If risk management tools had been more effective in preparing the banks for potential crisis, one could argue we could have avoided such a crunch. Many of the risk management techniques used were based on the assumption that the market is normally distributed, but from what we experienced, this assumption is undoubtedly inaccurate.

A Normal Distribution (graph below) is based on the theory that the mean of a sufficiently large number of random variables will converge to the average. The mean is in the middle, while the standard deviation (the amount of variation from the mean) is represented as sigma, to either side of the curve. With a large number of similar events occurring before, we can estimate the probability of a future event occurring based on the distance the future value is from the average.

Many risk management tools are based on the assumption that markets are normally distributed. Such an assumption can be true when the markets are steady, but once markets become volatile, the risk is uncertain and the models become ineffective in mitigating a bank’s risk.

Banks use Risk models such as Value at Risk (VaR) to reassure themselves that they are not taking excessive risk. This model is a financial market tool used to estimate the potential risk of a loss on a portfolio of financial assets in normal market conditions. In the late 1990’s, derivative trading became increasingly popular. As a result, the Securities and Exchange Commission ruled that firms had to include a quantitative measure of the disclosure of market risk in their financial statements. VaR was the most suitable model as it expresses risk as a single number, a currency figure. Traders with very little risk knowledge could therefore use the figure for quick decision making and were unwittingly accumulating risky trades on their balance sheets with no more than a VaR value to back up their investment strategy. Ultimately, this risk management tool gave traders a false sense of security.

Why is the model not reliable?

The model depends on the standard deviation and correlation of returns, where such variables only make sense under the normality assumption. However, in reality, the world is not normally distributed and abnormal events such as the financial crisis occasionally do take place. Such assumption claims that any deviance beyond 4 standard deviations can occur approximately every 4,000 years. In the summer of 2007 (the beginning of the crisis), the distribution suggested that the crisis was as likely as somebody winning the lottery 22 times in a row . It is clear that a model that failed in predicting the above losses should not be used as a risk management tool.

Lehman Brothers, like many other investment banks, declared bankruptcy as a result of the crisis. One of the humble rules in risk management is to keep a debt to capital ratio of less than 20:1, however in 2007 their ratio stood at 30:1. Unsurprisingly, Lehman’s primary risk management tool was VaR. They had a 99% confidence limit calculated on the daily price movements. Since the risk was calculated on daily price movements, that 1% therefore counts for a few days a year. This meant they expected to have losses greater than the VaR once every 100 days. The size of that loss remains unknown. Lehman’s debt ratio of 30:1 meant that a 3.3% decline of its assets would wipe out all of its capital, which is undoubtedly feasible in a volatile market. Given value at risk is used by banks to decide on how much capital to hold, if Lehman used a more accurate measure they may have been more prudent carrying the amount of debt on their books.

What can be done to make VaR an accurate Risk metric?

Rather than using a Normal distribution, distributions with more significant standard deviations can be used. Therefore, the probability of rare events occurring will be larger, allowing for banks to be better prepared for extreme losses such as the financial crisis. However, the downside of the normal distribution is that we are making assumptions based on past events, accompanied with the assumption that the past represents the future. To avoid such dramatic assumptions, creating scenarios of what the future may hold can prepare banks better. Since the crisis, there were regulatory revisions on the Basel II risk framework. The committee now requires banks to calculate a stressed VaR as an addition to the original. The stressed VaR is similar to the original; however, it also estimates the risk to the bank if the market is distressed – simulating various hypothetical scenarios under unusual market conditions.

The Lesson Learnt

The financial crisis was evidently caused by irresponsible mortgage lending in America and the fact that risky assets were passed on to financial engineers to diversify. Value-at-risk gave bankers a false sense of security, which tempted them to leverage the benefits of such diversification. The irresponsible trading of multiple CDO, CDS and the purposefully inaccurate ratings can be argued to be as result of the blinding security Value at risk gave individuals. The financial disaster is an example of how important accurate risk measures are. Banks should not only focus on more mathematically accurate risk metrics, but also consider worst case scenarios. The models used should undergo regular review, rather than blindly following numbers churned out by misunderstood models.

Bibliography
The Black Swan: The Impact of the Highly Improbable – Nassim Nicholas Taleb

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Financial and Regulatory Effects

Currently, as Britain is a member of the EU, they face regulations coming straight out of Europe, but what would happen to the UK should they leave the EU? Would the regulations be tougher or would there be less red tape, leaving them freer to operate?

Both Norway and Switzerland do not belong to the EU and they too face the scenario like the UK does in the sense that they had to adopt EU rules (e.g., free movement of labour, free trade amongst member countries) or face being excluded from the single European market. These regulations are vital for the UK to export goods and services. As a result, if Britain were to leave the EU and not voluntarily adopt the EU’s rules, it is likely that the UK’s trade would be severely hindered because of their exclusion from the European market. This begs the question, if the UK were to the EU but then adopted the EU’s rules, why would they leave in the first place?

