Capital

Banks must keep cool and not be intimidated by the approach of the next revision to Basel. By Alexander Dorfmann, senior product manager at SIX

Cast your mind back to around this time 14 years ago, when a certain investment bank’s share price nosedived amid major concerns that its short-term liabilities were far greater than its liquid assets. After losing control of its capital and liquidity requirements, it filed the Chapter 11 petition that remains the largest bankruptcy filing in US history, involving more than $600bn in assets. 

That bank was Lehman Brothers, of course, and its historic downfall was underpinned by a fundamental failure to understand how much capital it needed to hold in reserve and how much liquidity has to be available to make its short-term liquidity payments. It was the equivalent of the man on the street walking around with a debit card without enough money on the card to pay for everyday essentials.

Almost one and a half decades on, and the issue of how financial institutions review their capital for operational, credit and market risk are still major factors in the future of finance. First enforced back in the 1980s only to come into the mainstream after the 2008 crash, Basel is perhaps one of the longest running regulatory franchises in the entire history of high finance, alongside the likes of the Markets in Financial Instruments Directive and the European Market Infrastructure Regulation.

When major regulatory deadlines loom, there is an inevitable tendency for the financial industry to scramble for minimum viable compliance. The next version of Basel, despite being less than two years away, is no exception.

The trouble is that two years will come around sooner than people think, and no bank wants to run the operational risk of failing to calculate exactly how much capital and liquidity is needed to protect themselves from credit losses and sharp price falls, especially at a time when banks are under considerable pressure in the current pandemic-affected environment.

But unlike previous versions of the rules, this version of Basel is more evolutionary than revolutionary. This is due to the fact that, like so many other regulations that already have the basic framework of rules in place, there are no dramatic changes required this time. The revised Basel rules are mainly a series of intricate details that have been tweaked to keep pace with increasingly complex financial instruments, rather than as a response to an equivalent cataclysmic Lehman Brothers-type event, which caused a reconsideration of the framework maintaining banking stability.

These minor alterations to Basel come as regulators continue to increase their focus on high-quality, accurate and transparent reference data, and historical market data. However, no bank, particularly in the current economic climate, can afford to be running large-scale internal regulatory projects for just a few small incremental changes right now.

From Capex to Opex?

The acceleration of digital innovation in the financial markets and banking as a result of the pandemic has been sudden and is likely to lead to a continued search for efficiency savings as the business environment remains challenging. The reality is that this version of Basel is also a driver for greater automation and cost-efficiency. Accelerated by the new ways of working and the new Basel capital framework for credit and market risk, this quest for greater efficiency could be marked by a shift from capital expenditure to an operational expenditure approach. After all, with the Basel reforms it is not as if a bank has to disclose their client positions. It is all about what assets they hold. 

Cloud computing has the storage and computing power needed to find the edge for these operational data management tasks. Moving internal rule sets, financial products and databases into a cloud environment should, in theory, free up working capital for a bank to invest into profit making areas for the business. A hosted solution forces the bank’s data providers to deliver high-quality reference and market information in a format that can easily be integrated into existing reporting templates.

This is key as, ultimately, high-quality reference and market data are the foundations of strong regulatory data. Without this information, which is made much easier to analyse in a cloud environment, financial institutions will struggle to identify and address any non-modellable risk factors. The cloud allows firms to free up time and focus on higher value tasks such as interpreting and analysing data. 

All these years on, the vast majority of financial institutions have learned the lessons of Lehman’s collapse and, as a result, have their credit, market, interest rate and liquidity risk houses in order. While another incarnation of Basel will continue to steadily make the financial system more resilient to systemic risk, one can also see how banks could use the rule as an opportunity to seek out greater efficiencies across the business.

Just because a bank continues to build their capital requirements solutions on premise, as opposed to in the cloud, it does not mean they will go the same way as Lehman’s. However, they may find that they are overtaken commercially by early cloud adopters who have the headspace to focus on higher-value tasks without being weighed down by arduous administrative and operational tasks.

A Speakers’ Corner is an area where open-air public speaking, debate and discussion are allowed. The original and most noted is in the north-east of Hyde Park in London

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