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Concerns about the Focus of Estonian Banks Approach and Oracle Solution for Impl
Postitatud: Sunday, November 14 @ 22:07:16 EET by Jelena Abaimova

Pangandus

Abaimova

BASEL 2 VISION 

Since July 1988 when the current Basel Capital Accord was published, the world of banking has changed radically. It is a world transformed by forces of globalisation and consolidation, by new models of customer relationships, by powerful new instruments in hedging, securitisation and investment, and of course by new information, communication and business management technologies. 

On the geo-political front, a new more dynamic and uncertain economic order has replaced the relatively stable post settlement. The dot.com revolution has erupted and stalled. The Internet has changed everything: even the nature and pace of change itself. 

At a micro level, individuals and organisations have changed – and are continuing to change – too. Retail and corporate customers alike have new expectations. 

In response to all these pressures to rethink their role, our Estonian banks have developed a wide range of new products, instruments and channels to deliver customer and shareholder value, and meet the challenges of rapidly evolving financial, commercial and consumer marketplaces. 

Against this dramatic and sometime confusing background, issues of security, capital soundness, supervisory control and operational risk have naturally enough remained very much to the fore in the governance of banking organisations. 

However, not only is there the ever-present requirement on the part of the authorities to revise and renew the appropriate constraints and regulations, there is also the recognition that new kinds of information systems now available can provide space for greater flexibility and even liberalisation in some areas of supervision. 

That vision is a key component of the latest Basel process. 

In this article we look at some surprising implications of the emerging Capital Accord. For while this is one area where it is universally accepted that the supervisory regime needs updating to reflect the new risk factors, what has not been sufficiently highlighted is that the Accord itself can act as a catalyst for new rewards as well, across the enterprise. 

Basel 2 is not only of vital concern to managers and directors with direct responsibility for meeting the new regulatory requirements. It also provides the incentive for an information management framework, which will open new opportunities for sales, marketing and customer service. Indeed it is possible to argue that the entire value chain in banking will be revolutionised as organisations which maximise their supervisory freedom, optimise the allocation of capital, and utilise information proactively to drive business decisions will – almost over night – achieve massive competitive superiority. 

One key difference is likely to be between the US, where compliance will be confined to larger, internationally active banks, and the EU, where the proposed Risk-Based Capital Directive would apply the provisions to virtually all banks authorised under the Investment Services Directive. There will also be variations in the detailed implementation within the EU member states themselves. Many respondents are also concerned about whether supervisors possess the necessary ‘skills and resources to implement Basel 2 effectively’.  Estonia now is a member of EU, and everything mentioned above is very important for our financial institutions at present as well. 

Basel 2 will force banks to re-examine capital and funding decisions that they may not have tackled for some time. A seemingly small percentage saving in capital requirements under Basel 2 could release hundreds of millions of Euros of regulatory capital. Institutions must to answer the following questions: Do you return the cash to shareholders? If not, how do you invest to optimise value? 

The bank as a whole will be affected, but individual products will be impacted as well, for example: 

Estonian banks that adopt the more advanced approaches to risk management, especially in assessing the credit risk of borrowers, may be able to price more keenly and thus attract valuable customers away from less sophisticated competitors. 

The risk weighting for home loans will drop from 50% to between 35% under the Standardised Approach and as 8% under the IRB (Internal Ratings Based) Approach. This can affect on some Estonian financial institutions business and push them to move from wholesale market to core retail products.  

The relative Basel ‘rating’ implied by a bank’s use of a certain approach to both credit and operational risk measurement will provide an extremely visible and distinctive differentiator between those banks that win the regulatory seal of approval for their risk management, and those that do not. What does it means Internal Ratins Based (IRB) approach proposed in the New Basel Capital Accord (Basel, 2001)? The Basel Committee on Banking Supervision allows banks to calculate regulatory capital charges for credit risk based on bank’s internal credit risks ratings for their exposures. Probability of Default (PD) assosiated with individual grades in a bank’s rating system is one of the key component on the IRB approach. The other two basic risks components are the facility’s loss gived default (LGD) based on such characteristics as the presence and type of collateral or other risks mitigants, and the exposure at default (EAD), which measures the bank’s exposure at the time of default. These three risk componenets will be converted into risk weights to be used by banks for calculating risk-weighted exposures. The amount of risk weighted exposures determines the required regulatory capital.     