MiFID/MiFID II – Known as the Markets in Financial Instruments Directive, MiFID is a directive that aims to integrate the European Union’s financial markets and to increase the amount of cross border investment orders. The UK, and possibly the U.S., may need to look into restructuring some of its business to be compliant with MiFID II. Under the new MiFID II legislation, it may be possible for the UK to register as a Third Country Entity (TCE), meaning they can still carry out business with European countries. However, this method is not currently recognised under the existing MiFID II rules enforced by the European Securities and Markets Authority (ESMA); therefore it could be challenging for ESMA to understand how to adopt and regulate these TCEs under MiFID II. It may also be challenging for banks to understand what is required of them to be compliant when trading with the UK, as they may need to follow new rules when trading with a non-EU country.

EMIR – Known as the European Market Infrastructure Regulation, EMIR applies to financial and non-financial parties in the European Economic Area that need to report derivative trades to a trade repository. Should the UK decide to leave, this would not necessarily mean that the UK is exempt from EMIR altogether. However, if the UK were to set themselves up as a Third Country Entity (TCE), then they would be exempt from trade reporting, but would still need to comply with mandatory clearing and uncleared trade agreements.

Trade Effects

Currently, there are on-going discussions between the U.S. and the EU over the proposed Transatlantic Trade and Investment Partnership (T-TIP). This agreement would increase the opportunities for American workers and businesses in the European Markets, helping to bolster the already formidably strong U.S. economy.

Whilst debating Brexit, the UK has been warned by many senior political US figures, including Barack Obama, that if the UK were to leave the EU, trade agreements like T-TIP would no longer be prioritised. Some industry experts have predicted that these negotiations could last for around eight to ten years, so deprioritizing these negotiations would only exacerbate an already lengthy process.
This could have a detrimental effect on both the U.S. and UK. Currently the UK is the largest European importer of goods from the U.S and the seventh in the world (as of April 2016, the UK has imported $18,403.8m of American goods)1, and the second largest European exporter just behind Germany, and the fifth in the world (with $17,2987.28m of exports per year)2. If new trading tariffs were introduced, along with a weakened pound against the dollar (which could be a likely effect following withdrawal from the EU) then this is sure to affect both markets and consumers.
The U.S. is the UK’s largest importer of goods (importing $66.5bn in 2015, 14.5% of total UK exports )3 if the UK left the EU, this would largely effect the consumers in the U.S. Main exports to the U.S. include machinery and transport equipment, chemicals and minerals to name a few. If trading relations between the U.S. and UK fell through, then the U.S. market would certainly forgo these products and may have to source these from a separate country entirely.

Many large American banks and business also have branches and offices situated in the UK currently abiding by EU trading and regulation law. Should the UK decide to leave, many banks and business may also choose to relocate to somewhere else in Europe, instead of facing new laws and regulatory change that could be expected if Britain withdrew its European membership. This in turn would potentially have a downwards effect on foreign direct investment in the UK.
Conclusion

With the upcoming Brexit referendum around the corner, no one knows the true extent that this could affect the U.S. or the regulatory landscape in the UK. What is confirmed, however, is that if the UK did leave, then bilateral trade negotiations with the U.S. would need to start immediately to avoid disruptions in trade, along with a full understanding of where the UK stands with the current European regulations, such as MiFID II and EMIR. One thing is certain, though – following the referendum on June 23rd, these questions will be answered, and markets should stabilize, allowing the government to plan ahead for the future.

1 U.S. Census Bureau, Foreign Trade. U.S. Trade in Goods with United Kingdom. Available at: https://www.census.gov/foreign-trade/balance/c4120.html

2 U.S. Census Bureau, Foreign Trade. U.S. Trade in Goods with United Kingdom. Available at: https://www.census.gov/foreign-trade/balance/c4120.html

3 Workman, D. United Kingdom’s Top Import Partners. World Stop Exports. 2016. Available at: http://www.worldstopexports.com/united-kingdoms-top-import-partners/

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The annual sailing event will see students from over 40 schools from around the UK descend on the club for a week of racing around Chichester Harbour.

Since 1953 Itchenor Sailing Club has hosted the National Schools Championships, formerly known as The Public Schools Firefly Invitation Championships. Its aim was to promote inter-schools sailing competition and encourage participation in the sport. Previous winners have included double gold medallist and silver medallist Rodney Pattisson, double silver medallist and Itchenor member Ian Walker as well as international sailor Phil Crebbin.

This year will see the introduction of a practice race on Sunday 26 June for the RS Feva category ahead of the week’s races. Championship racing for the Feva class will take place on June 27th and 28th with the Fireflies and 420s taking over between the 29th and July 1st.

