes literally impossible for a board and the executive management to have a true feeling of the actual overall exposures and risks and hence enforce sensible departmental limits and thresholds. each department will then act solely out of local motives in the chase for this year’s bonus – something that probably works well in good times when everything points to the sky, but which is a risky recipe in stormy and unpredictable weathers.

was this excessive gearing and exposure understandable? from a short-term profit perspective – absolutely. from 1998 to 2006, house prices in the uS were booming, and as the saying went, ‘when the music plays, you have to get up and dance’. was it prudent? not at all. figure 1 shows the Case Shiller priceto-rent ratio in the uS, which basically measures how the price level for property purchase develops compared to price level for property rental. The graph clearly shows an increasing imbalance building up in the new millennium. according to traditional asset pricing theory, the price of an asset ought to be the net present value of all future cash flows, for the property market that would be the net present value of future rental income. So the only reason for expecting the imbalance between rental and house prices to be sustainable, would be if there was a fair expectation that household income would increase correspondingly so that renters would be able to pay higher rent. figure 2, which shows the price-to-household index shows that there was no reason to believe this to be the case. household income was lagging behind to the same extent as rental levels.

governanCe, riSk and ComplianCe (grC) The situation calls, again, for increased focus on corporate governance. The financial sector is faced with special challenges in this respect compared to other segments. The financial industry relies heavily on information, loads of information, and this information needs to be available at the right time, which, in many 1,8 cases, means immediately.

1,7 1,6 furthermore, companies in 1,5 the financial sector can 1,4 rapidly change their overall 1,3 1,2 risk profile, through actions 1,1 undertaken by portfolio 1,0 managers or traders, and the 0,9 0,8 different firms are so intertwined in their business that the collapse of some big 1,7 players quickly develops into 1,6 a systemic crisis that affects 1,5 the whole market.

• an enterprise data management (EDm) platform to provide all levels in the organisation with consistent, coherent and timely data; • the right analytical tools to transform these data into information; • a strong reporting platform to ensure that information can be consolidated and presented in the right format, such as level of detail for example, at all levels in the organisation.

The analytical tools must cover the appropriate models for calculation of market risk, for example, value at risk (var) recommended by basel ii, credit risk and liquidity risk among others. This is a prerequisite in order to be compliant with legislation, and the importance therefore almost goes without saying. Just as important is however how the iT infrastructure is able to reveal true business risks, including exposures against counterparties in the marketplace. when lehman brothers filed for bankruptcy in September 2008, it took many stakeholders weeks to figure out their claims and losses. Those who had full transparency of their total exposures also in the period leading up to the collapse

Figure 1.

The price-to-rent ratio 1987-2009: Calculatedrisk 26 may 2009 Figure 2.

The price-to-household income ratio 1987-2009: Calculatedrisk 26 may 2009

1990

1994

1998

2002

2006

2010

1990

1994

1998

2002

2006

2010

1,4

as information is the clue, sound corporate governance in the financial sector should start with creating the foundation for making the right information available

1,3 1,2 1,1 1,0 0,9 0,8

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Journal of applied iT and inveSTmenT managemenT

e rat st

a gic

ance orm t perf uremen s mea Figure 3.

The five pillars of iT governance

l ig

t en m n

va lue de li

It governance

ve ry

R man isk agem ent

20

Resource management

would have been in a better position to protect themselves. risk management is therefore not only about sophisticated maths and statistical models. The statistics will not help you much in times of extreme volatility or movement in prices. Sound risk management should therefore first and foremost take care of the bread and butter needs of the organisation. a company needs to have a true picture of how it is exposed and what the consequences are if such exposures turn into true liabilities.

ComplianCe ConCernS ConTrol meChaniSmS based on the hypothesis that you do not get what you expect, you get what you inspect, legislators very wisely make huge efforts to try and control the financial marketplace in a way that promotes good corporate governance but preserves the basic ideas behind the free market economy. a company needs, of course, to comply with regulation. The consequences of not doing so will be fines, compensation claims, loss of reputation and even loss of license to operate. it is however important not to reduce the control mechanisms to ensure compliance with external stakeholders. Just as important is to have mechanisms in place to secure compliance with internal governance policy and procedures. These must be seen as joint components of a company’s risk policy. risk budgets should be allocated to all levels in the organisation and proper compliance controls should be implemented to ensure the alarm bells start to ring if thresholds are exceeded. iT governanCe This is why, in the financial world, it does not make sense to talk corporate governance without also covering iT

governance. The amount and versatility of the data, the sophistication of the analytical tools and the flexibility of the reporting tools are at a level that makes it impossible to cope with without a sensible iT infrastructure. according to the iT governance institute (iTgi), sound iT governance should: • be closely aligned with the business strategy; • deliver direct value to the company’s business model; • be the foundation for the corporation’s control and mitigation of risk; • ensure effective use of company resources; • ensure performance of the it infrastructure is measurable. based on the overall business model, the iT organisation should therefore be given goals to secure delivery of true business value. Such goals should be made measurable (whenever possible) through key performance indicators (kpis). The risks of not achieving the goals should conversely be quantifiable through key risk indicators (kris).

Some examples of kris pertaining to stability, flexibility and security of the iT infrastructure could be: stability • statistics for central processing unit (Cpu) usage; • statistics for network traffic; • statistics for database traffic and available space; • statistics for how fast the databases grows, taking archiving options into consideration; • statistics for downtime of applications in the infrastructure;

SimCorp

• statistics for response times of applications; • statistics for recovery time in case of crashes. flexibility • statistics on how long it takes to set up a new portfolio or a legal entity; • statistics on how long it takes to add new applications to the infrastructure; • statistics on how long it takes to report total counterparty exposures; • statistics on how much redundant data (data which already exist elsewhere) a new application creates in the infrastructure. security • statistics on external hacking attempts, both succeeded and failed attempts; • statistics on internal breach of compliance rules and authorisation levels.

ConCluSion grC is becoming increasingly challenging for the financial sector due to its complexity. it is however not always the best approach to throw a complex solution at a complex problem. for the financial industry it is crucial to get the fundamentals in place, and this means a proper iT infrastructure to ensure quality and timely data. if the foundation is not of appropriate quality, further sophistication will probably just exacerbate an already fragile information infrastructure. The extra information provided with the increased sophistication will therefore at best be of little or no value, and at worst be directly misleading and introduce further risks for the enterprise. when the data foundation is in place, sophistication can be increased over time as a controlled process, adding more and more value to the business. This journey must however be stated in the corporate governance policy, set out by the board of directors and executive management.

Kjell Johan nordgard (mSc ee, BA Finance) is Senior Vice President and head of global market Support at SimCorp. he has several years of experience with iT services to the financial sector, including consultancy and training services as well as delivery of strategic solutions for decision-making, reporting and risk management.