In this article we shall outline the main points from the Accord as a background to a wider discussion of the information management issues it raises. While managers with risk responsibilities are already deluged with this information, it is important that it also reaches the widest audience of managers within the banking community. Everyone needs to be up to date with the Basel 2 recommendations. 

In simple terms organisations will now be able to operate with capital adequacy ratios dependent on their risk management, credit control and reporting capabilities. The rationale for this new position is that changes in the financial marketplace call for greater risk sensitivity, and thus flexibility, throughout the banking systems. 

The corollary is that implementing the data management and reporting systems required to optimise capital holdings will not only release resources to maximise return on capital, it will also support a wide range of other proactive business activities. The Oracle insight is that the degree of data reconciliation, management and reporting required by Basel 2, particularly in the area of operational risk, supports everything from maintaining the General Ledger, to enhancing HR systems, to implementing a CRM programme. Financial, operational, administrative and marketing activities can all benefit. 

Essentially the requirement is for bank-level management, market discipline, and supervision. Once it is understood that quality rather than quantity of capital risk is at issue, and that the actions of individual banks can impact their performance, the role of effective information management becomes clear. 

As the Basel Committee has said: “The best way to measure, manage and mitigate risks differs from bank to bank. This new framework provides a spectrum of approaches from simple to advanced methodologies for the measurement of both credit risk and operational risk in determining capital levels. It provides a flexible structure in which banks, subject to supervisory review, will adopt approaches, which best fit their level of sophistication and their risk profile. The framework also deliberately builds in rewards for stronger and more accurate risk measurement.” 

By adopting approaches which are comprehensive and sensitive to risks, Estonian banks will be able to adhere to capital requirements that are more in line with those risks, while having greater freedom to manage their entire business more efficiently. With this freedom comes a new degree of complexity. However, banks which adopt more risk-sensitive analytical methodologies, will gain the benefits which significantly exceed the cost. For the Basel Committee the aim is that: “The banking system should be safer, sounder, and more efficient.” 

You need to add this important rider: “And my bank should be more profitable.” 

THREE PILLARS OF THE NEW ACCORD ARE FOLLOWING: 

1. MINIMUM CAPITAL REQUIREMENT 

The new framework maintains the minimum requirement of 8% of capital to risk-weighted assets extended on a consolidated basis to holding companies of banking groups. As well as credit and market risk, operational risk is now included, defined as the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems, or from external events. 

2. SUPERVISORY REVIEW PROCESS 

Each bank must have sound internal processes in place to assess the adequacy of its capital based on a thorough evaluation of its risks. 

3. MARKET DISCIPLINE 

The requirement for enhanced disclosure ensures that market participants can better understand banks’ risk profiles and the adequacy of their capital positions. 

Each of these three pillars has specific information management implications: together they create the need for a new model in risk management systems – and beyond. There is a major challenge facing all banks, particularly smaller institutions, which are our Estonian banks, comparing to European large banks, first in meeting the requirements and second in maintaining their competitive posture. 

PREPARING FOR THE FUTURE – A BUSINESS CASE 

There is thus a broad business justification for investing in the most effective risk management, calculation and reporting applications, and in the system and database platforms necessary to support them. Gaining recognition from supervisors for the sophistication, comprehensiveness, accuracy, timeliness and visibility of your risk systems will ensure a fast ROI: you will have more efficient capital utilisation, a more favourable market perception of your all round strength, and indeed less risk! That all translates into potentially higher profitability and enhanced shareholder value. 