Commodore of Itchenor Sailing Club, Charles Hyatt commented, “We are delighted with the turnout for this year’s event. It is one of our long-standing annual events, with many of our most successful sailors starting out in this competition. It is great to see the racing standard get higher each year, particularly since we introduced the extra day of training. We look forward to welcoming the students to our club and wish them all the best of luck for the tournament!”

Last year saw an impressive selection of both junior and senior student sailors participate in the event which culminated with Hayling Island College being crowned the winner of the Feva competition while RGS Guildford took home the title for the Firefy championships.

A key date in the sailing calendar, this year’s event is sponsored by MPI Brokers and JDX Consulting. It also marks the start of a five-year sponsorship agreement with the travel insurance specialist, MPI Brokers.

The new agreement sees MPI sponsoring not only the Schools Week Championships but the Mirror, Laser, Topper and International 420 classes in the club’s Junior Fortnight which this year is from 26 July to 5 August.

MPI is no stranger to the waters of Chichester Harbour as, with its sister company Mind The Gap Year, it has sponsored the Firefly and International 420-class events at Itchenor’s Schools Week at the end of June for the past nine years.

Another returning sponsor, JDX Consulting has been involved in Schools Week since 2013.

Registration to the 2016 Schools Week Championships is now open and schools can enter at www.itchenorsc.co.uk.

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While these benefits may debatably be true, much of it is far from certain. Trade renegotiations will be what define the “post-Brexit” landscape and these are likely to be lengthy, fractious, and at this point the final outcome is extremely hard to predict. Certainly, there are a number of strong incentives for the major EU powers not to offer the UK favourable trading terms as a means of discouraging other EU members from considering similar options. Within the world of financial services, while the benefits of leaving the EU remain hard to quantify and are often centred on long term outcomes, the short term effects of the referendum have been subject to in depth analysis and several key outcomes have been identified. Short term confidence shocks (and subsequent deprecation of asset values), restriction of access to EU markets and legal disputes over previously pan-EU trading agreements are outcomes of a split from the EU that have been predicted with a degree of confidence.

What follows is a run-down of the most likely effects, focusing on the immediate and most prominent hazards that the financial sector must remain aware of and prepare for.

Foreign Direct Investments and depreciating UK Equity values

In the short term, the UK leaving the EU would lead to a confidence shock within the financial markets as a result of the uncertainty around the outcome of the renegotiation of trade agreements. Uncertainty would cause investors to withdraw from the market, reducing liquidity and making borrowing conditions unfavourable. Indeed, withdrawal of assets has already begun before the vote. Strong evidence suggests an exit from the EU will have a negative impact on UK Equities in particular; Deutsche Bank predicts a 15% decrease in asset values and many other banks and financial institutions have produced similar predictions.

On a macro scale, this may lead to reduction in Sterling against other major currencies but could also lead to a reduction in capital inflows into the UK. In 2014, the UK’s total stock inward Foreign Direct Investment from the EU was £496 billion; nearly half of the global total of £1 trillion . The UK’s place in the single market significantly increases Britain’s trade with fellow EU member states, and as such a change in the UK’s regulatory relationship with the EU could mean companies have less incentive to invest or may even disinvest.

Regulatory and operational impact on Financial Institutions

Thousands of UK financial services firms make use of the ability provided by a shared regulatory environment to provide services in any of the other 27 Member States without having to get local approval to begin trading.

An exit from the EU would erode the ability of banks and asset managers to use the UK as a hub to provide financial services into Europe. Furthermore, benefits that came under common regulation, including MiFiD, could potentially be eroded. UK firms and other financial institutions could be required to either set up subsidiaries or relocate their headquarters within another EU country, leading to an increase in operational costs for these firms.

However, conversely, regulatory changes to the UK financial services framework as result of the leaving the EU could potentially benefit challenger banks such as Aldermore, who for the most part do not have a presence outside of the UK and as result will not incur extra operational costs as a result of the new trading conditions. An environment in which borrowing costs are rising and large international banks are encumbered by a rise in already large operational costs, may provide an opportunity for smaller and leaner banks.

Effects on the Derivatives Markets

Leaving the EU could lead to serious legal challenges for the derivatives market in the UK, which represents a large share of UK financial markets. Currently, derivatives contracts such as Interest Rate Swaps, Commodities Derivatives and Credit Default Swaps are traded under International Swaps and Derivatives Association (ISDA) agreements and normally come under British or American Law. If Britain were to leave the EU however, would the derivatives contracts between two Non-UK counterparties in the EU be accepted by local courts if there was a dispute over terms of the agreement? If amendments were required to these agreements to reflect an EU exit, the banks and their counterparties would incur large costs as hundreds of thousands of agreements will be affected.