SimCorp

Journal of applied iT and inveSTmenT managemenT

# time to return to growth?

July 2009

21

returning to growth in the asset management sector is unlikely to be about getting back to business as the industry knew it before the crisis. The conditions are likely to be very different and the route to success will follow a different, more demanding path. by Professor Paul Verdin

g

rowth? at a time when we seem to be used to ‘crisis = business as usual’, and where we seem to have reached the point where many market participants, observers and policymakers are considering bad news as good news, on the basis that the worse it gets the less the chance it will get much worse or stay that bad‌ it may seem like an odd moment to be talking about growth again. first priority after the earthquake and the clean up has been obviously to contain further damage and tighten our management of risk. Second priority, as a result of the often dramatic drop in revenue and new business, has been to cut and control costs and dramatically so for some. both priorities remain high on the agenda. but suppose we have stopped the bleeding, suppose we have regained confidence and have upgraded our processes to avoid the dramatic situations still in vivid memory; how and when will we ever get back to growth? growTh iS noT a STraTegy, growTh iS The reSulT of a good STraTegy in order to answer that question, let us remind ourselves that most often growth in and of itself is not a good strategy, it is not even a strategy. it is more useful to see growth as the result of a good strategy. most successful companies, those that have been successful over the long haul in a sustained way, have shown tremendous

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# time to return to growth? the asset management industry, in several ways, one everyone has always been looking for any time, any day, all the time everywhere… however, there are a few things we have learned from research undertaken to date, even though most of what we think we know relates to what we can exclude from our list of prime factors of sustained, long-term success.

however, our results are rather robust and roughly in line with several other studies from different perspectives, with alternative data and statistical techniques. even michael porter, the pioneer of market or industry attractiveness as a cornerstone of strategy development, reported no more than 18% for industry or market factors2.

in a long-term international study covering a broad range of industries and countries and using different measures of performance, including economic value added (eva) and market value added (mva) as distinct from traditional accounting measures, we found that by and large it is not in the first place Jim Collins, ‘The Secret of enduring greatness’, Fortune, may 2008 the sector, the industry, nor even the country or the state of the economy that influences long-term bigger and bigger, even to the point of company success. all external factors, in dominating their market or industry, not our calculations, accounted for only about because they were bigger - certainly not at 10% of performance differences the start - but because they were just altogether. better at what they were doing. They managed to out-manoeuvre and outThese results did not remain uncontested perform their initially much bigger rivals by those consultants, researchers or or incumbents. market participants who spent their time searching for ‘attractive markets’, ‘growth while there are certainly areas and parts markets’, segments or countries, or of asset management that are subject to looking for the next newest, biggest or significant economies of scale or where highest-growth markets to bet on. size or market share per se may be the name of the game, let’s not forget that even today’s big players most often started out small. in addition, many smaller ‘boutiques’ or focused players show a significantly better return or overall Jim Collins, ‘The Secret of enduring greatness’, Fortune, may 2008, updating his ‘From good to great’ and ‘“Built performance than some of their larger to Last’ bestsellers. peers. if growth is the result of success g. hawawini, V. Subramanian and P. Verdin (2005), ‘is performance driven by industry- or firm-specific factors? and not the other way around, then what A response to mcnamara, Aime and Vaaler’ Strategic can we say about the determinants of management Journal 1083-1086; g. hawawini, V. Subramanian and P. Verdin (2004), ‘The relative influence success? of country, industry and firm factors on firm performance’

These findings may be seen in broad support of the famous words of peter lynch, celebrated investment guru who made the well-known fidelity magellan fund great, where he stated “if it’s a choice between investing in a good company in a great industry, or a great company in a lousy industry, i’ll take the great company in the lousy industry any day. it’s the company, stupid!” 3

growth. most often that growth was the result of their success in the market and in the business they developed, re(de)fined or (re)invented, rather than the result of a simple focus on size or growth, as it was in markets as they existed. nokia, ryanair, Toyota, dell, to name but a few that we have been watching over a significant period of time, or Cisco, medtronic, kellogg or even goldman Sachs which were shown as long-term winners in Jim Collins’ recent update1. They have become

“Firms don’t fail because of what the world does to them, but because of what they do to themselves.”

1

2

Journal of world Business, 121-135; g. hawawini, V. Subramanian and P. Verdin (2003), ‘is performance driven by industry- or firm-specific factors? A new look at the evidence’ Strategic management Journal 1-16; m.e.

Porter and A.m. mcgahan (1997), ‘how much does industry matter, really?’, Strategic management Journal, 15-30.

3

P. Lynch (1994), ‘The Stock market hit Parade’.

The faCTorS of SuCCeSS… let us start by reminding ourselves that there is a lot we really don’t know… if only we knew, it would be the holy grail of

our basic but important observation therefore remains that companies are successful because of what companies do, and don’t do. Conversely, and perhaps not less relevant if provocative in these challenging times, the same seems true with respect to down-side: “firms don’t fail because of what the world does to them, but because of what they do to themselves,” as Jim Collins put it.

Similar conclusions emerge from recent studies on the ‘stall factors’ that make companies stumble on their path to

“if it’s a choice between investing in a good company in a great industry, or a great company in a lousy industry, i’ll take the great company in the lousy industry any day.”

P. Lynch, ‘The Stock market hit Parade’, 1994

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strategies, something that arguably successful companies never lost sight of. others might have overlooked this in their attempt to cut corners, improve short-term financial results or search for fast growth above and beyond what their own value proposition, business model or organisation could bear and sustain.

growth. most companies’ growth stalls at some point, as there are only very few consistent and long-term winners in any market or industry. and stalling is mostly due to company-specific factors, a whopping 70% of a strategic nature and 18 % organisational factor, while only 12% can be attributed to uncontrollable external factors4. in other words: don’t blame the economy, and don’t blame the market or the industry. equally so, do not count on them to get you out of this downturn and get you swiftly back to growth.

23

sense, they put the cart before the horse. and the temptation to do so is always around the corner in a world of finance where numbers, discounted cash flows, expected earnings and financial ratios, represent our best estimate of future potential rather than actual or proven performance based on delivered results.

Successful strategies obviously require a lot of things, many of which we cannot mention here. at a minimum, however, they should be based on a relentless focus on creating value for the client, the customer or the market, above and beyond and ahead of what we call the capturing of value for the shareholder and management. of course, it is value capturing that entire chunks of the financial markets were very good at, without paying sufficient attention to the underlying sustainable value to the customer, the client and the market. in a

baCk To baSiCS: growTh iS abouT CreaTing value how then can we prepare for growth? ‘back to basics’ is a response we often hear these days, especially in financial businesses, asset management included.

There is obvious value and truth in that, but what does it mean? in our view it means returning to the roots of successful

July 2009

let us illustrate this by considering a simple 2x2 matrix (see figure 1), representing different combinations of value creation and capturing. it is not intended as a kind of ‘portfolio matrix’ but rather an illustration of the dynamics confronting companies no matter what business or part of the business they are in. entire pockets of financial markets, asset management included, have had an easy time benefiting from easy

A NEVER-ENDINg PRocEss Figure 3.

The dynamics in the value creation-capturing framework

value CreaTion

new entrants

heaven

nightmare 3

4

high

The horizontal game low

2

hell low © Prof. Paul Verdin, 2009

{

gravity law denial intertia lobbying restructuring m&a Competive pressure

monopolists

1

dream high

value CapTuring

4 m.S. olson, D. van Bever and S. Verry (march 2008), ‘when growth Stalls’, harvard Business review, 50-60.

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# time to return to growth? value capturing without creating much, as illustrated in position 1. long before the crisis struck, i remember some asset managers observing “…paul, we are off the chart!! …we are earning good money by capturing value but actually destroying value to our customers…,” referring to the overall negative performance of most asset managers compared to their benchmarks or indices. That indeed would put them in quadrant 1 with negative value creation - while still making handsome returns to managers and shareholders of asset management companies.

with a bang as in the ‘big bang’ of deregulation and most recently in the financial crisis.

