Proactive Risk Management – New KPIs for a Dodd-Frank World

The financial crisis of 2007–2011 is driving widespread changes in the U.S regulatory system. Dodd-Frank Act addresses “too big to fail” problem by tightening capital requirements and supervision of large financial firms and hedge funds. It also creates an “orderly liquidation authority” so the government can wind down a failing institution without market chaos.

Financial institutions will be spending billions to strengthen, streamline and automate their recordkeeping, risk management KPIs and dashboard systems. The implications on Data Retention and Archiving, Disaster Recovery and Continuity Planning have been well covered. But leveraging Business Analytics to proactively and reactively manage/monitor risk and compliance is an emerging frontier.

We believe that Business Analytics and real-time data management are poised to play a huge role in regulating the next generation of risk and compliance management in Financial Services industry (FSI).  in this posting, we are going to examine the strategic and structural challenges, the dashboards and KPIs of interest that provide feedback, and what an effective execution roadmap needs to be for every organization.

The Financial Services Industry (FSI) – Overview

The FSI industry is composed of commercial and retail banking, exchanges, asset managers, credit card, mortgage companies, regulatory agencies, market data providers. This entire industry is being systematically reconfigured by regulation and emerging risk management trends.

Figure below illustrates the current FS landscape. A variety of levers that are being pulled to drive transformational change including: de-risk the balance sheet, fee revenue, trading risk management, operating efficiency, customers & products, and regulatory compliance.

Strategic Challenges facing Financial Services

Market changes and regulatory pressure from the Dodd-Frank Wall Street Reform and Consumer Protection Act is generating several strategic challenges for financial services.  These include:

1) Returning to consistent growth and profitability from the trauma of the global financial crisis

2) Increased regulatory oversight and requirements (more capital, more transparency)

• Enterprise-wide compliance with increasingly complex and diverse regulations

3) Increased focus on compliance, risk and risk mitigation

• Need for risk management to be an integral part of the business strategy, not an independent activity focused on loss

4) Industry consolidation and convergence

• Competing on price, customer service, marketing, and efficiency
• Operating in diverse, fragmented markets with different regulations and cultures
• Need to integrate multiple business models into a unified strategic focus

5) Changing population demographics

• Increased competition to retain and attract assets of a risk-averse aging population that has just experienced a historic drop in asset value

6) Complexity of financial instruments and markets

• High transparency, effective knowledge transfer, and collaboration from front to back office

Bottomline — Large financial services firms are already struggling to manage their petabyte data stores in a way that satisfies existing regulatory requirements.  With the changes outlined about, the data management problem becomes quite a large undertaking with reverberations across the application and infrastructure landscape.

Structural Challenges

The Dodd-Frank Act mandates ad number of significant changes that include improving regulatory reporting capabilities. Changes will need to be executed in a coordinated fashion across number of business units. Will require a well managed information flow across different business units, selling and execution platforms.

The factors that inhibit change include:

• Large institutions are a collection of widely diverse business lines:
• Each with their own customers, business models, processes, risks, skills, and cultures
• Each with their own legacy technologies
• Each with their own data (silos of information)
• Each producing significant amounts of data daily
• Operating globally in a highly regulated environment with unique fiduciary relationship with customers
• Demands of the core, mission critical transaction processing systems take priority
• BI projects are usually technology driven and focus on the data and creating the perfect DW
• Using BI is the responsibility of business units, not technology, and has historically been created and delivered under the direct control of the business unit

Bottomline – While the external pressure is building, firms also have to deal with internal structural and overhead issues.  They will need a focused program management structure to manage the transition.  

Dodd Frank KPI’s and Dashboards

Analytics are seen in all aspects of the enterprise – Front, Middle and Back-office.

Typical business and operational analytics in this sector include:  Investment analysis, market analytics, risk management, Basel II, CRM, performance management,   loan process management and others.   See the figure below for a list of KPIs.

Dashboards and KPIs tend to fall into the following categories:

• Effective de-risking of the balance sheet
• Spreads, yields, returns, Return On Risk-Adjusted Capital (RORAC)
• Funds transfer pricing
• Capital ratios, risk management
• Maximizing fee revenue
• Share of wallet, pricing, up-sell, cross-sell
• Marketing campaigns
• Improving operating efficiency
• Operating leverage, activity-based-costing
• Cost of incurring errors, fails, breaks
• Managing customers and products
• 360 view of customer, segmentation, targeted service
• Customer and product profitability
• Fulfilling regulatory requirements for Tier 1 capital ratios
• Dodd-Frank, Durbin Amendment,  Basel II

Dodd-Frank also has broad implications for hedge funds. It requires all large hedge fund advisers to register with the SEC. Also the new rules on derivatives trading have an additional monitoring and reporting implications for many hedge funds.

