Banking: Understand systems first; DON’T over-regulate; save $200bn p.a. for starters…


I can see, precisely, where the headline-writer was coming from and why. The extract of the article from ft.com is below but I felt the need to bring this together with an IBM report (a link to the report at the end of this article) that gets closer to the root of the problem – it still falls short – but points in the direction of an alternate path…

imageBy my interpretation, IBM are telling banks to “look within for the answers they seek”. They have highlighted something pretty fundamental. Made even more tantalising when they quantified it at $200 bn per annum with an emerging market of $900 bn per annum to play for!

“The financial system on which Dodd-Frank is being imposed is far more complex than the lawmakers, and even most regulators, apparently contemplate,” wrote Mr Greenspan.

“We will almost certainly end up with a number of regulatory inconsistencies whose consequences cannot be readily anticipated . . . These ‘tips of the iceberg’ suggest a broader concern about the act: that it fails to capture the degree of global interconnectedness of recent decades which has not been substantially altered by the crisis of 2008.”

Just turning back the clock does not seem a viable avenue. These concerns do create even more urgency for regulators to insist that Wall Street spends money on making all the information it has more accessible.

John Liechty, a professor of marketing and statistics at Pennsylvania State University, helped create the Office of Financial Research, a new agency created by the Dodd-Frank Act that is charged with identifying systemic risk in the financial sector. He first got the idea when he met regulators at a workshop after the crisis.

“It really was surprising to me,” he said. “Regulators had a complete lack of real information about how the markets work, the size of positions and exposures among institutions.”

He believes there is a “national need” to gather the data and do the research to understand markets better, just as was done to better model hurricanes and their impact. It took decades – and was a serious project.

Mr Greenspan believes the markets are “unredeemably opaque”. Mr Liechty thinks this can be remedied – and pushing Wall Street to track data and use common tags to identify counterparties would make a huge difference.

Making this a priority for the financial industry is tough. But without a better way of knowing what goes on in the complex and interconnected markets…

via FT.com / Markets / On Wall Street – Understand the financial system first, then regulate it.

I am no world authority on the subject but invite challenges to my simple logic: more regulation is NOT the way forward. Nor is the separation of banking activities. Either approach hinders the ability of a bank to compete in a global marketplace so will only result in the need for more operational or product complexity = less customer value.

If my memory serves this quote comes from a McKinsey publication and makes perfect sense.

“Adding complexity to cope with complexity is a seriously flawed approach”

I must agree with Prof Liechty’s suggestion that tracking counterparties, presumably to monitor the potential for systemic risks associated with the industry but, is a MUST DO. As far as improving the customer proposition is concerned this is where early adopters can really secure and sustain some competitive advantage relatively painlessly. Read on…

If the above doesn’t excite you as much as all that talk of hundreds of billions of dollars per annum then, I suppose I shouldn’t be too surprised. So, here it is:

imageimage

Let me translate, because the following is only part of the whole story. For a bank or any financial organisation to be more “Client centric” requires that they STOP structuring, exclusively, WIN/LOSE contacts.

Quite simply, this is THE, vital, first step on a path that leads toward rebuilding TRUST. The bi-product of such a cultural change is that, so much of the costly complexity that comes with “disguising” products and services as customer centric; misaligned operations that have evolved over years of new or different technology; partial IT integrations and a prevailing culture that puts Corporate profit (and individual reward) above all else. All of these have required more GRC (Governance, Regulation & Compliance) whilst making actual compliance more difficult and costly.

The abandonment of strategies that placed the customer at the centre of the proposition, in favour of a results/reward-driven culture that fed high leverage/high growth models certainly satisfied its initial purpose but to the long term detriment of the individual organisations, global industry both in financial and reputational terms.

Gresham’s Law

image

Problem

IBM point the way but the sheer size of the “rewards” indicate the scale of the problem! Banks simply cannot afford to “come clean” about how skewed their operations and culture have been – although any informed observer already has a pretty fair idea – so a means of transition WITHOUT admission of culpability is required.

They have not provided a detailed plan for the transition because – whilst I have no doubt that the depth of understanding of COMPLEXITY lies within IBM at a philosophical level – they do not possess the practical tool-kit to tackle what they have identified.

Solution: Quantitative Complexity Management

Ontonix already have the required depth of understanding, rigorously tested technology and tool-kit to be able to tackle the problem highlighted by IBM. Of course of all the reports on the impact of complexity on business IBM’s is merely the latest and most specific to banking.

To be able to do so under the banner of “managing complexity” avoids the additional “pain” and potential loss of office or wealth associated with further public scrutiny!

Benefits: immediate and future

Added benefits: extended “risk horizon”, identifying “reducible uncertainty” within the system; gaining micro-level insight into causality; “crisis anticipation” e.g. deteriorating credit risk or customer relationship.

image

The cultural change also paves the way for Banks to fully, openly, engage with customers via a “Social business” strategy: lack of transparency being a major obstacle at present. This is the channel into which operational savings from reducing complexity can be invested and multiplied as

Over the last 12 months I have commented upon reports from, such as, KPMG, McKinsey, PwC, Economist Intelligence Unit. In addition complexity figured prominently in the World Economic Forum report on Global Risks 2010.

