 Steve Matthews
Chief Operating Officer
There is no doubt that today’s markets are in panic mode. Extreme volatility, record losses and debate over the regulatory shake-out are enough to send any company, financial or not, into a cost-cutting mindset. The market events that we’ve witnessed over the past year and a half fell outside any predictions, even “worst-case scenario” models, causing investors and traders to lose confidence in the financial system.
Firms have entered survival mode with a tactical focus on cost reduction. In fact, a recent poll by ISITC showed that 69% consider reduced IT budgets as having the biggest impact on their firms as a result of the current financial crisis. The industry is suffering from post-traumatic stress syndrome and it won’t be until we enter the analytical phase of this crisis many years down the line where it will be clear as to where our priorities should have been allocated, particularly when it comes to cost cutting versus investing in shoring up infrastructure and risk mitigation.
When organizations go into crisis-mode, it is normal and expected that paring down spending be a top priority. For the financial services industry, the often logical place to prioritize savings is in areas that don’t help the firm make any money. Infrastructure and operations are often subject to early slash ‘n burn strategies to salvage balance sheets and bring a company back into black.
However, in today’s marketplace, non-revenue generating areas of business are no less critical than trading desks. With eyes sharply on all things risk-management, it is time for the industry to stop knee-jerking to do away with investing in operational infrastructures and the staff associated with such critical areas of business, and yet the headlines are starting to heat up with stories of massive layoffs in banks’ and brokers’ middle and back offices. Morgan Stanley and RBS are a few of the latest and certainly won’t be the last firms to announce cut-backs. Such actions are looked at as cost-saving measures that trim the fat of non-critical areas of business, when in reality it equates to taking away the concrete foundation that holds up a house. All we are left to do is wait for it to crumble.
Firms must ensure that resources supporting risk mitigation, infrastructure and operations are firmly engrained as part of a firm’s overall business strategy rather than an afterthought. Senior executives need to be more involved to see which business strategies are being pursued to ensure that the operational and risk management strategies support and contribute to achieving those business objectives.
Providing appropriate visibility and actionable management reporting on the sources of risk is something every firm can pursue. Transparency on positions and the relationships with counterparties is a fundamental element. Provided these technologies are being deployed with tangible business strategies in mind, and not as a science experiment, they can be useful in turning data into useful decision making tools.
It is impossible to put a price on the prevention of failures. It’s like looking for a return on investment of buying auto insurance. After a year without any accidents would you conclude that insurance has no ROI and cancel your policy? Institutions have no choice but to invest in risk management functions and evaluate their success through regular audits and monitoring.
Managing counterparty risk and improving collateral management has to be a priority. The speed at which a counterparty can implode such as with Lehman Brothers or the economy of Iceland, combined with the opacity of many OTC instruments means that one of the biggest risks in today’s market is the lack of clarity about what risks exist – and who is vulnerable. And yet, these are the areas most vulnerable when it comes time to cut costs.
Investment made in processes that improve the identification and management of market, counterparty credit and operational risk, particularly in OTC derivative transactions will better equip firms to use leverage to generate returns. As more products become eligible for clearing, massive investments will be required to interface and interact with the risk management systems of central counterparties. Since it will not be feasible to clear all products it is important to prioritize investment in systems to monitor and manage bilateral credit risks. Astute firms will move the frequency of counterparty exposure monitoring from a monthly to a daily basis and factor in exposure created by new security types and transactions in the calculation of overall exposures.
It is critical for institutions to take inventory of all risks in their business including, market, counterparty, credit, legal and operational risk. Firms should focus on valuation risks posed by structured products and risks created by excessive leverage, concentrate on how to protect themselves against the default of a counterparty and the appropriate infrastructure to be more proactive in tracking credit risk. Identifying and managing these risks should be a priority and the automation of operational processes has an important role to play in this.
Such focus requires investment rather than cost-cutting. In fact, the ISITC poll highlights that the industry agrees. The survey found that the first priority identified by respondents for their firms is operational risk management, then cost reduction and increasing efficiency to meet client needs.
Operational risk management does not necessitate spending on large, monolithic, multi-year projects that are often associated with investment in infrastructure, risk mitigation and operations. A careful analysis of the requirements of the business strategy can help firms prioritize how to control, record, value and manage exposures. This is a pragmatic way to emerging from panic mode and prepare for future success and must be embraced if we’re to avoid further deepening of the current economic crisis.
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