As shown in the figure below, the Act leaves many specifics up to the regulators (FDIC, SEC, Federal Reserve, Treasury and numerous other oversight agencies).  Considerable uncertainty remains about the exact form of the new rules and what needs to be reported. The main tradeoff is between the government’s desire to learn more about what is going on, both to assess systemic risk and to protect taxpayers, and the compliance costs this imposes on firms and shareholders.

Bottomline — Support for new regulations will force firms to not only acquire more data for enterprise risk management but also provide increased transparency into their data. Firms will spend millions annually on technology and people to facilitate the process of bringing in and integrating reference data.

Call to Action – Creating an Effective Risk Analytics and KPI Roadmap

So, what’s next? What are the steps in meeting the demands of the regulators and better manage risk? What needs to be done in a phased manner? Here are some steps to follow as you go about strengthening your current and ongoing readiness.

1) Establish a strong information management and governance strategy/policy

• Start by forming a working group to improve coordination among various segments of the organization
• Clarify issues and formulate strategies, and develop action plans
• Perform a gap analysis by determining areas affected by legislation; determine processes in place and those needed
• Avoid the pitfall of scoping the program too widely. Taking an overzealous view of information governance as it pertains to every bit of data across an entire organization can be dangerous to keeping a program on track.

2) Leverage existing data and business processes

• With Data Appliances, institutions can quickly deploy a BI solution across multiple data sources without waiting for the “perfect” DW to be created
• Rapid deployment within existing processes ensures high user adaption rates, quick return on investment, and all the benefits of an enterprise-quality BI application
• Improve timeliness, reduce complexity, and increase transparency of the typical reporting activities in financial institutions

3) Monitor positions and exposures in real time across asset classes

• Portfolios and investments can be valued in real time with alerts and reports generated based on business rules
• Counter-party exposures and specific asset exposures can be quickly aggregated across funds, investment vehicles
• Scale the amount of data and number of users

4) Bring information and analytics into the workflow for improved decision making and collaboration

• Seamless, operational BI is easily achieved by integrating any BI platform (e.g., SAP BusinessObjects) into existing portals or process front-ends
• Information and analytics required by the decision maker (e.g., credit delinquency processing) are delivered in business terms as part of the workflow

 5) Engage customers in the business processes

• Extranet reporting and analysis integrates the customer into the workflow improving efficiency, lowering cost, and customer engagement
• Ability to handle the scale of both data and customers, and security are key requirements
• A recent survey found that highly engaged customers are 5 times more likely to bring additional business to the institution

6) Integrate risk management throughout the enterprise

• Granular data collected for risk management and used for other functions ensures that risk is integral part of all activities
• Regulatory reporting using the risk management data creates transparency
• Customer engagement, attrition, cross-sell, and up-sell opportunities can be identified with data mining and segmentation analysis of the granular risk data

7) Improve returns with more transparent financial reporting

• Balance sheet reporting that links balances, rates, interest income, interest expense, and funds transfer pricing at the business and department level creates an understanding of the balance sheet value across the enterprise and strategic control of the value by management
• Transparency in funds transfer pricing calculations by being able to drill down to individual instruments is an important part of the business

Bottomline – The new risk and compliance management models requires a mix of accountability, transparency, integrity, protection, compliance, availability, retention and disposition.  This is a substantial multi-year transformation effort. 

• Passage of the Dodd–Frank Wall Street Reform and Consumer Protection Act = More government oversight and increased transparency
• Proliferation of counterparties due to the rise in Latin America, South America, and Asia markets
• Ongoing stress testing = Ongoing bank closures
• More capital reserves? Basel III?
• New risks Emerging – New electronic payment vehicles, changing demographics, new channels, globalization

It won’t be easy for leadership to change existing financial institutions.  To go from calcified corporate cultures that results in business units hoarding their own information in silos into one that embraces risk management, transparency, and governance as a collective cause is not going to be easy or painless. 

Other Sources

We are simply in the first inning of a long transformation cycle for Financial Institutions.  If you are looking for additional insights around business analytics for regulatory oversight, contact us.

• Alvarez & Marsal has developed a dedicated Dodd-Frank practice based on the work we have done at Lehman Brothers (the only real-world case study of Complex Financial Institution Orderly Liquidation and “Too Big to Fail”).  Creating “Living Wills”  is another area of A&M expertise.

• Dodd–Frank Wall Street Reform and Consumer Protection Act – signed into law July 21, 2010, spans more than 2,000 pages and targets everything from the stability of   banks to debit card fees to mortgages and credit cards to the derivatives market.

• See http://www.WoltersKluwerFS.com\info\doddfrank for a comprehensive  Dodd-Frank Resource Center.