The Strategic Imperative to Align Risk and Finance

Bankers today find themselves in a swirl of pressures: global competition, shareholder demands to improve returns, and increasingly complex regulatory requirements.

On the regulatory front, the Basel II Capital Accord, the Sarbanes-Oxley Act and new accounting standards seek to achieve greater

That, in turn, requires effective processes and controls to better capture, analyze, manage, safeguard and report data. The risk management unit provides key inputs for the finance department's reporting, and regulation is driving a greater level of data integrity and reconciliation within the risk unit's data.

While banks' performance management professionals typically reside in the finance unit, most collaborate with their counterparts in the risk unit in order to deliver accurate profitability numbers to management. Increasingly, compliance requirements - particularly Basel II - are accentuating the need for risk and finance professionals to work even closer together.

In implementing Basel II for credit, market, and operational risk for several financial institutions outside the United States, we have found this alignment to be very helpful, if not required. In one bank, for example, the risk and finance departments were moved onto the same floor and required to share a common database. This alignment not only helped the bank comply with Basel II, it also resulted in more accurate and detailed risk adjusted performance management, a goal of AMIfs since its founding twenty-five years ago.

Investing to meet these new regulatory requirements is unavoidable. Even many smaller financial institutions in North America that are not required to comply with Basel II's advanced reporting mandate are nevertheless expected to adopt more rigorous risk management practices for competitive purposes.

OBSOLETE SILOS

Banks can no longer afford to maintain their risk and finance units as distinct, siloed entities. The traditional approach - separate processes, different operating models with independent infrastructures, and different responsibilities at group and operational unit levels - is becoming obsolete. Siloed technology systems chum out separate pools of data - increasing the risk of data error and inconsistency.

Indeed, aligning the two functions can deliver impressive savings and a significant return on equity.

With the volume and complexity of financial products in today's market, the convergence of accounting standards (in the US - generally accepting accounting standards or "GAAP", internationally - international accounting standards or "IAS") and risk management is a reality. While GAAP and IAS now require more sophisticated calculations, methodology and data, so too is risk being measured and managed in more sophisticated ways.

Basel II: Global Framework for Risk and Finance. Basel II, a revision of the capital adequacy framework established under the 1988 Basel Accord (Basel I), expands the guidelines that international banks must follow for risk management and the disclosure of risk calculations. The Basel II guidelines cover three primary areas: minimum capital requirements, a supervisory-review process, and market discipline.

The capital requirements are intended to help banks improve the way they measure and manage risk. Under Basel II, a bank's minimal capital requirements line up more closely with the specific risks of different assets than was the case under Basel I. The supervisory review encourages best practices in risk management, including risk related to a bank's business strategy and reputation. Market discipline requirements necessitate detailed, public disclosure of a bank's capital structure, risk exposure, ratings models, and capital adequacies.

Although Basel II focuses on risk management for internationally active banks, its principles are applicable for banks of varying levels of complexity and sophistication. Many national banking authorities may eventually mandate similar principles. The primary objectives of Basel II are to:

* Encourage a more comprehensive approach to managing risk, based on best practices and banks' internal ratings systems

* Maintain the current overall level of capital in the system

* Make capital requirements more sensitive to risk and business differences

* Improve risk transparency and disclosure

* Promote safety and soundness in the financial system

* Further enhance industry competition

Under Basel II, the rules for determining minimum capital requirements for market risk remain unchanged. The new framework revises calculations of risk-weighted assets for credit risk, however, and adds capital requirements for operational risk. Basel II also prescribes various methods for determining credit risk and minimal capital requirements for bank portfolios. These include a standardized approach, a foundation internal-rating-based (IRB) approach, and an advanced IRB approach. Basel II compliance supports an economic capital framework that takes into account the broader risk-adjusted return on capital (RAROC) and economic-profit requirements.

Basel II has become the catalyst for adopting the best practices in risk management that result in better risk/reward choices. As Basel II takes effect in the coming years, shareholders, Wall Street analysts, and rating agencies will pay close attention to how banks' risk management practices affect financial performance. The internal capital adequacy assessment required under Pillar 2 of Basel II, which essentially links risk assessment to capital planning, will further strengthen the bonds between the staffs of the risk and finance units.

In this new environment, Chief Risk Officers must measure and disclose risks across business units, while Chief Financial Officers are required to sign off on regulatory reports based on complex risk models. The resulting pressure to link risk and performance measures on an enterprise-wide basis is forcing bankers to address how to replace the old model with one that more closely aligns the risk management and finance functions.

Indeed, recent survey research by Accenture of senior executives responsible for Basel II compliance at 63 of the largest banks in North America and Europe underscores the high expectations for integration of risk and finance. Asked for examples of Basel II's benefits, the greatest number of respondents - 83 percent - cited two areas equally, improved capital allocation and closer alignment of the risk and finance functions (see Chart). This should improve the quality of the data that support decision-making, particularly through a more risk-sensitive approach to profitability analysis and capital management.

INTEGRATING YIELDS RESULTS.

Banks that lay the proper technology foundation now in order to more tightly integrate risk management and finance can achieve significant long-term benefits besides regulatory compliance, including improved process and operational efficiencies, reduced losses, enhanced pricing for risk, improved management of risk and better financial reporting.

Looking at it another way, failing to integrate is likely to lead to appreciably higher operational costs and overlooked risks. With distinct risk management and finance units, many banks suffer from multiple source extracts, redundant data, inconsistent data quality, and a lack of agreement about terminology common to both.

For example, at one global banking and insurance conglomerate, the three risk officers - one each for credit risk, market risk and insurance risk, and each with their own separate data bases - don't collaborate nor understand the interdependencies among them because they don't integrate data and risk analysis. The three risk groups each transfer data reports to the department responsible for external regulatory reporting which then must combine the data on spreadsheets to be sent to the regulatory authorities. The process is time-consuming, labor intensive and often plagued by inconsistent data streams. Additionally, the risk groups and the finance unit use incompatible product names.