The immediate reaction of market participants may vary but usually passes through one or more of the following, starting with denial: ‘it won’t happen to us’, ‘we are different’, ‘not so soon’, ‘we will worry about that later’ or ‘professor, this does not apply to us – we are a Swiss insurance company’. Then inertia follows, for instance: the ‘knowing-doing gap’, ‘tomorrow we will change’ or ‘let’s enjoy the ride while it lasts’. There may be other excuses for not changing or reacting to what we know and see coming. Then we can try to fight back and hold on to privileged dominance through lobbying or other defensive tactics such as alliances, (anti-)competitive practices or agreements or, last but not least, mergers and acquisitions inspired by ‘buying the competition rather than beating them’,‘growing market share’ or ‘industry consolidation’.

“in our view value creation in competitive markets is about innovation, providing ever more value to the customer.” while The going iS good… while position 1 seems like a dream, enjoy it while it lasts because dreams don’t last forever. Sooner or later competition catches up, (de)regulation strikes, technology shifts or the market changes.

This is something we have been able to observe in many industries over the last few decades, for instance in telecoms, utilities, pharma or even in energy or diamonds… Sometimes this occurs much later or slower than expected, as in different parts of financial services and asset management, sometimes though

deliberate attempts to reduce transparency or sneak in price increases in the wake of increasing competition are popular choices, as sometimes preached by desperate consultants or practiced by short-term opportunists, especially in today’s high-pressure environment. one-off cost-cutting or restructuring programmes, while obviously unavoidable in certain areas and conditions, also belong here, which i broadly refer to as ‘playing the horizontal game’ trying to move back on the horizontal axis to position 1.

Sooner or later however, one risks being pushed into the lower left corner (position 2),

not an enviable place as value added or value creation for customers is low and the possibility to capture any value severely reduced. This is typically the situation of commodity businesses or commodity traps: ‘we are stuck’. it is possible to escape however, but only through long, hard work. by arduously climbing the mountain of innovation or value creation; moving up along the vertical axis.

This is exactly what most Ceos had in mind when asked about their top strategic priorities. “either you innovate or you are in commodity hell”, said Samuel palmisano at ibm following lou gerstner’s dramatic turnaround starting from the customer. or Jeff inmelt, Ceo of ge: “Constant reinvention is the central necessity at ge… we’re all just a moment away from commodity hell.”

These are joined by many more, at least so it was before the crisis. and while the crisis may have made this challenge all the more difficult, the fundamental requirement should not have changed.

There is no other way, however much our current effort and attention may be focused on the short-term fire fighting or cost-cutting. value CreaTion and innovaTion in our view value creation in competitive markets is about innovation, providing ever more value to the customer. and the more competitive your market gets, the less you should focus on the competition, because the only way to beat that competition is to deliver better value to customers. even today there are really only two ways to consistently create value and innovate: either go for ‘cost innovation’, the continuous, relentless innovation in the business model, value or supply chain in order to continuously offer ever lower prices to customers. or go for ‘value innovation’, the continuous search to offer ever better and greater

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value to customers, based on the drivers and attributes of value they perceive and appreciate. Current recessionary times may have added pressure to this last option by forcing improvements in valuefor-money strategies5.

Climbing up the wall of innovation however still does not offer easy solace, as it makes us go through a nightmare (position 3), even if we manage to please the customer and add real or perceived value. eventually we need to be able to translate the higher value into higher margins, through higher prices, in the case of a value innovation strategy, or through higher volume driven by lower prices in the case of cost innovation strategies. both strategies will lead to profitable and healthy growth. but growth is not the driver of the strategy, it is the result of it. most, in fact all, successful companies actually reach this point (position 4) of being able to add good value and capture a sufficient part of that in the process in a consistent continuous way. we need to keep working at it, if only because of competitive pressure constantly trying to diminish or de-value our competitive advantage. otherwise we may start slipping and sooner or later fall victim to the temptation of slipping in innovation, ignoring the customer, and eventually falling down into the lower right quadrant. The law of gravity will take over. blinded as we will be by our own success or our own strong position, trying to hold on to value capturing while losing our value creation potential, thus jeopardising our long-term strategic health and sustainable growth. ibm, microsoft, intel, to name but a few, could be seen as going through this cycle at least once before. when fighting antitrust authorities starts taking centre stage, chances are you are in the final stages of such a cycle and it’s time to face up to the

July 2009

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“(…) beyond risk management and cost cutting, the next if not more important challenge for long-term success is to identify the relevant drivers or attributes of value of the groups of customers or segments, we want to serve and new ways of delivering that value in a better more efficient way than ever before. growth, therefore, can never be just more of the same as a return to the past.” next competitive cycle. The only way to avoid this ordeal is to keep innovating and facing up to competition rather than obstructing it. in conclusion, based on many years of involvement in banking, insurance and asset management, a successful strategy should always be guided by creating perceived value to the customer, the client or the market, while of course being able to capture at least some of that value, by way of pricing (fees, commission, basis points, …), in a continuous and consistent way. an undue or unbalanced focus on either one of those two basic dimensions of strategy invariably leads to problems, even to disaster, particularly over the medium to longer term, which is exactly what strategy and growth are supposed to be about.

So, beyond risk management and cost cutting, the next if not more important challenge for long-term success is to identify the relevant drivers or attributes of value of the groups of customers or segments, we want to serve and new ways of delivering that value in a better more efficient way than ever before. growth,

therefore, can never be just more of the same as a return to the past. in these trying times, it is a golden opportunity to be examining these questions again and go beyond the easy games of value capturing, merging and acquiring or just riding the market booms which have benefited and equally blinded many a provider in recent years. when will we geT baCk To growTh? how bad will it get and how long will it last before we can expect to return to easy growth? nobody knows. it may not come in the foreseeable future. Those who claim otherwise are just fooling themselves and others as well. economic predictions have always been hard to make “especially when they pertain to the future” as J.m. keynes used to observe. The actual record of economic predictions according to most studies is indeed dismal.

That is particularly true in the current environment where we are witnessing major shifts and changes into uncharted territory, implying that a mere

5 P. williamson and m. Zeng (2009), ‘Value-for-money strategies for recessionary times’, harvard Business review.

C. Kim and r. mauborgne (1997), ‘Value innovation – The Strategic Logic of high growth’, harvard Business review.

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# time to return to growth?

comparison to past crises here or there, while possibly useful in warning against some pitfalls, may be equally misleading. “it is time to suspend unquestioned faith in a quick return to the past and adjust to the reality of change,” as mohamed elerian, Ceo of pimco recently observed.

“There are two types of economists right now”, according to larry Summers, currently president of the national economics Council in the white house, “those who don’t know, and those who don’t know they don’t know.” and continuing, through the march 2009 market lows so far, “…there is one thing we know about financial crises like these; they all end.” in the meantime “we are still in uncharted waters and no one knows what comes next,” commented mervyn king, governor of the bank of england, in the financial Times, fund management, 18 may 2009).

6 ‘innovating for the upturn’, Accenture report 2003.

That leaves us little to go by, and based on what we reported and argued before,

that need not be so worrying or frustrating at all. long-term success, which is the essence of sustainable growth, will be as much of our own making as the result of spotting the right trends and riding the waves. “The real test is not whether a company has been smartest about predicting the timing of the recovery but whether it has been truly competitive in its preparation.” it will depend in the first place on taking our business into our own hands. and that requires a keen understanding of the current and future, actual and potential needs of our customers and clients, what it is that creates value for them as they see it, and how we will be able to deliver that better, cheaper, faster than our competitors in a sustainable way.