The attached White Paper “Reveal Your Hidden Profits by Simplifying your Business!” serves to reinforce much of what others have already said. It is very good.

However,  until IBM quoted these staggering amounts and “extra profit of 20%”, AT Kearney were the only one’s to conservatively suggest that managing complexity would add 5% to the bottom line.

The report: From complexity to client centricity

2 Responses to Banking: Understand systems first; DON’T over-regulate; save $200bn p.a. for starters…

  1. nick gogerty says:

    David,

    I guess I am more of a fan of seriously scaling back the size of banking operations. All systems fail or terminate. There are a handful of firms that live more than 150 years so a system should be designed to assume a 1-2% annual bank failure rate.

    I would rather have my systems be small and less connected when they fail. Gresham’s law as you clearly point out is the process of pursuing a short term efficiency for long term instability, it also aggregates risk efficiently into single entities.

    An example of outsourcing and behavioral issues is here. A large institution engaging in such behavior may have simplified its operations but at significant costs. The US system makes many 3rd world operations look honest and straightforward, but it is highly efficient. http://www.cbsnews.com/video/watch/?id=7361572n

    Behavior will not change and the tendency for systems that become self referential is to fail. ie. debt backed by assets that are used to increase asset values. A great book on the topic is Devil Take the Hind Most a great read or Kindelberger’s Mania’s Panics and Crashes.

    Debt and insurance as risk based systems are selling a commodity. Inevitably some of them fail, acknowledging the failure and putting in regulation to mitigate systemic risk is vital. I fear the monolithic model Basel or anyone’s that ends up applied to all banking/risk systems thus creating a homogenous operating and risk environment.

    I want the honest diversity of a robust resilient system which is likely failing somewhere in small ways all the time. It is the pursuit of perfection and low variance which silences the small failures until they become systemic that seems problematic to me.

    The notion of global competitive banks is I believe mostly a false one. Most banking is extremely local or national in nature with international flows really making up small bits of the business when analyzed. Yes forex and short term rate swap put out some huge notional numbers but make small P&L and exposures for most banks.

    Risk taking should be a highly localized sport, trouble happens when it is treated in a commodified fashion.

    Large national banks are more like giant holding companies of various lumpy business units labelled international but they really aren’t operationally. The banking operations are more just account summaries. A few basis points of extra yield or leverage to amp up ROE’s will always be present as will the desire to find cheap dumb money from somewhere this always leads to failure.

    I would be happy to see a less efficient (compartmentalized) banking system with occasional failures but systemically more robust. The Fed has gone to extreme lengths to bailout the system and now holds $1 trillion of mortgage related paper on its balance sheet of $2.5 trillion. The fed, Treasury, SEC and others haven’t really addressed the causal nature of the problem.

    I don’t know if you have looked at the details of the recent FOIA request of who got bailed out by the fed with swap lines and credit extensions during 2008, but it is indicative of global efficiency at the expense of stability.

    http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=aBuMYAgI4_GA

    I have skimmed some of the PDF’s in the collection and everyone is in there. From Libyan banks to the local. One day the Fed won’t be able to do it. The global machine looks less impressive by the day. I am not a fan of complex regulation as all that does is make dodging the rules a more opaque process. simplicity and clarity via compartmentalization is what I would strive for. Safety bought for the price of a few basis points and inefficiency.

    My own biases are rather than put in place a few more internal metrics into a systems that are bound to fail, make smaller systems. All systems fail and all components fail, it is only a matter of time. History provides excellent lessons about this.

    The trick in my mind is to design simple small systems that fails gracefully, smally and periodically enough to keep everyone in line. Those are my opinions and not very popular.

    Banking shouldn’t be as important in our lives as we have allowed it to become.

    Nick

  2. Nick,
    Many thanks for your, typically well-formed (and informed) comments.

    It makes sense to look at smaller entities but the issue remains that, we do not have “surgeons” sufficiently skilled to know where to make the incisions, because it is uncharted territory and the nature of complex systems is such that intuitive is not good enough!

    This issue and your comments reminded me of an old report that I commented on last year: Complex Systems and Ecology: Report by US National Academies…http://wp.me/p16h8c-c

    A more extensive extract and a link to the full pdf can be found by following the (above) link but I thought this particularly relevant

    As the report notes, this is a complicated question, because modularity will often involve a trade-off between local and systemic risk. Moreover, the wrong compartmentalization in financial markets could preclude stabilizing feedbacks, such as mechanisms for maintaining liquidity of cash flows through the financial system, where fragmentation leading to illiquidity could actually increase systemic risk (as in the bank runs leading to the Great Depression). Redundancy of components and pathways, in which one can substitute for another, is also a key element in the robustness of complex systems, and effective redundancy is not independent of modularity.

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