For our Estonian banks is very important to make a decision as to how to proceed in order to win those direct benefits will be driven by a number of factors: 

  • the amount of effort required to modify existing systems to support Basel requirements by 2004 – speed is crucial as many of the provisions carry the rider ‘in a reasonable time frame’ 
  • our banks organisational profile – it is important the whole organisation moves forward as one: for example the criteria for credit risk apply to all activities 
  • the quality and make-up of our banks risk portfolio: there are clear advantages in improving your risk quality since the disclosure requirements for the most advanced levels under Basel 2 will expose the full extent of your bank risk 
  • our banks internal processes: for example are you able to collect and report the granularity of operational loss data required? – the demands in this area are particularly onerous 
  • our banks ability to understand the implications of their management decisions: for example it is not automatically the case that adopting advanced levels of disclosure and control will automatically lead to lower capital requirements – that will depend on the quality of your risk, the length of commitments, the concentration of risk and so on  
  • our banks data quality and reliability: it is essential in your bank to identify any areas of weakness as data collection and analysis capabilities will be under the microscope 
  • our banks confidence in their procedures – the new regime will expose failings more harshly: for example adopting the advanced supervisory regime is an all or nothing decision. Banks will not be able unilaterally to revert to simpler levels, though the supervisor may compel them, with all the adverse consequences for market perception  
  • our banks international dimension – large institutions with global or multiple holdings, like our Hansapank, or Uhispank, need to give particular attention to operational risk, and to issues of consolidation in terms of total calculation of minimum capital. This has major implications for integrated  information management 

The first step is to undertake a fundamental review of systems and processes, and test them against the provisions of the Accord. That is a major task in itself. But the next step is even tougher: to align your risk systems with your maximum long-term business advantage. 

We move on to look at what the solution you should aim for should look like. 

Basel 2 impact analyses undertaken by many banks in Europe have identified dozens of gaps and shortcomings that are now being addressed by a quick and potentially conflicting fixes, isolated projects and often expensive IT developments that may not deliver anything like the value and benefits for the business that are planned initially. Very often the scope of the project is too narrow. For example, Basel data requirements as well as additional IFRS (IAS) requirements need to be fully integrated into IT development plans, rather than being an add-on or afterthought. But, from the other side, if you think that Basel is merely an IT or regulatory capital compliance issue that can be left to your backroom teams, then you are in trouble. 

How many banks in Estonia have considered the behavioural changes that will be required at all levels of the business to make sure Basel is fully integrated in decision-making? Similarly, how many institutions have brought in front office people to gauge the full impact of the Accord on the profitability, design, funding and structure of their key products? 

For our companies very often is complex to prioritise which gaps are urgent and which are not, a lack of coherence and co-ordination in resolving these issues and developing effective implementation plans, and, above all, the absence of clear thinking about what the new Accord really means for the operations and strategy of the business. 

Basel 2 offers lower capital charges in return for the development of a more effective risk management infrastructure. However, in practice, most institutions will continue to set their own level of capital, based on their evaluation of the amount needed to safeguard the business, allow for flexibility and, most critically, maintain the desired credit rating, which will be higher than the regulatory capital requirement. But for sure, companies need to recognise how the Accord will transform the competitive landscape, and how the new Accord is beginning to influence strategic thinking and capital allocation decisions. 

Our Estonian banks also need to bear in mind the parallel implementation of International Financial Reporting Standards (IFRS/IAS), which could lead to greater earnings volatility and heightened communication challenges. 

Basel could transform the behaviour and organisational structure of your enterprise: 

  • As mentioned in the beginnning of this article, the new Accord will not only transform the way banks control risk, but also the way they judge and reward it in pricing, credit approval, product design and other key business areas. Do your staff understand how this could affect the nature of their roles, decisions and accountability, as well as the basis for their performance incentives? Have you considered what changes to management decision-making are necessary to meet the ‘use test’ of Basel 2 risk management approaches? What are you doing to instil the right behaviour? 
  • Basel, in concert with IFRS (IAS), could transform your organisational model. Instances include the integration of risk, finance and compliance functions to provide a seamless approach to capital management and external reporting. Our bank’s managers must to answer the following question: Can your business cope with such root-and-branch changes on top of all the other market/regulatory challenges it faces? 

