New York — The dramatic changes that have been occurring in recent months are the beginning of a permanent restructuring of financial institutions and insurance entities.

We are entering a long-term environment where capital liquidity, lending criteria, and regulation will be much tighter. Most immediately, we are seeing one crisis after the next hit banks and insurance companies on the front lines of mortgage lending and capital markets activities. The secondary wave will involve the international financial intermediaries that provide capital, as well as state and federal regulators.

What do all these changes mean for banks and their technology initiatives?

Financial institutions have well-planned budgets, but during crises, organizations tend to freeze discretionary spending on technology. We should be cognizant that the issues facing many banks are crises of core capital — of survival, not a slower economy, softer demand for a particular product line, or a general need to cut expenses.

The American consumer did spur an economic expansion, but it did so through the perceived "wealth effect" of increasing home values and the discretionary use of credit. Consumer spending built a house of cards, endorsed by the U.S. banking system and by global capital markets.

As the economy continues to inch along with 1%-2% growth, risk is front and center across all facets of financial services, domestically and internationally. With the housing value correction and the payment stress on consumers in a slower economy, the global financial markets had a breach of trust from a risk perspective. This has produced the credit squeeze that institutions are feeling in their core mechanisms for funding growth. Many institutions are facing the reality of asset reallocation and further capital borrowing to fund consumer lending.

The credit crunch might not last forever, but the funding model has been changed materially forever. No longer will institutions enjoy free access to the capital markets for asset transformations. There will be increased scrutiny of assets and risk management, from the transaction level to companywide issues.

Increased regulatory oversight is certain. What is not yet determined is how far-reaching the new regulations will be.

Everyone preaches a desire to stem further government-sponsored "taxpayer bailouts" of institutions, owners, or groups of market participants. With a new, dynamic regulatory environment, vendors will be challenged to create new and improved solutions for data access, integrity, and security, predictive analytics, validation of business assumptions, and reporting efficiencies.

What is required now is partnerships among the industry, regulators, and lawmakers to ensure that new regulatory controls are effective at reducing risk in the long term and are not just short-term window-dressing to appease consumers and investors.

To put the situation into context, an historical perspective of industry changes over the past 35 years is helpful.

The concept of "too big to fail" did not exist in 1973. The U.S. financial industry was made up of regional players with fairly diversified balance sheets. Certainly, there were failures, but no single institution's failure could topple the industry as a whole.

In 1973, we did not have the expanse of secondary markets — the massive network of counterparty dependencies and derivative instruments — for just about any form of credit-based investment.

Up until the early 1980s most banking products and services (deposit accounts and mortgages) were highly regulated, as were the banking distribution channels (branches and early-stage ATMs). Commercial and investment banking were strictly separated, and bank holding companies were limited in their operating and investment activities.

Large institutions were vertically integrated — much different than the specialists that exist tod y. Lenders held most of their loans on their own books, reaping what they sowed from origination through servicing.

The forthcoming regulatory changes will consider enterprisewide risk issues, rather than looking for specific culprits for billions of unexpected losses. The financial services industry will be required to improve risk management at all levels of the business and to address many different forms of risk effectively. No longer will reviewing just the projected losses and cash flows associated with securitized pools be sufficient. The firm's strategy, culture, and tools for assessing, controlling, and monitoring risk will be fair game for regulators.

This paradigm shift in regulatory risk awareness will necessarily have to be adopted by domestic and global financial institutions. It goes beyond capital reserves and to the risk culture.

Vendors who provide the financial services industry with data, software, and intellectual property will have to be in alignment with the new risk culture created by regulators and imposed on institutions. vendors with the foresight to create offerings that address the evolved risk environment should realize new opportunities.

Timing for New Ground Rules
Treasury Secretary Henry Paulson's proposals address some of the lingering regulatory overlaps and gaps, such as merging the Office of Thrift Supervision into the Office of the Comptroller of the Currency and combining the Securities and Exchange Commission and the Commodity Futures Trading Commission.

Other new rules following the recent market volatility might include guidelines on short-selling by institutional traders, controlled fund redemptions by institutional investors, and a review of the procedures for ratings agencies to issue downgrades.

