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| Internal Controls: Data Management - The Next Frontier |
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| Tuesday, 06 November 2007 | ||
| APF | ||
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In an environment where the market for risk-tracking related software and financial services approaches $16 billion, we continue to witness 'surprising' credit crunch casualties. In its wake, entire management teams have been taken out and share prices have taken a battering. Defaults in U.S. subprime mortgages have contaminated the value of supposedly A-grade debt, and has created a domino effect in terms of destroying investor confidence in an increasing number of structured security products. As this unravels, U.S. market prices continue to tumble, and the value of the collateral backing the debt is being eroded. Clearly we are seeing a diminished prospect of a rapid solution to the current credit crunch. Over the past two decades, the growth of over-the-counter (OTC) derivatives has been phenomenal, thus, becoming the cornerstone of derivatives trading. The substantial growth of these instruments can be, in part, attributed to the market needing new investment vehicles to engineer finance and risk management applications to enable circumvention of foreign exchange and regulatory controls. However, as these structure products have been pushed out to a wider variety of financial firms, the intuitional understanding of these products has diminished. Throughout the boom in complex leveraged and collateralized debt instruments, high yields have all but blinded investors to the significant risk. Now that the market has turned sour, and lenders are calling in the debts, investors are learning the hard way exactly how CDO's and other exotic instruments unravel. The market will survive this crisis, but not without a few major casualties. To avoid more casualties, institutions need a comprehensive understanding of all the debt they hold, and of all the related information on customers, counterparties, issuers and collateral. With a clear view of both their exposure to risk and the collateral they can offset against that risk, institutions can weather the storm and prove their viability to the market. To financial and compliance professionals it is clear that the current risk measures are insufficient. They have learned that measures of credit worthiness cannot be solely left to rating agencies. Linked multi-variable understanding of security and collateralization attributes, transaction counterparties, and position detail are essential. It's no longer enough to ‘Know Your Client." We must also "Know Your Security". The Current Crisis in PerspectiveThe continuing credit crunch is not the first financial crisis we have faced, and it will not be the last. As the trend toward globalization in the financial markets has grown, so has the tendency for financial disruption whereby a relatively minor default in one country or area of the market can cause a domino effect in apparently unrelated regions or sectors of the market.Today's credit crunch is almost a textbook example of the domino effect: defaults in a $100 billion market sector - U.S. subprime mortgages - are destroying confidence in trillions of dollars of debt and structured instruments. Because subprime mortgages have been routinely pooled and packaged with other debt in large, complex CDOs, they are contaminating even highly rated debt, creating a risk-averse market. The subprime crisis has highlighted the over-exuberant valuation of much larger tranches of debt. Although the global economy remains strong, and interest rates are historically low, confidence in the market has taken a major blow. The raising of interest rates and enforcement of tougher credit standards has not been enough to stave off a full-blown crisis - precisely because the size of the potential losses is still unclear. Institutions don't know how much additional risk they need to compensate for, and are desperately clawing back liquidity from the market onto their balance sheets. The market has been here before, and will doubtless survive similar crises in the future. But not all the institutions in it will survive. To avoid joining the list of historical casualties, institutions need a clearer and faster understanding of the debt that they hold, and of the complex inter-relationships between their customers, counterparties and client. Current Industry InitiativesComprehensive and extensive security attribute and collateralization detail, feeding internal and third party risk systems, is often overlooked. Recognition of the importance of security attribute data has spawned an industry initiative aptly titled "Enterprise Data Management (EDM) and the EDM Council. The EDM Council, founded in 2005 is a non-profit business forum for financial instructions. The Council was created by a number of global financial participants to address underlying data management business challenges associated with security data and collateral management.Enterprise Data Management significantly increases the quality, breadth and depth of data attributes and collateral, enabling institutions to know exactly what they hold, who are their customers' and counterparties, and what is the mark-to-market position for any instrument at any time. By creating a complete detailed view all structured instruments, EDM delivers a single version of the truth and supports rapid, accurate analysis and operations. Fuelled by chief compliance officers, major financial firms have embraced the concept of centralized enterprise data. Projects to link siloed security databases to enable rapid valuation of even the most complex instruments, have become industry norms. These projects often extend to collateral management, where EDM makes it easier to prove that debts are adequately covered. The projects provide the financial professional with increased security level transparency and improved audit capabilities. In order to ensure that the firm is implementing an EDM strategy that best mitigates risk, the Chief Financial Officer must work closly with the Chief Risk Officer to ensure that all security data, including collateralized debt structure data, is transparent throughout the firm. Attribute information such as deal structure, counterparty financial roles, firm position and client information all need to be archived and linked. As one centralized enterprise view of security data is achieved, reporting and audit capabilities increase and default threat can be contained. Best Practice to Ensure TransparencyMust support unique, structured products while maintaining a clear top-level view; Must be transparent - when exotic new products are built, all the underlying links and dependencies must be transparent, enabling a clear understanding of the credit-risk profile of all components and counterparties for a particular product; Must ensure one can roll up or drill down through all data from any perspective; risk, profit and loss, collateral management; Enable new, complex structured, products to be created without any difficult or lengthy modelling work. Can begin trading new instruments quickly and easily. Value and inherent exposure of those instruments is always readily visible - helping to protect the institutions against risk.
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