Determining the full and lasting implications of “Brexit” on the UK financial services industry is extremely difficult given the uncertainty around the outcome of the numerous negotiations that would be required. It is possible that trade with non-EU nations such as China and other emerging market nations may make up for the loss of being part of a larger trading block, or an equivalency regime may be agreed allowing the UK to replace existing financial regulations without adversely affecting services in the long run. However, in the short term certain outcomes can be more confidently predicted. Depreciation in the sterling, a decrease in foreign direct investment and a potential need for legal and advisory services to renegotiate current ISDA agreements are all factors that financial institutions must be aware of, and ready for.

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Since the financial crisis of 2008, financial institutions in the banking and financial services industry have been under increasing levels of pressure to reduce costs attributable to shrinking profit centres. A number of factors can be seen to be impacting upon the profitability of the banking sector, including:

1. New regulatory requirements
2. More diverse competition from new and non-traditional service providers
3. Disruption by online non-banking financial providers
4. Low Interest rates
5. Political and social economic factors, e.g. Brexit

However, right-shoring is only one option, and, given its drawbacks, should not be looked at in isolation. In moving operations further afield, businesses must accommodate higher levels of risk, manage a potentially dwindling workforce motivation, consider external pressures and work to ensure their plans are future proof. Before deciding upon a right-shoring strategy alternative industry solutions should be explored, which, put together to bridge the gap, provide wholesale outsourcing and managed services. These are in many ways preferential, and are becoming more attractive with mounting confidence levels in their delivery.

What to consider in right-shoring?

Moving a function, process or service to another location brings with it a host of considerations. Not all functions can or should be moved to the lowest-cost site, despite the financial benefits this may bring. Higher risk business functions, for example, client service desks will require more careful consideration to the customer base, with many service functions retained on-shore mandated by regulation or preferential due to the business, social and time-zone advantages this brings.

Equally, in a regulatory market which is growing in depth and complexity, operations dealing with existing and upcoming regulatory compliance are often mandated to remain on shore, to ensure a better face-off to UK regulatory authorities.

It follows, therefore, that the first step in the right-shoring process must be a site review. Assessing suitability, sophistication and potential synergies of on-shore, near-shore and off-shore sites, for factors such as attrition, skill pool, education, language, geographical, political or economic risk, all in the context of the wider company strategy, will provide confidence and direction when compiling plans and obtaining buy-in from internal/external stakeholders and ultimately shareholders.

Once a suitability model has been established, this should not remain static but should be a constantly evolving measure against which a business can iteratively assess its transitional plans. In relocating part of any business, it is of utmost importance that along with people, processes and functions, culture and values are effectively migrated, instilled and upheld. Effective global alignment is seldom instantaneous, but will need to be honed to create mature, integrated and professionally attractive communities within global centres.

Ownership and accountability are key to any plan, and this must be scalable in relation to the number and sizes of the changes being considered. For plans impacting multiple business areas, a prudent approach would be to delegate departmental ownership to the respective management team members, which in turn encourages buy-in and accountability within an organisation.

Pitfalls to avoid

Right-shoring does not happen overnight, but is rather a structured and methodical set of changes that require sequential implementation. In offshoring a function, the new team will require documentation, handover and training, and post-implementation support. Focus should be on reduction of cost without negatively impacting performance. Companies that seek to realise benefits of a right-shoring exercise prematurely, doing too much too fast, often suffer in the long run, having to re-shore processes proven ineffective in their target site.

Adopting a wider perspective on change is crucial, by analysing business plans as a whole and not in a siloed manner, functionally or geographically. Ordinarily when the project or programme team responsible for management and implementation of the changes are reviewing these plans, cross-divisional dependencies and risks are unearthed. For example, concentration risk where multiple movements of resources are scheduled simultaneously will need greater levels of management and control. Equally a forward looking view of the functional organisation is crucial, ensuring time and money is not wasted relocating soon-to-be redundant or obsolete processes. The organisation can then make amends to avoid these risks and control dependencies as best as possible.

When starting down the path of a right-shoring strategy, it is recommended to utilise peer-analyses in the correct manner. Each bank or financial institution had different drivers and motivations toward tailoring their locational target states, be it price, local skills and expertise, or infrastructure. The key is to not simply follow the crowd, but rather utilise the results gleaned from the positive and negative experiences of others who have gone down a similar route. A right-shoring strategy should be bespoke to each organisation’s purpose, and in line with its higher-level strategic objectives.

That being said, plans must remain flexible, and an initially forecast target state may not need be final. It is not uncommon to see work being moved back on-shore to home countries, often due to factors such as: offshore supplier performance, inability to realise cost advantages, customer perceptions, time-zone considerations, social beliefs and government incentives.

Secrets to success

People dislike change. Change brings uncertainty, threatening the status quo. As most right-shoring strategies will span over months and often years, it is essential that management commissioning these changes receive buy-in from as many echelons of the organisation as possible. A management team with support lower down the organisation will almost certainly be more successful when implementing change. Proceed without and risk treading an onerous and costly road to achieve the end goal. When requesting that individuals work toward the demise of their own roles, motivational factors will need to be managed effectively – financial incentivisation and travel opportunity often weighing in more than longevity of employment.

