THE NEXT BANKING CRISIS? TOO ENTANGLED TO FAIL…

Posted on : 29-10-2015 | By : Jack.Rawden | In : Finance

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Many miles of newsprint (& billions of pixels) have been generated discussing the reasons for the near collapse of the financial systems in 2008. One of the main reasons cited was that each of the ‘mega’ banks had such a large influence on the market that they were too big to fail, a crash of one could destroy the entire banking universe.

Although the underlying issues still exist; there are a small number of huge banking organisations, vast amounts of time and legislation has been focused on reducing the risks of these banks by forcing them to hoard capital to reduce the external impact of failure. An unintended consequence of this has been that banks are less likely to lend so constricting firms ability to grow and so slowing the recovery but that’s a different story.

We think, the focus on capital provisions and risk management, although positive, does not address the fundamental issues. The banking system is so interlinked and entwined that one part failing can still bring the whole system down.

Huge volumes of capital is being moved round on a daily basis and there are trillions of dollars ‘in flight’ at any one time. Most of this is passing between banks or divisions of banks. One of the reasons for the UK part of Lehman’s collapse was that it sent billions of dollars (used to settle the next days’ obligations) back to New York each night. On the morning of 15th September 2008 the money did not come back from the US and the company shut down. The intraday flow of capital is one of the potential failure points with the current systems.

Money goes from one trading organisation in return for shares, bonds, derivatives, FX but the process is not instant and there are usually other organisations involved in the process and the money and/or securities are often in the possession of different organisations in that process.

This “Counterparty Risk” is now one of the areas that banks and regulators are focussing in on. What would happen if a bank performing an FX transaction on behalf of a hedge fund stopped trading. Where would the money go? Who would own it and, as importantly, how long would it take for the true owner to get it back. The other side of the transaction would still be in flight and so where would the shares/bonds go? Assessing the risk of a counterparty defaulting whilst ensuring the trading business continues is a finely balanced tightrope walk for banks and other trading firms.

So how do organisations and governments protect against this potential ‘deadly embrace’?

Know your counterparty; this has always been important and is a standard part of any due diligence for trading organisations, what is as important is;

Know the route and the intermediaries involved; companies need as much knowledge of the flow of money, collateral and securities as they do for the end points. How are the transactions being routed and who holds the trade at any point in time. Some of these flows will only pause for seconds with one firm but there is always a risk of breakdown or failure of an organisation so ‘knowing the flow’ is as important as knowing the client.

Know the regulations; of course trading organisations spend time & understand the regulatory framework but in cross-border transactions especially, there can be gaps, overlaps and multiple interpretations of these regulations with each country or trade body having different interpretation of the rules. Highlighting these and having a clear understanding of the impact and process ahead of an issue is vital.

Understanding the impact of timing and time zones; trade flows generally can run 24 hours a day but markets are not always open in all regions so money or securities can get held up in unexpected places. Again making sure there are processes in place to overcome these snags and delays along the way are critical.

Trading is getting more complex, more international, more regulated and faster. All these present different challenges to trading firms and their IT departments. We have seen some exciting and innovative projects with some of our clients and we are looking forward to helping others with the implementation of systems and processes to keep the trading wheels oiled…

What Tech companies can learn from Banks – There’s no such thing as a free lunch.

Posted on : 23-12-2013 | By : richard.gale | In : Finance, Innovation

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Rewind to the 1990’s 

In the early ’90s I moved from a Californian software start-up to a venerable merchant bank in the City. There were a number of changes in culture, which included being admonished for not wearing a jacket when walking through reception, but most thrilling was the staff restaurant…. It was free and you could eat as much as you like. I couldn’t believe my luck! Older hands complained that they could no longer have a glass or two of wine with lunch (also free) and that the breakfasts ‘weren’t like they used to be’. I was amazed that the bank could afford to give away so much and munched my way through most of the decade there.

Banking Innovation

Apart from the impact on my waistline it was an exciting time. Historically, banking had been a straightforward affair, but now there was ever increasing demand for new, innovative financial services and the profitability of these could be immense. I worked with the derivatives team for a while and they made huge amounts of money creating & selling bonds to allow exposure to emerging stock markets. These securities were complex and an increasing number of mathematical wizards and PhD’s came into the department attracted by the dual carrots that banking was becoming fun & fashionable (again) and vast quantities of money delivered in bonuses.

Complexity

As more rivals joined the market the products became more complex and I, for one, soon lost the ability to work out what the underlying securities & risks were. I’m sure the clients had a better understanding than me but was not always convinced.

The drive for new and more exotic products accelerated and the intake of post-doctorates rose further. There were a number on the team that really were ‘rocket scientists’… The bank was increasing sales and profitability through the creation and trading of these products and everything was good.

Financial services firms moved into new sectors they may not have had the same level of expertise in which resulted in varying degrees of success.

