Final net loss that this integrated database, linked to advanced modelling tools, can help make investing less risky. It will most likely be a complex and expensive project to set up, mainly because of the complexity and size of the data collected. See Table 7.1.
The formation of a complex loss database is a knowledge management structure that we are actively constructing. It requires a lot of data and system integration to link the disparate elements in a global bank. Some call this risk management system a "data warehouse" where information is packaged into one compatible format for analysis (see Enterprise application integration - EAI). The benefits are the harnessing of market intelligence to understand: who, when, how and how much money has been lost. Then, we can reinforce risk management procedures to avoid such a loss recurring, or to reduce the loss when the hazard strikes again.
CASE STUDY: ALGORITHMICS SYSTEM IN A BANK6
Bayerische Landesbank uses Algorithmics' Algo Collateral to manage its current and future cross-product margining requirements. BayernLB uses Algorithmics to update its trading limit systems with intra-day collateral balances. A banking regulatory data warehouse is then updated with capital requirements and collateral trade costs. Algorithmics Collateral also checks for valuation discrepancies and monitors data changes. Such systems perform various essential functions, namely:
• valuation modelling
• regulatory compliance.
Getting to the concrete system stage is putting everything from theory into practice. The IT task sequence is relatively simple in theory, but complex in execution.
1) Deal capture data must be collected in a timely manner from the simple trading ticket upwards throughout various application systems.
2) Standardise or pre-process the data into an acceptable and usable format. This can be done using enterprise application integration (EAI).
3) Transfer into another application system - in this case the risk management system.
4) Analyse and distribute output and reports to relevant systems and departments.
6 Algorithmics, www.algorithmics.com, October 2CC2.
Once the system design is successfully implemented, it has the potential to offer specific competitive advantage to the business. These have functional benefits of risk modelling analysis, risk monitoring, procedural alerts and regulatory compliance. IT systems used by experienced staff can reduce the risk exposure in bank portfolios successfully and cut down losses.
Integration and straight-through processing (STP)
STP would help us reduce losses where the buy and sell orders are either mismatched or lost. STP can reconcile trades and place them in accounts automatically by software packages. It would be admirable to have fast turnaround and cut down mistakes on trades. Trade processing errors can be costly, and they can be cut out using STP. Exceptions are costly; automating exceptions when processing trades can reduce costs by 25 %. Yet only 30 % of 500 financial institutions surveyed have fully automated exception reporting.7 STP will help us detect errors within our bank or fund, but will STP ever be implemented?
STP is the ideal sold by many systems vendors. But, in the real world where a front office may have a 100 IT systems and subsystems, STP may be part of the Holy Grail. The prospect of no accounting errors or orders mismatches is not borne out by reality. If an accounting error creeps in, how are we to flag it or reconcile it? It would be wishful thinking to wave a magic wand over the risk elements of fraud, mismatched orders and operations mistakes.
The idea of STP (see Figure 7.1) convey seamless processing between all three stages or departments, without any hitches or significant delays. There is no universal IT package that will fulfil all functions in the front, middle and back office.
Reality offers that one system vendor will eventually be called into the bank or fund and be instructed to connect its new system to all the existing legacy systems. This means that we are looking at a reduction of the number of IT systems and subsystems instead of an agglomeration under one "Big Brother" system. A bank may think of buying a "vanilla" IT package, but they really come in many different flavours.
The systems market is diminishing with the cut-backs in financial institution expenditure and more banking M&A. This means further cuts in the choice of systems suppliers. Choose one that survives.
Algorithmics, Barra, Sungard, eRisk, Pareto et al. are financial system vendors that offer "risk management" systems in one form or another. A web trawl can reveal a hundred names or more for systems providers. All systems suppliers write one IT system and hope to resell
7 Exceptional Progress: STP, Exception Management, Sungard, November 2GG2.
it many times. Their profits lie in amending previously written systems, not in tailoring each one from scratch for each customer. They are the greatest recyclers of our time.
For example, Reuters, Barra or Sungard should stress that there is no bog-standard "one-size fits all" package. Theirs is an adaptable systems tool-kit backed by a bespoke consultancy service that includes tailoring to the business and portfolio of the specific bank or fund manager. A company may buy a systems package with a fixed price, but have to add 300 % for the amendments, project implementation and support services.8 Even then, project success is not guaranteed in any way.
Numerous cases of cancelled or failed IT projects in the finance industry happen on an alarming scale. Many within the banking world are unreported because of reputation risk, i.e. risk of losing clients or looking foolish in front of rivals. There are four major reasons for IT systems failure:
• The risk management system was initially unsuitable for the bank or fund and could not be successfully tailored for use.
• The skills base of the business project implementation was not properly understood or resourced.
• Organisational politics or budgetary problems hindered progress.
• Operational errors or poor systems design ruined chances of success.
CASE STUDY: IT OVERLOAD
Intelligent technology is programmed and managed by people, so there is a lot of room for human error. IT systems failure (freeze or black-out) is one of the most well-known disasters under the operational risk category. The London Stock Exchange trading system fell down in 2000 because it could not cope with the load of processing traffic. Its IT system facility was managed by Arthur Andersen. The New York Stock Exchange had to install trading "breaker circuits" to stop the unusually high volume of programmed trades crashing the dealing system.
Spectacular IT collapses in traffic happened because of human-organised hardware or software problems. These can be "directed" or "undirected". The notable hacker or virus attacks are sent to specific destinations such as trading rooms. An electricity supply overload, flooding or short-circuitry in the computer room, or a drill piercing a telecoms cable in the street - all man-made. From personal experience in banking, all have happened to us - they could happen to you.
Disasters and system disruption arise from a variety of hazards:9
• 56 % failure in hardware, software, telecoms, power.
• 24 % natural disaster: fire, flood, earthquake.
• 20 % malicious intent, including September 11th.
All of these IT threats can be managed or mitigated, not eliminated.
8 Delivering on your e-Promise: Managing e-Business Projects, Y.Y. Chong, Financial Times Management, 2GG1.
9 "White Paper on Sound Practices to Strengthen the US Financial System", Sungard, December 2GG2.
A company's best move may involve buying in an IT vendor's outsourced risk management services. IT systems and services have been outsourced for many years now. Risk management services in the financial sector have generally involved external outsourced vendor systems and experts. But, value-added services rely upon the deep understanding of the specific business in question. The implementation of key risk management systems bought for the bank and adapted from insurance initially sounds fine; delivery can be something else. Tailoring it for retail banking uses can spell a disaster, it need not be cost-effective in time or money.
Successful risk management initiatives must come from the directors at the strategic planning level. Incremental addition of risk management systems or procedures may prop up the business weaknesses, but they may not cure the structural illness of the organisation. The Barings and AIB disasters showed that the directors either did not understand the target banking business, or were not too bothered to monitor real performance.
A global enterprise dealing in several foreign exchanges requires a central resource for effective internal corporate control. Otherwise, you end up with different divisions in parts of the world with varying standards of business operation and risk. One of these enterprises could have a business failure that could bring down the whole corporation. A survey of US directors revealed:
• 43 % of company directors cannot identify, plan for, or safeguard against risk.
• 36 % do not understand major risks facing the company.10
Companies that identify, plan and manage risk reap large potential business rewards. A basic view of corporate wealth formation, and risk horizons, is that it is created by the:
1. Directors' strategic leadership planning (long term) ^
2. Traders or fund managers' profit from tactical market moves (short term)
3. Risk management systems in place and effective (short to medium term) +
4. Portfolio or assets of company appreciate in value (long term).
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