Given the sensitive nature of this sort of change, the whole process must be subject to stringent controls. Communications to those impacted, and to the wider stakeholder group, including relevant trade unions, must be carefully disseminated in a controlled fashion to avoid any influx of unwanted activity or media attention. However, empathy, honesty and openness is key, with a management team far more likely to receive positive buy-in when openly discussing and substantiating their plans. A high level of control of communications, both internal and external, combined with speed of execution will help knock down barriers to execution before they arrive.

When moving into the implementation stage of right-shoring, wider areas of concern are often uncovered. Financial institutions should utilise the opportunity afforded by the right-shoring exercise to address uncovered issues and inefficiencies, and address these as part of the wider strategy. E.g. a lack of documentation can be addressed in effecting a concrete but documented handover to a nearshore/offshore team.
Is Right Shoring the right approach?

Seeking to cut a mounting cost base through an effective right-shoring strategy is not a new concept, but one that has been adopted and proved effective by organisations for many years. However, this option should not be used in isolation, and alternative remedies should always be considered for their suitability and financial benefit. The programme costs associated with implementing a right-shoring strategy, and longer lead times before any tangible benefits are realised may mean that a bias towards outsourcing becomes a more attractive option. However, if retained control and ongoing process optimisation is high-up on the agenda, retaining functions within the organisation, but operating at a lower cost will remain the preferred option. In either case, when deciding upon priorities and mapping out the options ahead, working with specialist consultancy firms with industry expertise will help close the knowledge gap, smooth out the process, and aid an organisation achieve its financial and global footprint targets.

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Banks: The Unwilling (or Willing?) Accomplices

In May 2015, the US Department of Justice filed an indictment against fourteen FIFA officials and sports business executives, alleging wired fraud, money laundering, racketeering and obstruction of justice over a twenty-five year period. Substantial amounts of money were allegedly channelled into private accounts of the officials involved, to the detriment of the sport and its reputation. Wire fraud and money laundering inevitably involve banks and payment intermediaries, often in complex chains channelled through tax havens. The use of financial institutions to facilitate the making of illicit payments, conceal foreign bank accounts, achieve income tax evasion, smuggle cash, and purchase property and other assets, as well as the obstruction of justice are just some of the chargers faced by the FIFA officials and the institutions involved. HSBC, Standard Chartered and Barclays have already been accused of accepting bribe payments in relation to FIFA. Whether willingly or unwillingly, banks will have played a role in this scandal. This is an association the industry can ill afford at present.

The Impact and Changes Needed

Primarily falling upon the sport itself, the consequences of the FIFA scandal may be considered as being rather narrow. However, other activities facilitated by inadequate AML / KYC controls, including terrorism and drug trafficking, can have far broader societal and financial repercussions. Corruption, for example, is shown to have a negative effect on domestic investments, tax revenues, inequality and the provision of basic services which inevitably impacts society’s most vulnerable. For the financial services industry itself, the consequences are primarily financial and reputational. The fines imposed on HSBC ($1.9bn) and Standard Chartered ($300mn) are just two examples of the willingness of regulators to impose penalties on firms who choose to circumvent AML / KYC controls or fail to enforce them. Furthermore, additional financial loss may stem from the reputational damage incurred, including damage to shareholder value and increased regulatory and operational costs.

Legislators have introduced measures designed to enhance accountability for AML / KYC amongst senior managements, the Senior Managers Regime (SMR), which came into force on 7th March this year, being one such example. The Regime focuses on individual accountability for those who hold key responsibilities, including AML / KYC, within certain institutions. Those responsibilities must be mapped to clearly demonstrate what they are accountable for should a regulatory issue emerge. The tasks firms are expected to perform have also been strengthened. For example, the Fourth Anti-Money Laundering Directive imposes more robust due diligence requirements as well as new reporting and record retention obligations. It also requires Member States to maintain central registers of beneficial owners.

Despite these efforts, gaps clearly remain and further action is required. There is evidence that suggests that as much as half of banks fail to apply EDD (Enhanced Due Diligence) to any level of meaning, a third fail to have effective measures to identify customers as PEP (Politically Exposed Persons) and a third of banks appeared to be willing to accept high levels of money-laundering risk if the immediate reputational damage was acceptable. This was especially applicable to smaller banks. Clearly lessons aren’t being learnt and more needs to be done. A paper published by the UK Department for International Development suggests that anti-corruption measures must take into account context, and be combined with broader institutional reforms, in order to be most effective as one size does not fit all. However, alternative incentives may be necessary to eliminate the weaknesses in AML/KYC procedures and controls.