Perhaps the most important reason to take control of your Basel implementation programme is ensuring that you decide what is done in your name. Regulators are increasingly insisting on individual and auditable management responsibility for risk control/mitigation. With each Basel-related change and each data, systems and process option likely to affect the way capital is allocated in the business, the board will need to justify its choices to shareholders and other stakeholders. 

There are considerable overlaps between Basel, IFRS (IAS) and the Sarbanes-Oxley Act (Corporate Governance and Internal Audit) requirements in areas ranging from executive responsibility to data definitions, accounting processes and internal control systems. Our Estonian organisations need to maximise synergies and avoid costly duplication. The response to these related regulatory challenges is an opportunity to show that the organisation can align its strategic vision and manage difficult change. Mismanagement could be interpreted as a sign of weakness or lack of control. 

Our Financial Institutions need to ensure that their strategic response to Basel is not solely driven by IT or compliance considerations; indeed the so-called ‘use test’ would proscribe such a narrow ‘rules-based’ approach anyway. Rather IT/compliance and other aspects of the Basel strategy need to be geared to safeguarding the business and realising the opportunities for value creation opened up by the new Accord. 

ARCHITECTING THE SOLUTION – WIN ON RISK AND WIN ON REWARD 

The Oracle approach is to harness: 

  • the most powerful data warehouse technology 
  • leading business applications and processes 
  • the most intelligent analytical tools 

SO – WHAT DO YOU NEED TO DO? 

There are three areas where you need to ensure systems are enhanced and readied for the requirements of 

Basel 2: 

    1. Collect and store data 

    2. Calculate risk and capital requirements 

    3. Model and report internally and externally 

In each case the specific requirements you decide to implement depend on the level of sophistication you intend to adopt. 

Oracle solutions can deliver the required functionality not only in these three broad areas of compliance, but across the emerging range of business opportunities. Equally Oracle is not an all or nothing approach. We recognise that there will be many cases where organisations will wish to continue to use existing systems. The openness and modularity of Oracle solutions – together with the wide range of applications supported by our technology – facilitate smooth integration with current infrastructure. 

Let us look at how Oracle can assist rapid and complete Basel 2 readiness, whatever your current starting point: 

1. COLLECT AND STORE DATA FOR TRANSACTIONS, CUSTOMERS, ASSETS AND OPERATIONS. 

ASSESSING EXPOSURES ACROSS COMPLETE RELATIONSHIPS 

Complying with, and being able to benefit from, the changes to the credit risk regime requires a complete understanding of the institution’s relationships with customers and suppliers, and visibility of all the instruments involved in transacting business with them. 

For example: when you are owed 1 million EEK by each of Margit Tamm and Indrek Tamm and Tamm AS are these all part of the same legal entity? If so you should really be treating this as one 3 million EEK exposure. 

This may trigger different controls, risk weightings etc. A comprehensive relationship tracking approach allows you to produce consolidated positions across countries, currencies, instruments and industry sectors. 


The functionality to provide the required visibility is present in Oracle’s Trading Community Architecture (TCA), which underlies the Oracle E-Business Suite. The TCA was designed to support Oracle CRM and ERP applications by providing a comprehensive data model catering for the most complex of party relationships. For example, in the case of individual employees of a counterparty it can maintain details of their relationships with individuals, departments, legal entities within their own organisation, within your organisation and with any other organisation. 

HOLDING DATA AT THE APPROPRIATE LEVEL 

Any institution wishing to benefit from applying the more advanced risk assessment approaches under Pillar 1 will have to collect a range of detailed information covering transactions, counterparties and instruments. As it happens, this information is broadly similar to that which is required for developing the income elements of a profitability management system. 