Concentration

As the demand for products grew and the supply of brain power was limited the inevitable happened and the price of skilled product innovators and traders went up. Also there were a significant number of acquisitions where global banks bought companies or teams with the lure of huge bonuses. This led to the concentration of skills within a small number of large organisations.

Costs

In addition to the high price of the Rainmakers, the cost of settling, accounting and monitoring the trades was rising. Small departments that could rely on shared knowledge (and a degree of shouting) became too large and compliance forced separation of roles (particularly after the Baring’s affair). This resulted in a much increased level of fixed people costs for the banks which was fine when business was growing but a heavy burden if the growth slowed as it was difficult to reduce the number of people without the processes failing.

Over-stretched

It is probably fair to say that a number of financial services firms over-stretched themselves financially and some of them both legally & morally too in pursuit of continued profitability & growth.

The now global complex web of front/back office interactions, teams of people trading and ensuring successful completion of trades, needed to be fed with even more new types of products. Some of these (such as sliced & diced packages of mortgage backed security derivatives) contributed to the banking crisis of 2008. Over ambitious expansion plans through acquisition & merger increased unwise leverage further.

Lessons learnt

Financial Services are now one of the most highly regulated and controlled industries in the world. The cost of doing business is extremely high as reflected in the large amounts of money being spent of regulatory and compliance projects. This is resulting in a smaller number of larger organisations running most of the global banking sector with reduced opportunities and, perhaps, less  inclination to be innovative.

 

Fast-forward to now

 

Tech companies are massively innovative with new and exciting products emerging all the time

Technology products are the most exciting and most accessible they have ever been.

Tech companies can be immensely valuable and command huge stock market valuations

Too many to mention here… Google, Facebook, Twitter, Amazon, anything new etc.

Tech companies have virtually unlimited amounts of money available to them.

Tech companies attract the top talent

Tech companies are fashionable, can pay well and have the additional attraction of huge bonuses in the form of share options.

 How these applications work is  a mystery to the average consumer

We use, buy and promote products often without understanding or even caring about where our data is going because they make our lives easier or more fun.

 There are a small number of large companies dominating the market

Any small innovative company is snapped up by one of the global giants, they have very deep  pockets and price is almost irrelevant to them over market share.

Costs are increasing

The older more established firms (Microsoft, Oracle etc) have large cost bases which is impacting their ability to innovate and also results in a lot of hungry mouths to feed which can eat into money potentially better used elsewhere such as R&D. ‘Newer’ Tech firms may not have reached that but will sometime soon (Google employees have increased from 20,000 in 2010 to 50,000+ in 2013). Not all of those can be working on front-line product innovation.

Tech companies provide free lunch

Most technology companies are desperate to retain their valuable staff so provide many mechanisms to do this; free massages, childcare & lunches. I have been reliably informed that Google provide an unlimited buffet in their London campus including lobster…

 

When will technology companies stop serving free lunches?

The Technology sector is part way through a sustained boom. How long it will last for is anyone’s guess but it would be good to think that the leaders of these companies can learn from the past and the mistakes made by some of the banks. If they think about how they are growing, what areas they are getting into, how well do they understand the products and risks, what impact does it have on the agility and complexity of their business and how can they prevent a drift towards complacency? How to stay aligned to the interests of your customers whilst continuing to remain profitable for the interests of your shareholders – it’s a difficult challenge when high levels of growth have been the norm.

If Tech companies do not recognise this and change then living up to those company slogans may get harder as employee numbers swell and profits get squeezed.

 

The next Banking crisis? Too entangled to fail…

Posted on : 30-10-2013 | By : richard.gale | In : Finance

Tags: , , , , , , , , , , ,

0

Many miles of newsprint (& billions of pixels) have been generated discussing the reasons for the near collapse of the financial systems in 2008. One of the main reasons cited was that each of the ‘mega’ banks had such a large influence on the market that they were too big to fail, a crash of one could destroy the entire banking universe.

Although the underlying issues still exist; there are a small number of huge banking organisations, vast amounts of time and legislation has been focused on reducing the risks of these banks by forcing them to hoard capital to reduce the external impact of failure. An unintended consequence of this has been that banks are less likely to lend so constricting firms ability to grow and so slowing the recovery but that’s a different story.

We think, the focus on capital provisions and risk management, although positive, does not address the fundamental issues. The banking system is so interlinked and entwined that one part failing can still bring the whole system down.

Huge volumes of capital is being moved round on a daily basis and there are trillions of dollars ‘in flight’ at any one time. Most of this is passing between banks or divisions of banks. One of the reasons for the UK part of Lehman’s collapse was that it sent billions of dollars (used to settle the next days’ obligations) back to New York each night. On the morning of 15th September 2008 the money did not come back from the US and the company shut down. The intraday flow of capital is one of the potential failure points with the current systems.

Money goes from one trading organisation in return for shares, bonds, derivatives, FX but the process is not instant and there are usually other organisations involved in the process and the money and/or securities are often in the possession of different organisations in that process.