Currently, banks can incur substantial fines for negligence towards financial crime risk, but perhaps there should be more severe criminal sanctions for the individuals responsible and the firms involved as a greater incentive. Governments and the industry could also strengthen AML/KYC compliance with greater cooperation, with governments working together in order to encourage greater and easier disclosure across borders. For Banks AML/KYC difficulty would thereby be diminished, whilst reducing costs, and weakening the appeal to ignore the problem. Governments could also provide resources where there is a recognised concentration of high risk individuals and business to assist in the enforcement of AML/KYC laws. Alternatively, supranational bodies such as the United Nations, the International Monetary Fund or the World Bank could get involved.

Should banks fail to take the initiative to properly implement change perhaps the only answer left is ever more onerous regulation of the industry by external sources. Furthermore, it is important that government officials and range of actors collaborate together to address key problems in the industry. Scrutiny over accounts, customer information, and those who are benefiting from or those who are handling an account should be increased in order to prevent future cases of money laundering and unethical behaviour. Situations like the FIFA corruption scandal can be avoided, but only where there are strict regulations in place which are followed diligently by all parties. Hence, regulations like the SMR is a step in the right direction.

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However, the use of technology in finance is not new; rather, it is the novel application of technology and its speed of evolution that makes the current wave of innovation unlike any we have ever seen before. Although there are clear benefits FinTech affords, the financial sector needs to recognize the associated risks as well, working together with the public sector to mitigate these risks and ensuring the financial industry and its customers can benefit from what new technology has to offer.

This past January, economic advisors from all around the world and experts from the industry convened in Davos, Switzerland for the annual World Economic Forum (WEF). This year’s theme: “The Role of Financial Services in Society – Understanding the impact of technology enabled innovation on financial stability”. The aim of this meeting was to foster competition between traditional financial institutions and new entrants, while preserving system stability in the time of technological advancements.

The WEF’s report identified six big advantages to FinTech:

1. Increased competition
2. Increased collaboration
3. Diversification of risk
4. Improved risk management
5. Lower costs
6. Increased access to financial services through means such as smartphones.

But along with the advantages of technological innovations, come a new set of risks to the financial services industry. Activities such as risky peer to peer lending from inexperienced investors, the exploitation of trading algorithms (i.e. dark pools), the securitization of large stores of data, misconduct, and arbitrage could affect monetary policy worldwide, potentially far outweighing any positive contributions arising from technological innovations.

To combat these existential risks, members of the World Economic Forum set four key recommendations for stopping FinTech companies creating systematic risk. These are:

1. Debate on the ethical use of data
2. Set up a global public-private forum for discussion of technological innovation in finance
3. Create international standards for monitoring FinTech startups
4. Set up a private sector’s standards body that enforces good conduct at new players in the market.

The explosion of FinTech demands a joint effort on oversight and creates an urgent need for collaboration to spur competition while preserving stability. Influential executives from some of the world’s biggest banks should create public-private relationships to lead the way in developing regulations for the burgeoning financial technology industry.

Governments also need to do their part by creating bodies that would enable them to govern technologies that are transforming everything from the capital markets business to consumer payments. We have already seen some progress in governmental agencies studying and implementing practices on FinTech: in the US, agencies including the Treasury Department and Consumer Financial Protection Bureau have been studying ways to bring new systems under existing regulatory frameworks; in the UK, the Financial Conduct Authority is developing a system aimed at spurring innovation, including a model that allows companies to test new products with guidance from regulators themselves.

Within FinTech, tremendous potential still awaits. FinTech firms are developing their own industry, and while setting out to bypass banks and be more agile in meeting their customers’ demands, financial firms are increasingly banding together to develop their own technology-driven services. New technologies pose both competitive threats as well as opportunities to cut costs and bolster profitability – in the end, benefitting the customer.

There is a critical need to understand how the new industry works. When all players in the financial technology business manage risk and maximize potential, FinTech will garner the trust from society and be successful in the long run. FinTech companies entering the financial services market have the potential to digitally disrupt and shrink the role and relevance of today’s big banks. These large banking institutions have been overlooking financial technology and the digitalization of the business for many years. Now, FinTech has found a way to service those who were left out and fill a niche in servicing the once missing digital market.

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What exactly is RegTech and why is it essential for the financial services industry?

In simple words, RegTech is the use of technology to facilitate the delivery of regulatory requirements. In pairing up with RegTech companies, financial institutions have a more reliable means of delivering data and analytics to industry regulators, satisfying their, often onerous, demands, a good example of which being timely and accurate data reporting. The following aspects typically characterise RegTech:
• Agility – Cluttered and intertwined data sets can be de-coupled and organized through ETL (Extract, Transfer and Load).
• Speed – Reports can be configured and delivered more quickly.
• Integration – Solutions can be integrated and delivered much faster
• Analytics – RegTech uses analytic tools to mine complex, large data sets and use them for multiple purposes.

How does RegTech benefit regulators and why are they pairing with RegTech companies?

