An Emerging ’New Science’

The latest study from the Basel Committee on Banking Supervision shows that financial institutions will face a 10 percent increase in capital requirements to cover operational risks under the new Basel II proposals. That increase could reach 15 percent for smaller, specialized institutions which perform activities such as asset management and custody.

"Operational risk is a big concern for everybody," says Guillermo Kopp, an analyst at Massachusetts-based TowerGroup. "If a company was to do nothing but stay like they are, they will have a 10 percent increase in capital reserves because of the new provisions and the cost of operational risk. That provides a big enticement for companies to take action now."

The impact study is part of the work being done to prepare financial institutions for the Basel Capital Accord expected to be in place by the start of 2007, as part of an initiative by the Banking for International Settlements (BIS). It wants financial institutions to get a better handle on three types of risk within their enterprise - capital, market and operational - with an eye on better managing capital reserves.

A new consultative document from BIS proposes that the agreement will apply to internationally active banks and their relevant financial activities, which could include portfolio management, investment advisory and safekeeping services.

It is expected that the accord will cover the 12-20 top internationally active banks, including firms like JPMorgan Chase & Co., Citicorp and Banc of America, which have large securities divisions.

3-2-1 Impact

Regulators in home jurisdictions will be responsible for developing the rules to implement the accord and experts say it will have broad business, technological and regulatory impact across the capital markets for a variety of reasons.

The jockeying has already begun, says Andrew Wilson, risk-management partner in the financial-services practice at Accenture in New York. He says that financial institutions are busy lobbying Congress, the Office of the Comptroller of the Currency and the Federal Reserve Board to make sure that the rules are "correctly shaped and U.S. institutions won't be put at a disadvantage. The Europeans are trying to do the same with their national regulators."

Dean Jovic, group-management director for SunGard Trading and Risk Systems in Bern, Switzerland, says, "Basel II puts banks and their securities operations under new regulation. It makes a huge difference. It will have a competitive impact on certain institutions."

The heart of the accord, which focuses on risk, and the recent qualitative-impact study (QIS3) released May 5, 2003 has some "pretty interesting stuff in there," Jovic notes.

First of note is the size of the study. It included 365 banks from 43 countries, includes 188 banks from the G10 countries; such as the United States, France, Germany, Canada and the United Kingdom. The study didn't name the participating firms.

Rather, the banks are split into two groups. Group one includes large, diversified and internationally active banks, with tier one capital exceeding more than $3 billion (Euro). The second group is smaller and more specialized. The study assessed risk on a variety of models and approaches.

Peter Keppler, a senior analyst at research firm Financial Insights in Framingham, Mass., says the BIS is "in the final stretch of implementing this new capital accord. The QIS3 has shown that they needed to tweak some areas, for example operational risk management" and specialized lending areas.

"What's interesting about operational risk is that an institution that has concentrations in particular business areas will be allowed to implement different levels of sophistication in terms of the (risk) methodologies they apply to different business lines." So, in instances "where they may not have the practices or data-collection facilities in place" they can apply a different standard as "their sophistication is stepped up."

TowerGroup's Kopp says operational risk "has been the most neglected area of the three major risks" - credit, market and operational. As a result, it also provides the biggest area for improvement and the ability to reduce risk, which means ultimately reducing the need to reserve capital.

Weird Science

"You have to think of operational risk as a new science in its early stage," says Kopp. Now, firms simply assume they have risk and accept there will be losses for things like failed trades. However, he says, "It doesn't require rocket science" to reduce your operational risk from 10 to 7 percent. By investing a few million dollars in "driving operational-risk-management improvements through the use of technology," a firm can save twice that in the cost of the funds that they would have to set aside for capital reserves, he explains. "Plus, you would be reducing your losses. It's a no brainer. Why pay up more than you should? Why keep on losing money."

Accenture's Wilson says, "We tend to classify them as two types." First, there's the high-frequency and low-impact event with a relatively small dollar amount that adds up over time. Then there's the high-impact, low-frequency event, such as the Barings Bank collapse, which Wilson says was "a fundamental breakdown of the front-office and back-office responsibilities."

That's where technology comes into play. To reduce operational risk, a firm needs data. It needs to understand what is happening at all times throughout the organization.

Kopp says the big challenge is data integration and being able to pull everything together in real time and understanding the areas that are ripe for "controlling and mitigating losses."

Wilson says it's data classification and capture that are the main challenges, so analytics and storage technology will be key. He says that financial institutions, subject to Basel, have done a good job of building enterprise-wide data warehouses to help them assess credit risk. "Now, they are doing the same with operational risk" and firms, especially in Europe, are spending millions of Euros on data collection and aggregation technology to build enterprise data warehouses.

What will be important is ensuring consistency across the organization in building that historical pool of data upon which companies can do predictive modeling for dealing with the Basel Accord. He says firms need to avoid building competing data warehouses that don't integrate.

TowerGroup estimates that spending on risk management by financial institutions will rise to $21 billion by 2006, up 4 percent year-over-year from today.

On the other hand, some firms will be complacent and will do very little in terms of risk management, says Kopp. "They will stay with what they have. Their business results are not going to improve much and their ratings are going to stay basically the same or deteriorate," which makes it harder to raise capital, he adds.

At first blush, it could be argued that the accord creates an uneven playing field among those that have to comply and those that don't, giving the latter a competitive leg up. However, Wilson speculates that as compliant firms manage their risks, they will be able to lower their capital reserves. They may also discover they are better off trading with a compliant firm.

Large Wall Street players like Merrill Lynch already have sophisticated risk-analysis tools, he says, "So I don't think it would necessarily have a big impact on them. It's the mid-tier firms." As they're put under the "lens" by larger shops, Wilson says, they could find themselves on the outside looking in if Basel-complaint firms decide that there is too much risk dealing with mid-sized firms or small hedge funds.

Wilson says that Basel will not only impact external competition among firms, but will likely raise the internal heat as well. Firms will start examining their internal risk more carefully, which, he says, could have an impact on those with large-volume clearing and settlement operations. "Some of these large processing institutions ... are considered inherently risky businesses. We will see some changes."

Moreover, as firms examine their business lines, it could lead to a reallocation of capital. "For some businesses, it might be a good thing to get more capital than in the past," says Wilson. Other divisions will get cut back, impacting their ability to compete in their sector, he predicts.

Fallout

Moreover, even though Basel is geared at large diversified institutions, the fallout will have a far-reaching impact that other investment firms won't be able to avoid. Kopp says, "The fact that the securities commission hasn't taken an active stance on (Basel) doesn't mean that they won't" and he expects securities regulators will become more active on the risk-management front, possibly using Basel as a starting point.

Wilson notes that while European firms are focused on Basel, U.S. firms have had their attention focused on the Sarbannes-Oxley fallout and the Patriot's Act. However, that's not all bad. He notes that the initiatives are similar in nature, in that they are "driving more detail and more transparency. It implies a greater level of rigor."