Oracle’s Financial Data Manager (OFDM) has been developed specifically to enable financial institutions to store the large amounts of data required to operate at the necessary level of detail for both risk and profitability objectives, whether at account or individual transaction level. Oracle has already begun the process of working with clients to introduce the data elements necessary to support optimal capital allocation approaches. 

2. CALCULATE AND ADD DETAILS OF RISK AND CAPITAL REQUIREMENTS. 

DELIVERING THE NEW REQUIREMENTS IN OPERATIONAL RISK 

The obvious way to minimise “the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems” is to make maximum use of  technologies which specifically address each of the three possible points of failure.  

Oracle’s complete suite of e-business applications answers the need in the following ways: 

  • processes are predefined and comprehensively specified for all day-to-day tasks, leaving the organisation free to concentrate on developing value-adding and differentiating solutions 
  • people are empowered to take responsibility by the use of extensive self service facilities, while control is maintained by comprehensive security features and the wide range of built in reporting and monitoring tools 
  • systems are built to work together, eliminating the common pitfalls of integration and removing the major causes of systems failure  

The implications of the Operational Risks requirements of Basel 2 are wide reaching. Many organisations have not yet understood that the implications extend deep into corporate procedures that may not seem obviously connected to financial risk management. Oracle E-Business Suite applications ensure that areas such as recruitment, training and system maintenance are all properly recorded, that procedures are documented, that organisation charts and lines of responsibility can be tracked and reported as required. 

The message is clear: the new risk regime calls for a holistic, integrated, comprehensive approach to traceability throughout all lines of business and departmental structures, and most of our financial organisations have not fully woken up to the fact. 

SATISFYING INTEREST RATE RISK CRITERIA 

At a more specific level, the Basel 2 proposals include interest rate risk within Pillar 2 and recognise institutions’ internal systems as the principal tool for measuring and reporting. 

Oracle Risk Manager is an integrated asset/liability management application designed specifically for use by financial institutions. It employs account level data to support structured interest rate risk analysis, balance sheet forecasting, and market valuation. Every loan, deposit, investment and portfolio security can be measured and modelled individually, using both deterministic and stochastic methods. 

Risk Manager is part of Oracle’s financial services suite. It shares data and processes with the other applications described in this paper which handle account level income, cost, risk and profitability calculation and reporting, ensuring a fully integrated solution. 

3. MODEL AND REPORT INTERNALLY AND EXTERNALLY. 

IMPLICATIONS OF PILLARS 2 AND 3 

Because of the inter-relationships between the three Pillars, much of Basel 2’s impact on an institution will be determined by its ability to comply with the supervisory review process and to submit to market discipline. 

Institutions which have a complete set of data held in a consistent and accessible form will be able to select and supply the documentation and evidence required by regulators and reporting authorities. It is likely that much of this information will need to be supplied over the Web.  

In addition to best of breed reporting, Oracle reporting solutions enable selected external parties – and in particular supervisory authorities and markets – to view those parts of the institution’s data which are appropriate to their needs. This will utilise Oracle’s standard self service approach to data collection and viewing under which all interested parties, for example employees, customers, suppliers and investors have access to those areas which are applicable to them. This improves the service available to the other parties while reducing the cost to the institution of receiving, processing and responding to queries and basic data amendments. 

WHAT ELSE DOES THE ORACLE APPROACH ENABLE? 

THE NEW PROFITABILITY OPPORTUNITY 

Any institution wishing to benefit from applying the more advanced risk assessment approaches under Pillar 1 will have to collect a range of detailed information covering transactions, counterparties and instruments. 

This information is broadly similar to that which is required for developing the income elements of a profitability management system. Oracle’s Financial Data Manager (OFDM) and Performance Analyser (OPA) have been developed specifically to enable financial institutions to store the large amounts of data required to operate at the necessary level of detail for both risk and profitability objectives, whether at account or individual transaction level. 