Given the characteristics and the fast-paced nature of the financial services industry, the UK government gave a budget to the Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA) to find ways to support new technologies to help facilitate new regulatory requirements. This allowed regulators to better support the burgeoning RegTech community by providing expertise on what is expected by the UK regulatory framework. In return, regulators receive data from RegTech platforms in a format that is easily usable through an automated and efficient process.
One real-world example of regulators benefiting from RegTech is real-time transaction reporting. Trade reporting was previously a time consuming, intensive and often expensive task as banks used different systems, and each system had its own way of handling and reporting transactions. RegTech companies were able to harmonise this reporting process making it far simpler for regulators to obtain transaction reports from institutions.

How can RegTech benefit financial institutions?

Equally, banks and other financial institutions benefit from RegTech through automation of their compliance and risk programs. Using RegTech, institutions can track any suspicious activities and market abuse from their early stages. This can be achieved by automating the reporting process, allowing global banks and financial institutions to manage their risks of misconduct in real-time by accessing data quality and analysing behavioural signs, avoiding any fraudulent activities.

Risk managers and hedge funds use RegTech companies to collate and calculate their institution’s risk exposures on a global level. In this way, they are better prepared to tackle any firm-threatening problems that might arise. Furthermore, the imposition of fines due to breaches of regulation can be avoided since hedge funds can track investment restriction breaches and shareholding disclosure requirements by cloud-based technologies.
RegTech also provides the technology to pull, consolidate, and manipulate existing systems and data, and produce and report regulatory data in a more cost-effective, flexible, and timely manner. This is vital across the financial services industry, as firms and financial institutions are under increasing pressure to meet deadlines imposed by regulators. For example, with the introduction of EMIR in Europe and the requirement to report trades to trade repositories on a T+1 basis, most of the major players in the industry have developed IT solutions. These deliver straight-through processes, enabling timely trade reporting, thus increasing speed and efficiency, while reducing the possibility of human error through manual interventions.

The way forward

Banks and financial institutions need to understand the benefits of collaborating with technology innovators instead of competing against them, this being the only way forward given the constantly evolving regulatory landscape. Outsourcing responsibilities to RegTech companies will allow banks to focus time and resources on what they do best, making banks more profitable and efficient. Likewise, the transparency, flexibility, speed, and automation offered will enable regulators to monitor the activities of the industry and act on potential threats in almost real-time. Banks and regulators are beginning to realise the benefits of RegTech companies, and instead of resisting their integration, should accept and become a part of the shift in industry norms.

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The release of the Panama Papers, consisting of 11.5 million files from Mossack Fonseca – the world’s 4th largest offshore law firm – has drawn a great deal of attention in the media in recent weeks. Much of the data leaked does not reveal any illegal activity, but rather opaque, yet legitimate, business practices usually designed to minimize tax bills. However the data reveals how complex ownership structures; offshore shell companies; and nominees can be used by those who wish to disguise the ultimate beneficial ownership of funds. The media has taken the opportunity, with some justification, to label these practices as a deliberate attempt by some to avoid tax, implicating a number of world’s foremost political and business leaders in the process . Another consequence, not yet highlighted in earnest by the mainstream media, is what hiding beneficial ownership means for financial institutions in the fight against money laundering and terrorist financing.

Any KYC practitioner will know the importance of identifying Beneficial Ownership (BO) of an entity as part of good practice. Identification of beneficial ownership gives banks the opportunity to identify and prevent placement (the first stage of the money laundering process where illegal funds are introducing into the financial system) and layering (the second stage of the money laundering process where a series of transactions aims to distance the funds from the initial criminal conduct). Only by knowing the true sources of funds can a bank hope to identify the proceeds of crime, PEPs (Politically Exposed Persons) and funds originating from sanctioned countries.

The ease of identification can vary substantially. Often ownership crosses borders and jurisdictions, including areas with stringent privacy laws and varying levels of publically available information. Identifying the beneficial ownership of a UK company listed on the London Stock Exchange is in most cases a simple check of public records – as public companies are required by law to make such information available. However, doing the same for a private company based offshore is not nearly so simple. Given the expense and time required to deal with these cases, too often KYC is becoming an afterthought as the desire to service a client and transact business outweighs the need to complete due diligence. Too many of these exceptions are being made by banks and other financial institutions and the culture needs to change before changes are enforced by law.

Precedent tells us that the consequences of failing to ensure such processes are effective are both financial and reputational. Making exceptions for clients by shortcutting or overlooking the KYC process is one of the leading reasons behind some of the fines levied against banks in recent years, such as for Standard Chartered $340m (2012) & $300m (2014) fines, ING $619m (2012), HSBC $1.9bn (2012) and BNP Paribas $8.9bn (2014). When you include Credit Suisse’s $2.6bn (2014) fine for assisting with client tax evasion, the potential scale of the risk that banks face with the leak from Mossack Fonseca becomes apparent – especially if the leaked documents reveal something a bank should have captured during onboarding. The FCA has made tackling money laundering one of its priorities for 2016 and has begun making enquiries relating to the leak, as has the US government. A total of 60 financial institutions have been contacted by the FCA in relation to the Panama Papers. Whether this leads to further legal action and prosecutions remains to be seen, but it may be too late for banks to correct any wrong doing yet to be revealed by the masses of leaked data.