In trying to break the logjam, the company developed a common vernacular so that the risk managers and financial reporting teams would use the same name for the same product. This was a small, but important step in setting the risk and finance units on a path of closer alliance. With a common infrastructure and language, the risk groups could more easily exchange information with the regulatory reporting unit, more effectively work together to understand the correlation of risks, and share investments in maintaining the infrastructure.

INITIAL SAVINGS.

Once implemented, what impact would tighter integration of risk management and finance have on a bank? We calculated the overall benefits of integrating finance and risk architecture and aligning finance and risk operations by using a model of a hypothetical bank with $200 billion in assets, book capital of $16 billion, finance and risk information technology costs of $160 million, and finance and risk operations costs of $100 million.

We estimate that integrated data architecture at this model bank can generate net potential benefits of up to $26 million in reduced finance and risk information technology system and support costs. The savings would be driven by the elimination of redundant data bases and systems, reduction in data storage and information technology support personnel, and the elimination of multiple applications.

There is no uniform approach to integrating architecture and the assumptions above do not imply abandoning existing data bases in favor of a single enterprise-wide data warehouse. . The key is to have various data bases talk to each other which will in turn, enable multiple reporting. The architecture should lead, over time, to enhanced productivity (revenue per person) as a result of realigning resources.

The model projects further savings of up to $28 million in reduced operating costs through the alignment of finance and risk operations. These savings would derive from efficiency gains as the finance and risk units align and are cross-trained, shared compliance reporting services, reduced reconciliation and remediation costs, and shared processes using a single "version of the truth".

Migrating data analysis and reporting of risk and financial results into a shared services center is likely to accrue additional benefits:

* Centralization of data quality and validation rules leading to improved consistency of analytics and reporting.

* Economic and regulatory capital alignment provides both compliance and performance reporting.

* Financial and risk processes are rationalized and streamlined across the business.

* Finance and risk data is reconciled, maintaining the integrity of performance measures.

* Integrated architecture provides the platform for embedding Basel II within the business and generating significant benefits from the regulatory investment.

* Streamlining of processes will leverage the commonality in finance and risk regulatory requirements, improving skill utilization and cross-training in financial processes such as external regulatory and financial reporting.

BENEFITS BEYOND EFFICIENCY IMPROVEMENTS.

These improvements - more efficient systems and greater staff integration - will lay the foundation for the most significant payback: the implementation of enhanced business analytic capabilities across the enterprise that can deliver up to a four percent return on equity, and an enhanced return on assets. For our hypothetical bank with $200 billion in assets, the net potential benefit would be upwards of $265 million spread over a span of two years of implementation and five years of value realization.

Shared financial analysis processes will be embedded throughout the bank, providing enriched economic capital and profitability information to decision makers at all levels. Economic capital - in line with Basel II regulatory calculations - will be used to eliminate excess book capital not required for strategic actions. Additionally, the integration of finance and risk will provide real-time updates of performance calculations to support active portfolio management and risk based pricing using management accounting data to measure RAROC (risk-adjusted return on capital) potential and actual results.

Here is a closer look at these benefits:

* Improved Capital Management.

Improved capital management is the essence of Basel II compliance. Banks will gradually reduce or reallocate excess book capital based on a "bottom-up" loss measurement view driven by economic capital By implementing Basel II's advanced capital measurement approaches for credit, market and operational risk, and understanding expected and unexpected loss at a customer account level, we estimate a net benefit of between 175-200 basis points on current book equity.

* Active Portfolio Management.

Portfolio managers will have accurate risk and profitability information for setting pricing and limits to exposures at the portfolio level across segments and products. Active portfolio management can yield an estimated net benefit of between 80-100 basis points on current book equity.

* Risk-based Pricing.

Risk-based pricing is an underwriting method by which a credit application is evaluated based on how much risk it contributes to a bank's global portfolio. This method can achieve greater and faster improvement in shareholder value because it drives banks to differentiate pricing based on customer or segment characteristics. More than just an isolated tool, risk-based pricing can be part of the performance measurement process. Correct pricing can be lever aged to not only increase price on certain segments, but also eliminate value destroying business. Risk-based pricing can yield an estimated net benefit of between 70-80 basis points on current book equity.

* Profitability Reporting.

Profitability reporting is another risk-based tool which, in line with the dictates of Basel II, enables banks to allocate capital based on risk-adjusted measures. RAROC is a methodology based on measuring the expected and/or historical return on a transaction or portfolio on a risk-adjusted basis. Measuring profitability using RAROC can help banks decide where to reallocate capital and make other strategic decisions.

As risk and finance information technology architectures become more integrated to meet Basel II, financial institutions will further adopt new accounting standards and other regulatory requirements, risk measurement methodologies and portfolio management tools.

MANAGEABLE PROJECT.

Designing and implementing an integration plan need not be an overly time-consuming, resource-draining experience. Indeed, in most cases, we've found that it takes about two months to complete an initial assessment: diagnostic and needs analysis, high-level architectural and organizational design options, the business case, and the implementation plan.

The implementation itself is typically broken down into a series of logical steps to facilitate progress tracking and minimize risks. As a general rule, to build, test and implement the various phases of an integration - aligning finance and risk data management, architecture, operations and business analytics, and developing program management, governance and communications - takes roughly 18 months.

Basel II is driving the move to more closely align risk and finance. Operationally, this will deliver a range of benefits and avoided costs, through better systems integration, enhanced data quality, consistency between risk and finance data, automated reconciliation, and involvement of risk in the calculation of regulatory capital.