This is not rocket science to conceive or to find out. it is a continuous and relentless search-by-doing process to make it happen. we need to try and

create our own growth. how exactly we do that, we cannot give you on a golden plate. in a future publication however we will try and develop some more in-depth insights and observations and point to concrete paths and pictures, while attempting to show some of the pitfalls to avoid.

Paul Verdin (Ph.D., harvard) holds the Chair of Strategy and organisation at Solvay Business School (uLB, Brussels) and is Professor of Strategy and international management at KuLeuven, Belgium. he was formerly Distinguished Visiting Professor at inSeAD where he has been on the faculty for over 15 years and has consulted on strategic issues and processes in the financial sector (banking, insurance, asset management) over the last 20 years. paul.verdin@ulb.ac.be

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# preparing for uCits iv european Parliament approval for the undertakings for Collective investment in Transferable Securities (uCiTS) iV has been greeted with enthusiasm by trade bodies and the asset management industry as a whole. now everyone is asking how it’s going to work. This article gathers views on what industry professionals think the uCiTS iV future may hold. by richard willsher

i

f uCiTS iv fulfils its promise then the package of measures it ushers in could make a very real difference to scope, scale and organisation of fund management in europe. The european funds and asset management association has described it as ‘a new milestone in the creation of an effective single market for investment funds’. and its president, mathias bauer commented, “efficiency and confidence are crucial if the investment fund industry is to remain competitive, in particular under the

says, “will simplify the regulatory environment; create cost savings through economies of scale; give greater choice of investment funds to investors; and increase investor protection by making sure that retail investors receive clear, easily understandable and relevant information when investing in uCiTS funds.”

market practitioners agree that it will have significant effect on the market. “i think it will,” comments adam fairhead, global head of product development at hSbC global asset management.

“The master feeder arrangement could encourage a lot of consolidation of funds thereby cutting costs.

The management company passport could lead firms to domicile all their resources in a single location instead of Ceo Jamie macLeod, Skandia investment group having them spread about. fund mergers cross border should certainly be easier current difficult market circumstances. though there is no solution on the tax uCiTS iv will enable asset managers to side, which is important.” deliver these efficiency gains, increase confidence in the existing uCiTS he adds that the structural change that framework and help promote the uCiTS uCiTS iv will bring about will mean that brand even more…” businesses may alter the way they set up and organise their fund management Jarkko Syyrilä, of the london-based operations though not what products they investment management association is sell to investors or the way the sell them. similarly upbeat. “The new directive,” he

“(…) while we have noted a number of benefits… and the desire of regulators to work more closely together, there remains a lack of detail… The result is that we cannot make business decisions until these proposals have been fully worked through (…)”

Jamie macleod Ceo of Skandia investment group says that his firm “very much welcomes the variety of new initiatives being pursued with the development of the uCiTS iv regime. however,” he continues, “while we have noted [a number of ] benefits… and the desire of regulators to work more closely together, there remains a lack of detail… The result is that we cannot make business decisions until these proposals have been fully worked through…” indeed many firms have a number of wide ranging business decisions to make regarding how they are structured, locally, cross border in europe and globally. aegon investment management among a number of others, is in the process of reorganising its business into a global asset management structure and helen webster aegon’s head of products says that uCiTS iv provides her firm with some of the tools to do so. at Standard life investments phil barker who is head of european business development adds that it will help reduce costs and help increase efficiency. richard pettifer kpmg’s director of investment management identifies three key areas that firms will now be focusing on. The first is where to locate their principal management company. The second is where to put their master-feeder agreements and thirdly, where will fund administration be carried out?

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# preparing for uCits iv “Just preparing an inventory and understanding their own cost structures will be a challenge for some firms.”

The counter to such suggestions lies in the deep pools of expertise and excellent regulatory environments that dublin and luxembourg already have in place.

To replicate that elsewhere Director richard Pettifer, KPmg investment management would take a great deal of time and cost. moreover these two centres will compete tooth and nail to hold on to all aspects of asset pettifer queries whether luxembourg management work because of their and dublin will continue to grow as significance to their local economies both centres for all or some of these activities. in terms of income and the employment or will, for example, firms with head of human resources. offices in say frankfurt, london or paris, place their management operations, and meanwhile before many firms can begin master-feeders in those centres and to address such issues kpmg’s pettifer transfer fund administration to low cost goes on to point out that they need to centres elsewhere, such as, he suggests, better understand their existing businesses poland or india?

especially where they are spread across several locations around europe. “Just preparing an inventory and understanding their own cost structures will be a challenge for some firms,” he says. in summary, uCiTS iv’s impending implementation addresses a number of longstanding industry issues. but it also raises a number of structural and strategic questions that many firms are not yet necessarily well positioned to answer. meanwhile those that are, could be best placed to seize valuable first-mover advantages in the new, europe-wide investment management market. richard willsher is a London-based financial journalist and former investment banker.

UcIts IV – Key features

UcIts IV – timetable

uCiTS iv ushers in several measures intended to promote grater efficiency in pan-european management of funds:

following approval by the european parliament, the remaining timetable is clear and is unlikely to change:

• management Company passport – a management company located in one country will be able to set up and run a fund in another (a fund’s nationality will be determined by the country where it has been authorised);

• level 2 detail is currently being worked through and Directive is due to be issued in summer 2010;

• supervision – a management company will be subject to the supervision and regulation of the country where it is based;

• Economies of scale across borders.

• notification procedure – quicker, more simplified regulator-to-regulator communication; • key investor information – to be simpler than the existing ‘simplified’ prospectus; • mergers – framework governing both domestic and cross-border mergers between funds; • master-Feeder structures – allow funds to build economies of scale across borders.

• member states to adopt and implement rules which should be effective through the Eu by 1 July 2011;

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# Cost management in a more regulated asset management industry This paper reviews some of the current cost reduction activities in the asset management industry, some familiar and some not seen so often in the past. it also considers the most recent indicators for the future of regulation of the industry issued by the european Commission, and looks at the impact that this, and other regulation in the pipeline, are likely to have on the cost base of an asset manager. by Crispin rolt, Director ernst & Young

C

ost is a measure that tumbles down the priority list when markets are buoyant and investors are abundant. however, when the sun stops shining, the issue of cost is promoted, almost overnight, to the top of the asset management executive agenda. large outflows of funds and markets that have fallen significantly from their levels 18 months ago have led to a contraction of the asset management industry. The european asset management industry shrunk by €2.9 trillion in 2008.

as has been the case in other downturns where asset managers focus on cost, their first reaction is to stop or significantly reduce discretionary spend. only business critical projects are not put on ice overnight. The second reaction is redundancy or ‘right-sizing’as the industry would prefer to have it. non-revenue generating and non-business critical business areas are usually the first to be targeted. more recently, with globalisation, firms are looking at their business models and stripping out layers of management that they deem superfluous. for example, some are questioning whether they need a business head in each region in which they operate. it is of course important that resource cuts are not made too deep, preventing the organisation from reacting quickly to gain market share when the industry eventually starts to recover. it remains to be seen who got ‘right-sizing’ right and who got it wrong.

“Cost is a measure that tumbles down the priority list when markets are buoyant and investors are abundant.”

