We saw this movie before, at least the rough cut. On July 9, regulators jointly released Basel III: The Final Cut. Large institutions will be required to begin to implement Basel III on Jan. 1, 2014, with smaller institutions scheduled to begin on Jan. 1, 2015. Furthermore, as a compromise for regulators who didn’t think the international Basel III standards went far enough, supplemental leverage ratios were proposed to begin to be implemented for the very largest banks beginning in 2016.
Concurrent with Basel III are the stress testing rules, in effect today under the Federal Reserve’s Comprehensive Capital Analysis and Review (CCAR) and CapPR for larger institutions, and effective Oct. 1, 2013 for smaller ones. As part of the oversight, the Federal Reserve Board (FRB) and other regulators conduct or will conduct annual assessments, including “stress tests,” of the capital planning processes of financial institutions to ensure that these institutions can continue operations in the event of economic distress. This is followed by an expectation for the banks to have credible plans showing that they have adequate capital to continue to lend, even under adverse economic conditions. In addition, Basel III will also have safeguards to ensure banks are well-capitalized, and not overly leveraged in times of economic stress, and may even impose a “countercyclical capital buffer” if, in its opinion, the times warrant.
Whether it is meeting the requirements of BASEL III and CCAR, CapPR, or other stress testing regulations, institutions need to commit sizeable resources to abide to new and ambiguous regulations within short timeframes. Nevertheless, these compliance responsibilities offer an opportunity for a bottom-up approach to credit strategies, which can also be applied to other business processes.
Basel advises banks to measure credit risk: “Banks should have methodologies that enable them to assess the credit risk involved in exposures to individual borrowers or counterparties as well as at the portfolio level,” reads Paragraph 733 of the Basel text. Sounds reasonable, and a bit self-evident; banks should be able to assess their credit risk—whether Basel mandates it or not.
If this were a movie, it would have a depressing tone. Planning for the worst case scenario is not an exercise that generally lifts one’s spirit, but is there a way to turn this scene into something that would bring a more positive, uplifting message. It is about constantly assessing your current processes and strategies, so that you are prepared for regulations and are operating at maximum efficiency.
In response to the challenges of CCAR, stress testing and BASEL, many institutions are choosing to restructure their businesses to meet compliance. Some banks may move away from certain business lines in response to the new capital requirements or risky concentrations. For example, a retail bank may shed an investment banking unit, or increase retail lending, while decreasing corporate lending. These moves are taken toward the goal of optimizing a bank’s Risk Weighted Assets (RWA) and use of capital, as these “RWA Optimization Strategies” may minimize regulatory impact.
While some banks follow this approach to optimizing their RWA, a case can also be made for a bottom-up approach, one that focuses on operational processes like credit rules, thereby driving value from existing portfolios. For example, improved customer screening to accept or reject applicants, applying finely-grained pricing limits based on credit data, or matching actual risk with expected or forecast risk.
Because each strategy shift or operational change has consequences to multiple interconnected processes, it becomes imperative to test prospective moves before putting them into place. Every decision can have far-reaching consequences. A decision-optimization framework is essential to enhancing credit strategies. This requires data analytics, optimization software, and a consistent decision engine that can be customized for specific variables, tested and modified so that it becomes self-learning over time.
Notably, few processes operate in a vacuum; addressing credit rules, policies and processes impacts every department. The interaction between strategic decisions and operational processes has an exponential effect on both processes and profit. For example, credit decisions made in the front office must align with the operational systems and processes of the back office.
A decision optimization framework allows an organization to test which strategy best aligns with its goals and risk tolerances. How much can prices increase before losing customers? At what point does the increased price outweigh that lost business, and when does it still make sense?
In one testing exercise, Experian applied portfolio data, variable offers, rules and decision options to an optimization engine. The intent of this testing was to evaluate how likely loan offers would be accepted or rejected, and the ultimate effect of long-term profit. The results indicate that an organization can increase its booked loan amount while increasing the value of its loan portfolio.
Strategic decisions such as which business line to pursue or where a financial institution should locate, are made based on clear goals and expectations for risk and reward, not clouded by regulatory mandates. These choices do not come easily. And because they so heavily impact a bank’s profitability—and its reputation—any credit strategy decisions should be tested prior to implementation.
Stress testing offers an opportunity to drive more value from existing operations, customers and profits. Capital is enhanced (and thereby further satisfying the demands of CCAR and BASEL) without sacrificing growth potential or competitiveness. So if a bank is already compelled to put its capital assets and resiliency to the test for Basel III, doesn’t it also make sense to conduct testing that might find operational deficiencies and profit opportunities?
Shannon Lois is vice president of consulting for Experian’s Decision Analytics’ Global Consulting Practice. She may be reached by phone at (678) 731-1165 or e-mail email@example.com.