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Financial institutions must prepare for new regulations, says risk expert
Feb 25 2011 Patricia Lee in Singapore

Risk transparency, investor protection, as well as capital market rules and IT infrastructure governance will take priority at financial institutions as they prepare for the onslaught of new regulations coming from the US and Europe, according to Philippe Carrel, a risk management and financial derivatives expert. Carrel, who is also executive director at Thomson Reuters Enterprise, made these observations during a keynote presentation on risk management and stress testing at a conference held in Singapore last week.

Carrel's observations were based primarily on the Dodd-Frank Act, which he said aimed to address consumer protection, systemic risk, "too big to fail", as well as Wall Street transparency and market control. He also took into account the Volcker rules, the derivatives rule and the new No. 4 ruling under Undertakings for Collective Investment in Transferable Securities Directives, which came into effect in July 2010, from among a host of recent regulatory changes.

Risk transparency

Risk transparency, he said, would take precedence for any financial institutions following the implementation of new regulations, particularly the Dodd-Frank Act, and would require them to carry out enterprise-wide risk aggregation. The risks, he said, could range from customer loans, trading book exposure to collaterals, tradable collaterals and tangible collaterals such as real estate and aeroplanes.

"When financial institutions are exposed to Basel III, central counterparty clearing for OTC derivatives under the Dodd-Frank Act, UCITs and even Hong Kong and Singapore's transparency best practice rules, there is no way that they can go through those exposures without an enterprise-wide aggregation of their risks. What is your risk? How much are you exposed to and to what? These are simple questions that will come with complicated answers," he told Complinet in a separate interview.

Carrel noted that the complexity of financial institutions' business models and the products they offer have made it difficult for them to understand the impact of a market shock on their balance sheets.

"No market risk is totally independent from credit risk or liquidity risk. That's how interconnected they are," he said.

To this end, he suggested that financial institutions gain first and foremost a good understanding of enterprisewide risk, which will give them a chance to reassess their risks and carry out stress testing. This, he said, would require financial institutions to delve into risk factors which could arise from such activities as money lent to

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hedge funds, proprietary trading, options and mortgage-backed securities. Understanding these risk factors would be difficult without an IT infrastructure that also carries out governance duties. "The IT infrastructure should mirror any financial institutions' governance rules. Otherwise there's no way that the new rules implemented will the complied with," he said.

IT infrastructure as the foundation of governance

Carrel said that historically the IT infrastructure found in most financial institutions was designed around bandwidth to be able to push through the largest number of transactions in a minimum amount of time. "Because that's how they make their margin," he said. He also pointed out that none have invested in an IT infrastructure that offers a horizontal type of connectivity that connects custody, fund administration, clearing venue and execution venue, amongst others. He said this would facilitate pre-sale and post-trade compliance checks. An IT infrastructure that offers horizontal connectivity would be the way to go when the new regulations come into effect, Carrel added.

Fiduciary responsibility

With consumer protection featuring strongly in the Dodd-Frank Act and the existing Markets in Financial Instruments Directive, Carrel said financial institutions would be expected to report the pricing each time they execute a trade or carry out the allocation of a trade. Regulators would seek valuation transparency, which would require financial institutions to declare the formula, the methodology and the curve they use to derive the pricing of a trade, he added.

Valuation transparency aside, Carrel also noted that financial institutions would be hard-pressed under the new regulations to exercise post-trade transparency (i.e., disclosure) and trade allocation transparency as fiduciary responsibility assumes greater importance.

"The new regulations have gone at length into fiduciary responsibility and how we are moving from asset allocation type of modelling to one that is risk-based which is more dynamic," he said.

According to Carrel, the new ruling on fiduciary responsibility says that even after financial institutions have signed documents with their customers that outline risk disclaimers, financial institutions would be obliged to pay their customers for any losses that the latter has incurred.

He cited a hypothetical example where a customer orders a trade that does not fit his risk profile. In this instance financial institutions would be obliged not to carry out the trade on behalf of the customer. In addition, financial institutions would be required to move an instrument that has become too risky out of their customer's portfolio to avoid being sued. Alternatively, financial institutions would be required to carry out a complete overhaul of the customer's risk profile or make extensive changes to all the documentation required for carrying out a trade, he said.

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Risk intelligence

Be it the Dodd-Frank Act, the Volcker rules or the derivatives rules, Carrel said regulators are now expecting a lot more from financial institutions in their compliance systems and controls.

"Regulators are telling financial institutions to be a bit more intelligent and dynamic. They are telling them to bring risk intelligence into their internal models. That would mean going beyond credit scoring, credit rating or statistical analysis," he said.

Carrel said the new regulations also require financial institutions to have in place a compliance framework that takes a preventative approach. They would also be obliged to rethink their governance rules to be able to manage their risk better while complying with regulations, he said.

"The new approach of regulators would be to force governance rules that are directly related. In that process, financial institutions would become more 'risk intelligent' and take a more hands-on approach in their risk management. There will be less box ticking, less quantitative analysis," he added.

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