1 european Fund and Asset management Association (eFAmA).

This has placed increasing pressure on profit margins. although some asset managers entered the financial crisis in better shape than others, all are now in a period where cost reduction and cost management are in the minds of senior management.

asset managers are also reducing cost through less familiar and perhaps more

constructive activity. first, it is widely recognised that product proliferation has led to far more products in the marketplace than is either necessary or desirable, which is leading to product rationalisation. asset managers are taking the opportunity to consolidate products that have accumulated as the result of earlier mergers or to close products that have failed or become inefficient to manage.

Secondly, many asset managers are reviewing their third-party service providers with a view to consolidating and thereby reducing cost through scale or, at the very least, to renegotiating contracts.

Thirdly, many are reviewing how the money managers and traders in the organisation are rewarded. realigning the remuneration of managers with the risk profile of the fund and incentivising them in a way that is in line with the investment interests of clients is a tricky balance to strike, although also long overdue. fourthly, asset managers are analysing the operating model to identify opportunities to reduce fixed costs and build a more variable cost base. ideally this redesign of the operating model should have been completed in the years prior to the financial crisis. we have encouraged our clients to review their operating model on a periodic basis, one of the principle reasons being to create a robust operating

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# Cost management in a more regulated asset management industry model that could cope with precisely this sort of downturn. This ‘weatherproofing’ may have resulted in a more expensive operating model, paying a fee to outsource providers based on a percentage of assets under management. however, it is currently being proven to be more robust as the cost of the operating model drops with the aum. who will regulaTion affeCT The moST? The alternative asset management sector is, unsurprisingly, likely to be the target of much of the expected new regulation. at the time of writing, the most recent document released on future regulation was the eu framework proposal for managers of alternative investment funds, issued by the european Commission (eC). This draft legislation is the next step in an eu program designed to ensure financial markets across europe are secure and that market actors operate responsibly.

The eC believes that the oversight and supervision of the activities of managers of alternative investment funds (aifs) across europe need closer regulatory engagement and supervision. The key principles include an increase in the focus on what the eC believes to be the sources of systemic and operational risk, enhanced investor protection and regulatory disclosure.

due course define the conditions for determining independence.

The organisational design is a common theme throughout the proposed directive. it requires independent depositaries and custodians to be appointed to the aif – eu credit institutions subject to prudential regulation – which is a significant change in practice and a challenge for the existing prime brokerage and private equity models. The aifm is required to have a structure to identify, prevent, and disclose conflicts of interest. There is also a requirement to have an operationally separate portfolio risk management function, although again it is unclear how independence should be achieved. other requirements include measures regarding; • liquidity management, stress testing and redemption policies; • procedures to ensure that short positions are covered at delivery date; • requirements that must be met before an aiFm can invest in securitised investments; • authorisation by local regulators of the delegation of activities and apparent anti-avoidance provisions to prevent excessive outsourcing.

highlighted below are the elements of the recently proposed directive on alternative investment fund managers (aifms) that will have greatest impact on the cost base.

The directive proposes minimum capital requirements calculated as €125k plus 0.02% of the value of the assets under management, subject to a €250m hurdle.

Therefore, the manager with €5bn in assets under management will need to hold an additional €1m of capital – not an insignificant amount.

The most eye-catching element of the operating requirements for aifms is the requirement for the assets of a fund to be valued by a valuer that is independent of the aifm. while third-party pricing sources of market and private trades is common, this appears to be a requirement for the annual valuation to be struck independently. The Commission will in

whaT will be The inCremenTal CoST? increased regulation will inevitably mean more cost to the manager. however, this will vary significantly, depending on the degree to which the operational infrastructure has the resource and data required to undertake the additional regulatory compliance. for example, the

cost implications on aifms complying with the proposed eu directive will vary significantly depending on the size of the organisation. The largest managers will, however reluctantly, be able to comply with the proposed directive. many of the proposals embody business best practice, even if shoehorned into a one size fits all approach. The data is likely to be available albeit in disparate systems and records, but reporting in a timely and accurate fashion whilst managing confidentiality and commercial pressure will be more challenging. for those areas that are different – for example, mandating independent valuations, independent risk management and custody arrangements – it will be challenging to translate high-level principles into practical, commercially viable guidance. other provisions, such as notifying regulators of delegations, or periodic reporting to authorities of leverage, fund profiles or controlling interests, will be burdensome and require improvements in internal reporting systems.

The larger aifms that have evolved within the industry over the last few years have implemented an operational infrastructure that can cope with the increased regulation with an acceptable incremental cost increase. This legislation will however apply to aifms with total assets under management greater than €100 million. This is a low threshold and will catch many small aifms who are less likely to have the entire infrastructure that will be required by this directive. This required investment may question the viability of the business itself.

Traditional asset managers, as opposed to the aifms, are used to complying with the voluntary and involuntary demands of investors and regulators and should be in good shape for when the additional regulation that applies to them becomes clearer. They have also come to recognise the additional benefits and good business

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sense of complying with some voluntary self-regulation. for example, the SaS 70 report has evolved to be a globally recognised method of demonstrating transparency and control in the organisation and therefore an important and effective marketing tool. These asset managers will already understand whether they have adequate and efficient data architecture to provide accurate and timely reporting on the aspects of any new regulation. if they do not, it will be a familiar question that they face: whether to invest and upgrade the operational infrastructure to create a more efficient platform or to continue with the current environment and continue to bear the cost implications of the inefficiency.

ConCluSion – deSperaTe TimeS Call for reSponSible and ConSidered meaSureS asset managers are digging deeper for cost saving than they have done in the past and they are undertaking a wide range of activities to achieve the cost reduction objectives.

The inevitable increase in regulation as a result of this financial crisis will increase cost and will impact the asset managers

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“(…) it will be a familiar question that they face: whether to invest and upgrade the operational infrastructure to create a more efficient platform or to continue with the current environment and continue to bear the cost implications of the inefficiency.” on a scale inversely proportional to size, to the extent that it may make operating in the new environment too costly for some small alternative managers to continue.

silo. by looking at the spectrum of reporting requirements, asset managers will be able to effectively comply with the demands whilst minimising incremental cost.

when the new wave of regulation is clear, it is important for these managers to take the opportunity to address the demands of the regulator and the investor from an enterprise-wide perspective and to resist the temptation to address each requirement (e.g., risk, compliance and control) or source (e.g., investor and regulator) in a

Crispin rolt is a Director and global markets Leader in ernst & Young’s global Asset management practice. Crispin has 12 years’ experience delivering business change in the asset management industry. he has worked for both global asset managers and leading providers of advisory services.

i The views reflected in this article are the views of the author(s) and do not necessarily reflect the views of other members of the global ernst & Young organisation.

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# Reduction of settlement costs:

a post-crisis risk management perspective in times where cost cutting is not so much a trend as a necessity, fund managers are trimming budgets everywhere with information technology (iT) and operations being no exception. by Jan Vendel Petersen

w

hile cost cutting for some organisations is achieved either by stopping investing in people or by introducing redundancy packages, leading technology providers argue that cost savings can be achieved through investment in new technology.

The over-the-counter (oTC) post-trade

but post-trade processing, such as trade confirmation, settlement, portfolio reconciliation, exposure calculation and collateral management are still slow, highly labour intensive and prone to operational risk. in today’s market where billions of dollars are invested in non-standard products, human error can lead to huge losses and must be closely managed. with investors and the media more critical than ever towards the magnified risk inherent in derivatives trading, every step must be taken to ensure efficient confirmation of contracts through wellimplemented technology and workflow processes.