Institutional investors by sheer volume of trades can introduce instant volatility into a stock by shorting large blocks, which can cause an instantaneous downward price spiral. We have seen examples of funds beset with massive redemption orders from institutional investors, resulting in temporary fund closures. And ratings agencies hold the power through downgrades not only to issue a negative opinion of a company's outlook, but also to induce a liquidity crisis for the firm.

These are just a few examples of how certain actions have tangential consequences and produce market volatility. So many variables are subject to changing conditions (and "new" news) that anticipating a new set of regulatory entities and regulations has a limited value, similar to long-range scenario analysis.

Assessing the Impact

The regulatory infrastructure is going to change — the uncertainties over how much and where are subject to assumptions and the political lobbying process. For starters, the following things are worth incorporating into your planning process.

  • There is a high probability of the OTS combining with the OCC and the CFTC combining with the SEC.
  • There is also a high probability that the National Credit Union Administration will be absorbed. Look for the Federal Deposit Insurance Corp. to emerge as the single deposit insurance agency for all depository institutions.
  • Investment banks and brokers are in for a regulatory change, too. The reformulated SEC may have its role redefined to focus on regulating security instruments, distribution licensing, and public company reporting.
  • We are witnessing the emergence of superinstitutions such as Bank of America Corp., Citigroup Inc., and JPMorgan Chase & Co. The Federal Reserve Board's role of providing stability to the capital markets will mean an increased regulatory interest in these "too big to fail" institutions.
  • State and federal regulatory boundaries will be revisited. Expect the FDIC to be the regulatory hammer to produce a more consistent playing field between state and federal charters for insured depository institutions. Noninsured institutions will be another matter subject to intense debate.
  • Noninsured products, starting with mortgages, will be subject to the legislative equivalent of making sausage. The issue is policing and enforcing a national market with 50 sets of state laws. Licensing requirements and the need to audit/enforce them will add to the cost of doing business.
  • With an incoming administration, look for intense focus on the Fed and the Treasury Department during the first quarter. The next president might create a Cabinet-level position of "capital markets czar" to coordinate national economic strategy and create accountability between regulatory agencies and Congress.

Looking to the Future
The key technology decisions organizations will make over the next year will involve governance, risk management, and compliance.

Understanding portfolio risk and being able to communicate that effectively to directors, investors, and regulators will be a top priority. Business intelligence software, intellectual property, and hardware that powers risk management will get top investment prioritizations.

Organizations will also be looking at the consolidation of redundant processes such as loan origination, servicing, and collections. In uncertain times, vendors should consider cost and efficiencies as key differentiators. The ability to implement something quickly with minimal invasion of an organization becomes critical. Web-enabled, hosted solutions will gain priority over larger, installed applications.

Preparing for regulatory changes is not an area where banks usually choose to invest. However, well-prepared institutions will be able to make adjustments faster and will be better informed throughout the process. What makes this process so painful is that new revenues or lower costs are rarely, if ever, a potential outcome. In most cases, the opposite happens, especially regarding costs, which only go up.

Banks, thrifts, and credit unions are already facing much more rigorous examinations from their federal regulator. Suppliers, especially the core processing, risk management, and business intelligence ones, are likely indirect beneficiaries of this cycle, as institutions invest in compliance over the coming years.

Financial services firms need to re-evaluate their enterprise risk management programs and processes sooner rather than later. Is there a culture in place to look at risk across the organization? Are firms in a position to leverage their data to analyze dynamic financial and credit risks? Once assumptions are made, is the data and technology available to stress test assumptions and communicate findings to a changed regulatory audience?

Investments in enterprise risk management programs cannot be directly tied to any revenue from new markets, products, or expanded wallet share among existing customers, but they are insurance polices against potential catastrophic risk.

Vendors that are flexible will be better positioned to retain and attract clients.

Overborrowing by consumers, an economic slowdown, the bursting of the housing bubble, and credit tightening have formed a perfect financial storm. This storm will abate in two to three years, but only as trust is rebuilt with regulators and the capital markets and consumer confidence is restored. As regulation tightens and evolves, risk management practices in the financial services industry will also have to evolve, and vendors will have to meet them halfway.

Source: American Banker

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