Taming the Wolf: Managing Risk in a Regulatory Environment

The Wolf of Wall Street highlighted the excesses of the financial services industry. LOC Consulting’s James Keenan examines how investment banks can address complex issues arising around culture, risk management, and transparency, at a time of significant regulatory reform.

Martin Scorsese’s portrayal of the rise and fall of Jordan Belfort of brokerage firm Stratton Oakmont, is said to have stretched beyond the realm of possibility. Audiences loved it, more circumspect financial services professionals hated it, and film critics described it as ‘the rigging of the American game unveiled’.

Nevertheless, several elements of the film ring true.  The crux of the story is that Stratton Oakmont’s success was built on the fraud known as ‘pump and dump’ – a technique that works by buying up the stock of worthless companies through nominees, selling it on a rising market to genuine investors, and then unloading all of it. This practise eventually saw Belfort jailed.

Systemic risk

James Keenan

The Wolf of Wall Street serves as a cautionary tale. Certainly it can be hard to see the wood from the trees with highly complex products being traded. Moreover, investors need to be cautious when the wood (i.e. the bourse) happens to be inhabited by wolves.

Likewise, the latest regulation sweeping the financial services industry is necessary to protect the wealthy one per cent of potential investors that Belfort urges his ‘wolf pack’ to ‘harpoon’, or to guard against rogue traders committing securities fraud by pricing derivatives portfolios in a way that reduces reported losses.

Derivatives are contracts between banks and other investors. Linked to corporate debt, commodities, currencies, and other assets, they are a major source of credit exposures between the largest global institutions. The collapse of Lehman Brothers in 2008, came about because Lehman’s portfolio was tied up in highly complex and opaque OTC derivatives.

Lehman was just one of many major banks and financial institutions bundling complex OTC derivative instruments together such that the true risk inherent in transactions was not obvious. Due to this high complexity, lack of transparency, and a culture focused on financial gain, banks failed as things went wrong, bailouts ensued, and the leveraged debt around certain trades had a disproportionate effect on financial systems and the global economy.

Exponential problem

Recognising that comprehensive OTC derivatives regulatory reform regulators are introducing numerous rules including EMIR, Dodd Frank and MiFID. These aim to reduce counterparty risk, improve transparency, and enable regulators to better assess, mitigate and manage systemic risk. They present substantial challenges for financial institutions.

Implementation is problematic as regulators are putting in different obligations at different times which can be contradictory. The new rules also continue to evolve and expand to eventually encompass all relevant OTC derivative asset classes.

Inherently complex

Delivering business change to ensure compliance in these circumstances is inherently complex. Employing a conventional project structure and approach to address regulatory change is not an option. There is a diversity of internal and external stakeholders involved, and the fact that mandatory delivery timelines can move makes scheduling difficult.

Furthermore, the interdependency of rules calls for fundamental system changes, many of which will need to be delivered concurrently, and without impacting on ‘business as usual’ activities. The core concern for financial institutions is that regulations cannot be delivered to the required quality through existing organisational structures, leaving significant areas to address.

Ongoing analysis of the evolving market, deep industry knowledge and interpretation of the in-coming regulation will be essential in ensuring that new central clearing and e-trading platforms are delivered in a compliant way. It will be vital to clearly set out and communicate the new workflows and technical capabilities necessary to execute the electronic trades, and ensure that all members of staff have a full understanding of the behaviours no longer permitted.

The rationale for the workflows is important given the complexity of the often competing regulations cross-jurisdiction, such that key workflow aspects are not inadvertently removed leading to a regulatory breach, or obsolete elements left in place leading to inefficiency.

Strategic delivery capability

With substantial financial and reputational implications attached to any instance of non-compliance or breach, it’s essential that senior decision-makers are engaged in the implementation of any rules. A strategic delivery capability is therefore required and can be achieved by establishing a governing committee to span all regulatory delivery. Led by a senior chair under which design authority committees can sit, this enables financial institutions to manage operational risk arising from regulatory change.

Taming The WOLF: Managing Risk In A Regulatory Environment

A dedicated business project team should also be established to provide an effective conduit between programme sponsors managing trading sales activities and the IT teams making system changes. This way, aims are understood and requirements clearly defined before being fed into the IT teams. A defined methodology is recommended covering the following:

• Rule interpretation by legal, compliance and business experts
• Impact analysis by business experts
• Definition of IT requirements
• Dependency management and implementation scheduling (with integration in to change management roadmap)

It must be recognised however, that project teams are temporary by nature, thus the financial institution itself needs to embed the required responsibilities within the organisation. This is where many organisations opt to engage an experienced external provider to drive the structural change required and ensure that the necessary level of in-house competency is achieved to sustain the capability going forward.

Strong and collective desire

For an industry often accused of gaming the system, regulation is the only game in town for the next five years, making it imperative that financial institutions enshrine compliance and transparency firmly within corporate culture. Regulation cannot ever eliminate risk completely, but it can improve the way risk is managed provided it is approached with the appropriately level of gravitas.

Without a strong and collective desire to not only follow the letter but the spirit of the rules, organisations will always find ways to work with those rules to their competitive advantage – those then become industry accepted norms and the circle starts again. Industry-level cultural change is the only way to avoid such a circle, and requires strong, prohibitive action from regulators at individual and corporate level.

With a strategic delivery capability for managing business change built on a robust governance structure, strong senior-level buy-in to drive towards greater compliance and including a communications programme embracing both internal and external parties, financial institutions will be better equipped to successfully transform their business with minimal operational disruption.

Importantly, they can employ the same mechanics and structure to respond rapidly and appropriately to further regulatory shifts, engage with trading partners compliantly, and intervene in a rapid and appropriate manner should issues arise.