“in today’s market where billions of dollars are invested in non-standard products, human error can lead to huge losses and must be closely managed.” environment and corporate actions are both fields where reduction in operational costs could be achieved by improving efficiency through:

1

operations management group

2

international Swaps and Derivatives Association

3

managed Fund Association

4

Asset management group of the Securities industry and Financial market Association

5

Source: http://newyorkfed.org/newsevents/news/ markets/2008/regulators_letter.pdf

• reducing the likelihood of human error; • eliminating the need for numerous internal spreadsheet solutions; • offering the ability to meet the rapid changes introduced by regulatory bodies; and last but not least • offering the ability for potential growth. oTC poST-Trade proCeSSing a lot of investment has gone into the development of front office solutions where traders are able to execute oTC derivative trades in the blink of an eye.

it is no longer acceptable for trades to go unconfirmed and inevitably escape risk.

Compliance and risk management systems now keep a close eye to ensure that trades, and the models behind them, are tracked and managed closely. now is the time for dealers and buyers of oTC derivatives to stop putting the needs of the back office behind those of the front office. There is no question that the business is based on traders that can create and execute the deals; however, their creativity and sales power provide little value if the agreed upon transactions cannot be processed.

To support the evolution in oTC derivative trading, a number of infrastructure and software providers such as dTCC deriv/Serv, markitwire and

T-Zero have developed or enhanced electronic trading platforms specifically for this purpose. although the rate of adoption by fund managers has been relatively low, this may be about to change. omg1 together with iSda2, mfa3 and Sifma4 on 31 october 2008 suggested a number of radical changes to the federal reserve bank of new york and many of these changes are now being implemented across the industry. There is an increased focus on electronic processing with priority given to the equity derivatives market and already now the major dealers will no longer accept novation consents by e-mail but only consents that are submitted on electronic platforms. although users can use the infrastructure to manually enter their consents, this is a labour-intensive procedure that leaves plenty of room for human error. The challenge of the software providers is to ensure that their products can interface to the infrastructure and support the functionality that is already offered by the existing infrastructure. in the weeks after the lehman collapse many fund managers wished that they had a solution in place that could assist them in managing the numerous novations that needed to take place. where the buy-side client normally represented the outgoing party they suddenly found themselves in a situation where they were the remaining party.

CollaTeral managemenT Collateral management is another area that has attracted a lot of attention lately.

The iSda Collateral Committee is working on a number of enhancements5:

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• best practice to ensure trade and position data integrity and the timeliness and accuracy of valuation data, on which accurate collateralisation in turn depends; • possible benefits of standards for electronic communication of margin calls between firms, including the potential use of standard product definitions; • changes to market practice to further mitigate risk between firms of collateralised derivatives by tightening timeframes for margin calls and settlement and shortening cure periods, thus reducing the scale of residual unsecured exposures; • definition of market practice for the calculation of exposure under the isDa Credit support annexes; • common practice for the process of portfolio reconciliation, including the timing of trade file exchange, process automation across the market, and the consistency of data between trade files and the margin calls to which they relate. prior to the credit crunch and the lehman collapse the buy side may have considered the management of collateral as an operational task of lesser importance, something that was controlled by inhouse developed spreadsheets or administrated by prime brokers or third party collateral service providers. Today the management of collateral is one of the most critical operational areas where efficient workflow processes and solutions are a must, not least due to the change in collateral preference (see figure 1). noncash collateral has been considered as old fashioned and not as attractive but it has become trendy again. These days the king of collateral may no longer be cash but rather non-cash collateral. The buy-side will be looking for solutions that among other things allow them to monitor transactions, to view positions, to monitor recall opportunities, to track collateral

under a rehypothecation agreement, to handle substitutions, to address disputes, to identify issuer and credit risk, and to monitor upcoming corporate action events on pledged securities.

CorporaTe aCTionS although a lot of investment has gone into the development of solutions that will help fund managers to automate the processing of corporate actions, the industry still seems to be struggling to find the ideal solution. Some organisations have created in-house solutions, others have acquired one of the available best of breed solutions but most organisations are still considering which route to take.

The optimal solution that the market is looking for seems to be one that supports the import of information from multiple sources, includes some sort of data cleansing capability, such as comparison of information from two independent sources, includes functionality to notify decision makers of any upcoming corporate action events at a very early stage, a solution that supports defaults election decisions per event type and not least the communication to/from

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custodians and reconciliation of the resulting cash and nominal amounts. while corporate actions have, in the past, mainly been considered an operational task for positions in equities and bonds, this task has now expanded not only to include support for corporate actions on underlying securities in securities lending, repo and collateral transactions but also to include support for corporate actions on synthetic positions used in oTC derivatives such as contracts for difference (Cfd) and total return swaps (TrS).

The constant increase in complexity and growth in the number of transactions, and the shift from local to global, means that this business area is surrounded by a constant threat of failure and error which may result in losses.

Jan Vendel Petersen is Domain manager for Settlement within SimCorp’s Strategic research group. he is the architect behind the development of the securities lending area and has recently been focusing on corporate actions and collateral management. Previously, Jan Petersen worked for several years in the financial industry.

Figure 1. growth of value of total reported and estimated collateral, 2000 – 2009

4,000

Billions of US$

3,500

Reported

3,000

Estimated

2,500 2,000 1,500 1,000 500 0

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

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Imagine we could start again Many decisions in life, once taken, are unfortunately irreversible. In the aftermath of the crisis, many investment management firms agree that were it not for past operational decisions, more firms could be better strategically positioned for whatever the future may hold.

However, evident to most, adapting to the near future requires a significantly improved ability to mitigate risk, reduce cost and capture a profitable part of future growth. Some decisions can actually be corrected. In many cases they ought to be. Think strategically when investing in software.

SimCorp Dimension is a scalable and modular STP front-to-back enterprise system for the investment management industry that enables institutions to mitigate risk and reduce costs while enabling growth.

www.simcorp.com MITIgaTe rISk

reDuCe CoST

enable growTH

ยง

SimCorp

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Journal of applied iT and inveSTmenT managemenT

July 2009

35

Regulatory update This quarterly regulatory update covers major new regulatory requirements and substantial developments that affect the investment management industry.

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european parliamenT approveS ‘SolvenCy ii’

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on 22 april 2009, the european parliament voted overwhelmingly in favour of a framework to improve the financial stability of the insurance industry.The legislation will lead to the introduction of more stringent solvency requirements, which will better reflect the risks that insurance and reinsurance companies face in the course of their business. There is to be more transparent and better-defined relationship between the solvency capital requirement (SCr) and the minimum capital requirement (mCr). an aim of this legislation is to move to a more pro-active supervisory regime that will look more closely at the risk management regimes used by individual insurance companies. in addition a revised method of supervision by supervisory colleges was approved which will facilitate the exchange of information between supervisory authorities and this would also provide insurance companies with savings on their compliance costs.

