Finding return in risk management: banks will benefit from the implementation of Basel II requirements. Introducing the right technology is a crucial piece of the process.

The major regulatory changes that are now happening among all publicly listed companies came slightly earlier to the world's banks. They have been working through the requirements set by the Basel Committee on Banking Supervision for many years now.

A recent major initiative of the committee is the Basel II Accord, which seeks to strengthen existing capital adequacy standards by introducing more sensitive measures for credit and market risks, as well as new capital requirements for operational risk. Set to replace the Basel Accord of 1988, which is used by nearly all countries as the basis for the regulation of their banks, the Basel II Accord stipulates how much capital banks should hold to mitigate their risks.

Basel II is intended to prevent banks from going broke due to bad risks or a hostile operating market. Nick Leeson's role in the collapse of Barings Bank in 1995, in which he secretly accumulated hundreds of millions of pounds in losses from risky futures and options trades, played a significant role in prompting updates to the original 1988 Accord. And while some provisions of the new Accord are still under review, it should take effect in early 2007.

Undoubtedly, banks will have to make a significant investment in both capital and time as they implement the tools and processes necessary to comply with Basel II. But financial institutions that see this as a hindrance, or are taking too narrow a view of the provisions of the new Accord, are missing the point: Basel II should bring about deep-rooted and positive changes to the very way in which banks use their information and operate overall, and how adaptable they are to inevitable changes in the future.

Like the internal control regulations brought on by the Sarbanes-Oxley Act in the U.S. and Bill 198 in Canada, the Accord should be a catalyst for banks to review their information management, integrate their information more effectively with management processes, and build in the control and reporting capabilities that the Accord essentially encourages. Organizations that take this view will not only meet the Basel II challenge, but also gain a clear competitive advantage in their business.

Benefiting through compliance

The Basel II Capital Accord is founded on three pillars. Pillar one is maintaining a minimum capital requirement to protect against risks; pillar two is the supervisory reviews process; and pillar three addresses market discipline and reporting. Each pillar has specific implications for information management; together, they demonstrate the need for all banks to assure that their information management systems are carefully deployed, preserving their competitive position in the marketplace.

There is a demand for more risk sensitivity and flexibility throughout the banking system. With these changes, banks will operate with capital adequacy ratios dependent on their risk management, credit control and reporting capabilities.

Effective risk management, calculation and reporting software applications, and the systems and database platforms to support them, are an integral part of realizing the benefits of the new regulatory environment. With the mitigation of risk, banks should have fewer losses, stronger earnings and more efficient use of their capital, ensuring a proper return on investment. Also, the increase in operational transparency could improve the public and stakeholder perception of the company.

Improved information management will also support a wide range of proactive business activities. The degree of data reconciliation, management and reporting required by Basel II, particularly in the area of operational risk, supports everything from maintaining the general ledger, to enhancing HR systems to implementing a customer relationship management (CRM) program. Financial, operational, administrative and marketing activities can all benefit. Those companies that can best realize the direct and indirect rewards of the Accord will do so by aligning risk and compliance with every aspect of their business.

Return in risk

There are three areas in which a financial institution needs to ensure its systems are enhanced and readied for the requirements of Basel II: the collection and storage of data; risk calculation and capital requirements; and internal and external modeling and reporting. For each area, the individual requirements an organization decides to implement will depend on the level of complexity the organization intends to adopt.

At the heart of any project, regardless of its complexity or sophistication, must be a unified source of information through consistent, integrated, reconciled data--a "single view of the truth." This accuracy and level of transparency should not only meet Basel II's requirements on risk data collection, calculation and reporting, but also create new business benefits for the organization.

To achieve this, however, banks shouldn't immediately dismiss their current information management systems. Improving a bank's current system may involve enhancing that system with new technology that introduces the necessary flexibility, while providing a wide range of supported applications.

Data collection and storage

An institution must completely understand its relationship with customers and suppliers and all the instruments involved in doing business with them to comply with, and benefit from, the changes to the credit risk regime. Instituting a tracking system for these relationships allows banks to create a consolidated position across countries, currencies, instruments and industry sectors.

Those banks hoping to benefit from applying the more advanced risk assessment approaches under the first pillar of the Accord, protecting against risk, should be able to consolidate a range of detailed information involving transactions, counter parties and instruments in a robust system.

This information is broadly similar to that which is required for developing the income elements of a profitability management system. Banks can use software that specifically enables financial institutions to accumulate the large amounts of information necessary to operate at the required level of detail for both risk and profitability purposes, whether at account or individual transaction level.

Risk calculation and capital requirements

One of the key requirements of the new Accord is monitoring "the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems." Technology can support the monitoring of each of these potential vulnerabilities.

For instance, most day-to-day tasks and processes are comprehensively specified and predefined, which allow an organization to create systems that support careful monitoring of them. Employees can use self-service applications, while control is maintained via comprehensive security features and a wide-range of built-in reporting and monitoring tools. When such systems are built to work together, it eliminates the common pitfalls of integration and removes some of the major causes of systems failure.

Many organizations haven't yet understood the implications of the operational risks requirements of Basel II. These extend deep into corporate procedures that may not seem obviously connected to financial risk management. HR systems, for example, must ensure that procedures and documents surrounding such tasks as staffing, education and system maintenance, are properly recorded and documented, and that organization 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. Most organizations aren't fully aware of this fact.

Modeling and reporting

It only makes sense that organizations with consistent and accurate information available in a reliable format will be able to quickly provide regulating and reporting authorities with the necessary documentation when required.

With the global nature of today's financial institutions, technology strategies must be robust and flexible enough to ensure multi-country, multi-supervisory coverage based on common data and modeling. And given the increased dependence on the Web for information transfer, Web-enabled reporting systems are a must. Software solutions can enable selected external parties to view those parts of the bank's information that are appropriate to their needs. This eliminates the need to reconfigure and recalculate data for discrete geographies.

The pressure right now is on financial institutions to focus on compliance and improved reporting, and it doesn't end when Basel II is fully implemented. Organizations must take the opportunity to ensure that their systems, applications and processes remain flexible and scalable enough to evolve with future developments. The construction of a powerful information management resource will help banks seize this important opportunity and realize a significant competitive advantage. In meeting these challenges and seizing these opportunities, a new risk and reward landscape opens up.

Dave Rumer is senior director of North American field marketing for Oracle Corporation Canada.