Financial institutions have started to focus on their own KYC practices, in some cases considering them to be a competitive advantage. In recent years we have seen commitment by the banks to reform of KYC across the industry with the introduction of several KYC Utilities and common standards . This mutualisation of cost and oversight gives the banks a certain strength in numbers, while also shifting the burden of data collection to the utility firms – but it doesn’t in itself fix any underlying cultural problem and, for some, may be too little too late.

This is an industry that cannot continue to endure the financial and reputational damage caused by lapses in KYC processes. Despite the advances being made, some will always be tempted to weigh the risk of fines and reputational damage against the profit made by transacting with clients before proper due-diligence is conducted. It is the culture that needs to change in order for AML become more effective. KYC first needs to become the norm and senior management should embody this. Banks must consider the introduction of zero tolerance policies for front office staff attempting to affect the due-diligence process. You must know your customer before you transact to solve the BO problem.

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Covenants are restrictions within the trust indenture that protect the bondholders’ interest by imposing restrictions that prevent the bond issuer from carrying out certain actions that could affect their ability to repay. As subordinated debt, high yield bondholders will only be repaid once all senior debt is settled, provided there is cash remaining. Thus the covenants contained in the indenture will aim to preserve the pool of capital available upon default and prevent further subordination. High yield lite bonds, on the other hand, omit these important covenants as investors sacrifice protection in return for a higher return.

What are the risks to the investor?

To ensure there is enough money left to pay the bondholder, covenants which impose a limitation on indebtedness prevent the issuer from overleveraging (borrowing too much money), while those that place limits on restricted payments prevent the leakage of value through affiliate or subsidiary transactions. The covenants, naturally, have carve-outs and baskets , and their ‘occurrence’ rather than ‘maintenance’ nature means the issuer has the flexibility to run their day to day operations. By omitting these covenants and others like it, the high yield lite bond issuer is free – whether recklessly or fraudulently- to take on additional senior and unserviceable debt, make payments to affiliates, and sell off assets. This not only depletes the capital reserves, reducing the chances of recovery, but could actually be the driving force behind the default. The bondholder may quickly find himself holding a bond for a company he probably wouldn’t have invested in in the first place.

Covenants protecting the issuers’ reserves will protect the bondholder to an extent, but it is equally important to protect against subordination. Subordination refers to the order of claims in the event of bankruptcy or default; it can be affected structurally by granting a lien over an asset. As senior debt, liens receive priority over high yield bonds when it comes to repayment. Commonly found in traditional high yield bonds, the restriction on granting liens and anti-layering covenants protect the bondholders ‘place in the queue’ for recovery. Without these covenants, the issuer is able to give other creditors the legal right to property or acquire debt more senior to the lite bonds. The fact that the low or unrated issuer is in a position they need acquire more debt suggests troubled waters while the investor is left without a life jacket.

Removing even just one of the covenants may leave the bondholder powerless against the issuer. Any attempt at preserving the capital is neutralized if the issuer is just able to push the bondholder further to the back of the line.

What are the risks to the market?

Market participants should be concerned about the future of high yield lite bonds, given recent Covenant Quality (CQ) scores and high yield bond default rates. CQ is a market average recorded by Moody’s and a higher score effectively indicates relatively unrestricted covenants, offering little in the way of investor protection. The recent upward trend is evidence of both the increasing number of high yield lite issuances (which automatically receive the maximum score) and the overall deterioration of investor protection within the high yield bond market. While the market is fairly stable at the moment, we are already seeing danger signs as default rates are on the increase. Moody’s have recently reported that, following the slump in commodity prices at the end of last year, they expect the high yield default rates to break 4% in 2016, up from 1.7% in April 2014 . While not cause for immediate concern, the high yield bond market has historically been extremely volatile and, as default rates rise, perhaps driven by a tightening in monetary policy, market liquidity will drop making it difficult for investors to close out on their exposed holdings. The combination of higher CQ scores and increasing high yield default rates ought to be setting alarm bells ringing, even if the threat is not yet imminent.

Investors should be cautious when investing in high yield lite bonds; although the rates may be attractive now they need to ensure that they have sufficient covenant protection to ensure both recovery in the event of default and to prevent the issuer from operating in a reckless manner. Until investors start insisting on proper covenant protection, we can expect the CQ scores to continue to rise. For many in the industry, it is not a question of if the bubble will burst but when. In the interim, as the market share of high yield lite issuances continues to rise, so too does the risk and severity of consequences we would have to face in the event of mass default

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