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The directive must be transposed by member states by 31 october 2012. insurance companies can now prepare themselves for the new supervisory regime. a summary of the approved legislation can be found at http://www.europarl.europa.eu/news/ expert/infopress_page/042-54087-111-04-17-907-20090421ipr54086-21-042009-2009-false/default_en.htm

iaSb april board meeTing

The international accounting Standards board is shortly expected to issue its exposure draft on fair value measurement. it may include additional disclosure for interim reporting. its april meeting discussed several other key issues such as management commentary, earnings per share and post employment benefits about which exposure drafts are expected in due course. more information at www.iasb.org.

nCoil propoSed CdS legiSlaTion

in a letter dated 22 may 2009, the Securities industry and financial markets association (Sifma) and the international Swaps and derivatives association (iSda) voiced their concerns over model legislation to govern credit default swaps, proposed by the Task force on Credit default Swaps regulation of the national Conference of insurance legislators (nCoil). The letter may be viewed at http:// www.isda.org.

SeC perSonnel SeCuriTieS Trading propoSalS

The uS Securities and exchange Commission has set out proposals to tighten its internal compliance governing securities trading by its staff. Chairman mary Schapiro outlined the proposals in its news digest on 22 may 2009 saying, “it only makes sense that we have a world-class compliance program – just as we expect from those we regulate… These measures will further bolster our standing by helping to prevent not only an actual impropriety, but the appearance of one as well.” more information at http://www.sec.gov/news/digest.shtml.

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July 2009

Journal of applied iT and inveSTmenT managemenT

SimCorp

# mergers and acquisitions in Banking and Finance: What Works, What Fails, and Why ingo walter, oxford university Press, 2004 reviewed by editor-in-Chief lars bjørn falkenberg

m

ergers and acquisitions (m&a) are among the most powerful and flexible growth tools employed by companies of all sizes and in all industries. it is widely recognised that a well-timed purchase or a well-planned merger can boost both the immediate financial position and the long-term outlook for an organisation. on the other hand, these transactions can entail a company’s quick downturn if not set up and executed carefully, legally, and wisely.

The investment management industry has carried out m&a transactions on a large scale as part of a reconfiguration of the industry. The results have revealed that there are indeed both failures and successes. ‘mergers and acquisitions in banking and finance: what works, what fails, and why’ aims at evaluating m&a as a key tool of business strategy to enhance shareholder value; in other words, ‘doing the right thing’.The author analyses whether the drivers, the basic economic concepts and the strategic principles that generally urge companies towards m&a are actually valid or not.

Just the extent of m&a in the investment management industry makes it an important subject to in investigate. The book focuses especially on the merger implementation process as a key to success or failure. on the cost side, the challenges of post-merger integration consistently present difficulties in achieving the expected economies of scope.

The book is written for academics and practitioners alike. Scrutinising both the strategic drivers and general assumptions behind m&a as well the actual experiences by investment management

companies with regard to particularly the implementation process, the book represents a valuable tool for both audiences. The author reveals how complex it is to estimate whether mergers and acquisitions will lead to success as the m&a process is affected by not only internal business processes but also implications of external factors like regulations and market conditions.

“This book is a key tool for financial firms in responding to changing competitive pressures and executing viable strategies. The clarity of the presentation nicely complements the book’s substantive incisiveness. For anybody seriously interested in the subject this book is a must.” dr paul m. achleitner, member of the board of management, allianz ag, germany

Qualify for the

SimCorp StrategyLab riSk management exCeLLenCe award 2009

riSk management exCeLLenCe award 2009 simcorp strategylab invites investment management institutions to participate in an assessment of their ability to mitigate market risk, operational risk and governance risk. the assessment will be based on their achievements and developments accomplished in the period from 1 august 2008 to 31 July 2009. the international jury consists of well-known specialists and academics within finance, governance and risk management. submission deadline is 31 July 2009. the risk excellence award 2009 will be announced on 17 september 2009, at a ceremony in luxembourg. the result of the competition will also be announced in the october issue of the Journal of applied it and investment management.

Learn more about the award and find submission guidelines on http://www.simcorpstrategylab.com/riskaward

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Journal of applied iT and inveSTmenT managemenT

SimCorp

Recent research and white papers #

dropping The regulaTory hammer: Ten impending regulaTionS in uS SeCuriTieS and inveSTmenTS

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by Dushyant Shahrawat, CFA, Towergroup

The securities and investments industry is abuzz with talk of a new regulatory structure and impending new regulations set to take effect in 2009 and 2010. This is expected to be the biggest regulatory change since the 1930s and will have an enormous impact on the securities and investments business. This Towergroup research note discusses 10 new regulatory priorities for the uS institutional securities and investments business as well as the expected impact on the technology and operations functions of institutions to enable securities firms to begin planning for these new rules. dropping the regulatory hammer: Ten impending regulations in uS Securities and investments http://www.towergroup.com/research/search/search_reportexhibits.htm?x=31&researchformatid=6&se archType=newSimple&searchSwitch=&keywords=&serviceid=210&y=11&reportSort=sunrisedate&e xhibitSort=sunrisedate& Towergroup research note, april 2009

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eTfS weaTher volaTile CapiTal markeTS and reporT Solid growTh raTeS

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go or no go: The STaTuS of buy-Side baCkoffiCe proJeCTS in 2009

by Dayle Scher, research Director, investment management, Towergroup

The credit crisis of 2008 will have a prolonged effect on the investment management industry well into 2009 and beyond. The drastic decline in assets under management resulting in reduced revenues is forcing asset managers to make painful decisions about how to meet clients’ needs while keeping expenses down. Their decisions on which development initiatives to proceed with and which to put on hold or even axe will determine how they emerge from the turmoil. This Towergroup viewpoint summarises numerous conversations with some top-tier global asset managers and assesses the impact of the credit crisis on the investment management community’s back-office technology and operations projects. go or no go: The Status of buy-Side back-office projects in 2009 www.towergroup.com Towergroup viewpoint report, february 2009

deloitte’s global economic outlook for april 2009 comments: “Since our last outlook in January, the financial crisis has deepened and become a truly global recession. economic activity in the united States, europe, and Japan has declined at an alarming rate. emerging countries in east asia and Central europe have experienced sharp drops in economic activity with the latter at risk of further financial turmoil. even the briC economies that at one time seemed relatively immune to the global financial situation, have experienced serious problems. global trade has plummeted, causing concern that the increasingly global nature of the economy leads to more rapid transmission of trouble than in the past.” global economic outlook april 2009, 2nd Quarter 2009 http://www.deloitte.com/dtt/article/0,1002,cid=256836,00.html a deloitte research Study, 40 pages, 2009

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The exchange traded funds (eTf) sector is one of the few asset management segments that did not only withstand the current financial market turmoil but even reported solid growth rates last year. while the mSCi europe declined by roughly 48% in 2008, eTf assets in europe surged by around 24.3% to eur 112.9 bn in 2008 (eur 90.8 in 2007). The deutsche bank report on exchange traded funds looks into the main driving forces behind this development. eTfs weather volatile capital markets and report solid growth rates http://www.dbresearch.com/servlet/reweb2.reweb?addmenu=false&document=prod00000000002 37986&rdleftmargin=10&rdShowarchiveddocus=true&rwdspl=0&rwnode=dbr_inTerneT_ en-prod$banken&rwobj=redisplay.Start.class&rwsite=dbr_inTerneT_en-prod deutsche bank research, february 2009

global eConomiC ouTlook april 2009, 2nd QuarTer 2009

a praCTiCal guide for inveSTmenT fundS To iaS 32 amendmenTS

an amendment to iaS 32 and iaS 1, ‘puttable financial instrument and obligations arising in liquidation’, was issued in february 2008. it requires the classification in equity of some puttable financial instruments and some financial instruments that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation if certain criteria are met. This publication addresses the questions that are arising in applying the amendments in practice. a practical guide for investment funds to iaS 32 amendments http://www.pwc.com/extweb/pwcpublications.nsf/docid/5d792d00e903C38a8525755f001aCe6a pricewaterhouseCoopers, 14 pages, 2009