For example, net interest margin components are calculated and allocated with Transfer Pricing and Performance Analyser, and interest rate risk exposure of the balance sheet is generated – all from the same account-level data. 

The associated Oracle Activity-Based Management (ABM) and Performance Analyser modules facilitate the extraction of detailed cost data from the ERP applications into the OFDM and thus provide a complete profitability solution. Linkage to Oracle Financial Analyser provides for comprehensive financial reporting, analysis, budgeting, and planning, integrating management data with powerful analytical tools. 

Users of these applications are already benefiting from what will also be a valuable contributor to Basel 2 compliance. 

ADVANCES IN PLANNING AND FORECASTING 

Given the range of approaches which will be possible under Basel 2 it will be important that an institution can model the impact of adopting any particular approach. 

Supervisors are also sure to seek assurance as to the robustness of the preferred approach. They will require more extensive sensitivity analyses that the current interest rate shock estimates, for example. The key to being able to meet these requirements is to have a single, comprehensive source of actual data and a set of tools which can make dynamic use of it for all planning and forecasting tasks. 

Oracle’s Financial Analyser budgeting and planning module provides that tool, and uses the OFDM to provide a complete view of the current position and to produce a range of forecasts. 

REPORTING IS THE KEY – TO COMPLIANCE AND PROFIT 

Any institution which adopts an advanced Basel 2 approach will automatically have at its disposal a large pool of detailed data which can be of great value throughout the business. 

In order to be able to realise this value the data has to be held in an appropriately structured way and suitable reporting tools must be available. 

Under the Oracle vision all data is held consistently. It is immediately available to the appropriate reporting system which can range from predefined executive level balanced scorecards to highly flexible ad hoc query tools. 

This knowledge base can inform treasury of capital available for investment. It can provide management information to support mid and long-term business decisions. It can give campaign managers up-to-the minute marketing information to assist profiling and targeting. It can be used to drill down to accountlevel profitability data and drive CRM programmes. It can be used to prioritise investment in new channels. 

And above all, its use throughout the business is enabled thanks to the integrated Oracle platform. 

CREATING A SINGLE VIEW OF THE TRUTH 

In order to grow and run an e-business, managers at every level of the organisation need access to actionable information. Consistent reconciled real time data from multiple data sources, both internal and external, needs to be available to everyone – from HR to marketing, from finance to sales, from procurement to payroll. 

The Oracle Warehouse and related data marts are powerful data repositories to support your business intelligence requirements. The warehouse maximises the leverage and re-use of information by providing a central point for common definitions as well as a scaleable time intelligent data repository. Oracle Business Intelligence Suite’s analysis and enterprise reporting tools are fully integrated with the Oracle Warehouse to provide complete and scaleable applications. 

Oracle Warehouse Builder simplifies the creation, development, implementation, use and management of data warehouses that can meet the demands of today’s market with sophisticated Business Intelligence capabilities. It is essential that you achieve a total integrated information platform which consolidates islands of transactional information in a single point of data storage which can be mined for any purpose

The Oracle architecture not only provides full scope for leveraging information beyond the Basel baseline; its real justification is that it gives ready access to the major  competitive advantages Basel 2 will confer on banks with the most risk-sensitive systems. 

Finally, Estonian financial institution’s top level managers must be able to answer the following question: do you as a member of the senior management team have sufficient faith in your institution’s Basel systems, controls and strategy to put your reputation on the line? In short, are you confident that your Basel strategy is appropriate for your organisation, that it will get you to where you want to go and that you have mapped out the best route? 

Those institutions that take the Accord as their prompt to review the totality of their information management, to integrate that information more effectively with management processes, and to build in the control and reporting capabilities that the Accord inherently rewards, will be meeting the challenge, and incidentally gaining a clear competitive advantage across the totality of the business. 


Jelena Abaimova
Oracle Cosulting Services
Principal Consultant
 


 
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