This “Counterparty Risk” is now one of the areas that banks and regulators are focussing in on. What would happen if a bank performing an FX transaction on behalf of a hedge fund stopped trading. Where would the money go? Who would own it and, as importantly, how long would it take for the true owner to get it back. The other side of the transaction would still be in flight and so where would the shares/bonds go? Assessing the risk of a counterparty defaulting whilst ensuring the trading business continues is a finely balanced tightrope walk for banks and other trading firms.

So how do organisations and governments protect against this potential ‘deadly embrace’?

Know your counterparty; this has always been important and is a standard part of any due diligence for trading organisations, what is as important is;

Know the route and the intermediaries involved; companies need as much knowledge of the flow of money, collateral and securities as they do for the end points. How are the transactions being routed and who holds the trade at any point in time. Some of these flows will only pause for seconds with one firm but there is always a risk of breakdown or failure of an organisation so ‘knowing the flow’ is as important as knowing the client.

Know the regulations; of course trading organisations spend time & understand the regulatory framework but in cross-border transactions especially, there can be gaps, overlaps and multiple interpretations of these regulations with each country or trade body having different interpretation of the rules. Highlighting these and having a clear understanding of the impact and process ahead of an issue is vital.

Understanding the impact of timing and time zones; trade flows generally can run 24 hours a day but markets are not always open in all regions so money or securities can get held up in unexpected places. Again making sure there are processes in place to overcome these snags and delays along the way are critical.

Trading is getting more complex, more international, more regulated and faster. All these present different challenges to trading firms and their IT departments. We have seen some exciting and innovative projects with some of our clients and we are looking forward to helping others with the implementation of systems and processes to keep the trading wheels oiled…

Too big to fail…or too big to succeed?

Posted on : 30-11-2012 | By : jo.rose | In : Finance

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In a recent blog we touched on what the future might hold for retail banking and some of the challenges facing them that have been played out in the open around brand and reputation, plus how potential new entrants could disrupt their traditional business model.

This month we thought we’d explore a little more the “legacy” that is inherent within the larger financial services organisations, specifically from the angle of the infrastructure cost burden that banks carry with them.

Most firms realised a while ago that their ratio of back-office to front-office expenses had become imbalanced or needed to be addressed. Years of growth, increases in business applications, product complexity and acquisition have added layers of cost elements. Of course, application and infrastructure consolidation is mooted along the way, but is often not executed.

Consequently, cost savings initiatives and operational efficiency have been part of the objectives of technology departments for many years (10 plus for some). Operating models have been modified, organisations have been de-layered, contracts consolidated, software and hardware standardised, development work best-shored, operations departments moved to Eastern Europe, infrastructure outsourced, contingent workforce rates reduced etc…

This is all good stuff, but one question remains (particularly if you’ve been a front office, revenue generating, observer during this period)…Are we going to run out of time?

It’s a serious question and one which we think is valid to ask against the new technology landscape. Let’s explore a few (maybe uncomfortable) points.

  • Could (or should) more have been done at a faster pace over the years? Financial services technology departments have always been a cost centre/enabler and therefore demonstrating tangible benefits through driving operating efficiencies has been a good way (sometimes the only way) to demonstrate value. So with technology leaders building careers around this, it’s good to “hold some cards in the hand” for next years’ bonus, right?
  • A second point is around the size and scale of the infrastructures within the big banks. With this complexity building up over many years is it just too big to fix or make competitive? Technology leaders will measure against their peers in terms of delivery and efficiency, but is that actually the problem? The oil tanker analogy is often used and yes, there’s a lot of hull to turn, but should we not be issuing the abandon ship order in favour of a more nimble vessel?
  • Lastly, what about the operational resourcing. Whilst sourcing models have changed and target ratios of perm to contract tinkered with, how often is the question of really matching demand to supply looked into? Or measure productivity and shift unused resource capacity based on peaks in demand? It’s not easy, but perhaps more could be done. Indeed, whilst pointing to reductions in workforce in a measure of driving down costs it often detracts from the still substantial size of the remaining organisation.

Again, it’s a difficult problem solve but the risk is that there is a positive answer to the question of running out of time. Are we simply been delaying the inevitable…a death by a thousand cuts?

Part of the problem is that for a large percentage of retail customers what they need now in terms of banking has changed significantly. We know that online/digital is where most customers want to transact and the more complex branch based services and advice is declining.

Some banks are adjusting their services portfolios to address this, such as Swedbank who recently announced completely hiving off its digital banking operations into a separate business entity. A recent Telegraph article also talked about the importance of improving online services in order to retain customers, with a third citing frustration with the current offerings. And then there’s the new generation who most likely will have a completely fresh set of banking needs.

So there’s a lot that needs to be done in order to retain customers, stay competitive and at the same time tackle the legacy and at the same time keep an eye out for new entrants, with more lean online services and no “baggage”.

But its not all doom and gloom. Ironically, it could be that the ability to absorb the infrastructure requirements of increased banking regulation might actually deter competition…