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iT Spending in finanCial ServiCeS: a global perSpeCTive

in this report, Celent analyses iT spending trends across different industry verticals (banking, insurance, and securities and investments) and different regions (north america, europe, and the asia-pacific region, latin america and africa). The prime focus of the report is to compare and contrast the direction of iT spending trends among financial services institutions. Celent estimates that global information technology spending by financial services institutions will reach uS$353.3 billion in 2009, representing a decline of 1.3% over 2008. This figure is substantially lower than the 4.5% growth achieved in 2008. although the next couple of years will be challenging, Celent expects global spending on iT products and services to grow to uS$364.5 billion by 2010, a mere 0.9% Cagr from 2008 to 2010. iT Spending in financial Services: a global perspective http://www.celent.com/124_483.htm Celent, 70 pages, January 2009

SimCorp

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Journal of applied iT and inveSTmenT managemenT

CoST per Trade and STp benChmarking

by Jeremy Smith, head of Z/Yen Benchmarking, mcLagan [Z/Yen]

most non-financial services industries have longstanding measurements of efficiency, from profitability in sawmills in the uS (pwC) to cost benchmarking for mobile phone operators in europe (aT kearney). however, formal efficiency measurement in wholesale financial markets is much less developed.

There are a number of key reasons for this:

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• The continual evolution of financial products makes year-on-year comparison difficult; • Usage of different technology platforms (both internal and external) leads to incompatible process flows; • The banks themselves have traditionally focused more on driving business forward than on back office processing metrics. however, there have been a number of initiatives in recent years to measure back office efficiency and banks have begun to take cost and efficiency benchmarking seriously. This paper outlines the mclagan Z/yen approach to cost and efficiency benchmarking in the back office and sets out two case studies where banks have used both technology and process re-engineering to reduce cost per trade.

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inTernaTional fundS and fund managemenT Survey

This kpmg survey is a unique, thorough, and authoritative point of reference for financial services companies that market investment funds and hedge funds around the world. This year’s survey is being released at a time of great turmoil and uncertainty in the industry. asset values are falling and the number of funds is contracting. however, such circumstances also give rise to new opportunities and robust organisations may benefit. one certain consequence of this turmoil is more intrusive regulation at all levels in the future. Therefore having access to up-to-date information on taxation and regulation has never been more important. international funds and fund management survey http://www.kpmg.com/global/issuesandinsights/articlesandpublications/pages/funds-and-fundmanagement.aspx kpmg, april 2009

eXeCuTion CoST managemenT: improving marginS, STrengThening relaTionShipS

by matthew S. Simon, Analyst, Tabb group

Cost per Trade and STp benchmarking http://www.poweringposttrade.net/Cost%20per%20Trade%20and%20STp%20benchmarking.pdf mclagan [Z/yen], 27 pages, June 2009

“while it is a broker’s fiduciary responsibility to approach every venue necessary to achieve best execution for their clients, they also have the right to manage the costs of fulfilling their obligation,” writes author matthew Simon. This report investigates the proposition that, “brokers who achieve best execution at the lowest possible cost can improve the margins on their execution business, and offer more competitive rates to capture additional market share.”

2008 ifrS Survey: where are we Today?

execution Cost management: improving margins, Strengthening relationships http://www.tabbgroup.com/publicationdetail.aspx?publicationid=446 Tabb group, march 2009

given the impending move to ifrSs (international financial reporting Standards) in the united States, deloitte surveyed senior finance professionals of u.S. companies on ifrS issues. The primary goal of the survey was to ascertain u.S. companies’ level of awareness about and interest in ifrSs. This report presents the survey results and analysis, addressing a variety of ifrS topics, including:

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• Companies that would consider adopting IFRSs for U.S. reporting purposes, if given the choice by the SeC; • The expected IFRS adoption date by U.S. issuers in general; • The timeframe of potential IFRS adoption; • O verall familiarity with IFRSs and general visibility over local or statutory reporting; • Potential obstacles to IFRS adoption.

porTfolio deCiSionS and Trading: aligning eXeCuTion To inveSTmenT needS

by matthew S. Simon, Analyst, Tabb group

matthew Simon the author of this second Tabb group report introduces his theme by writing, “from traditional mutual fund and hedge fund companies to the largest of broker-dealers and the retail investor, the goal is universal: to find the right portfolio mix and maximize returns for an appropriate level of risk. even when the change in a portfolio is the closing of a single position and the opening of another, that change is made in the context of the rest of the holdings. whether the investment decision stems from a rate cut or an index rebalancing, the goal is to improve the return of the portfolio.” no surprises this far then. but this report goes on to discuss alternative trading systems and technologies that are being developed to the ultimate good of the client. portfolio decisions and Trading: aligning execution to investment needs http://www.tabbgroup.com/publicationdetail.aspx?publicationid=431&menuid=14&parentmenui d=2&pageid=9 Tabb group, January 2009

operaTional riSk managemenT in The nordiC finanCial SeCTor

by Vishal Dugar, Cognizant Technology Solutions

This article concludes that nordic institutions have done a ‘decent’ job of addressing issues of operational risk, despite the fact that there are no ‘apparent returns’ linked to it.

The author examines the way operational risk is handled by the nordic financial sector from a number of angles. he says that they should continue to invest in operational risk management as business in the region increases and transactions become more complex.

2008 ifrS Survey: where are we Today? http://www.deloitte.com/dtt/article/0,1002,sid%253d177677%2526cid%253d207229,00.html deloitte, 20 pages, may 2008

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operational risk management in the nordic financial sector http://www.gtnews.com/article/7608.cfm gTnews, 12 may 2009

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inTelligenT riSk managemenT & ComplianCe CoST reduCTion although spending on risk management and compliance has spiralled over the last several years, the full value of this investment has yet to be reaped. This report from pricewaterhouseCoopers is about creating a sustainable risk and compliance organisation while reducing inefficiency and improving effectiveness.

The report suggests that cost savings can be made in the areas of risk management and compliance, especially in the more tightly regulated more risk-conscious, postcrisis environment, counterintuitive though this may be. Successful companies, this report concludes, are those where senior management is prepared to adapt to change, take tough decisions and articulate those decisions to employees, the board and the regulators. intelligent risk management & Compliance Cost reduction http://www.pwc.com/extweb/pwcpublications.nsf/docid/56e86742C884da25852574e9007eCadb pricewaterhouseCoopers, 25 pages, 2008

mitigate risk

reduce cost

enable growth

simcorp is a leading provider of highly specialised software and financial know-how for the financial sector. established in 1971, with approximately 1,000 employees, simcorp is listed on the nasdaQ omX copenhagen a/s. the simcorp system, simcorp dimension, is sold, implemented and supported by the head office in copenhagen and subsidiaries and branches in amsterdam, brussels, Frankfurt, helsinki, hong kong, kiev, london, los angeles, munich, new York, oslo, Paris, singapore, stockholm, sydney, toronto, Vienna and Zurich. www.simcorp.com