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The transformation of the banking industry: a brave new world

A collection of visionary articles from senior executives illustrating what lies ahead for the banking industry and how it is transforming in light of the effects of the global financial crisis.

Introduction
For over 35 years, SAS has partnered with some of the most successful organisations in transforming the way the world works: from revolutionary medical break-through to innovations which ensure the right products reach you when and where you need them. Many of these organisations are from the financial services world, one that has witnessed dramatic highs and lows over the years as the global economy changes. The evolution of the consumer society has taken us from a comparatively simplistic, low-tech world of a few of decades ago, to todays complex and constantly changing one. In response to change, businesses have had to adopt a program of continuous modernisation and adapt to change rapidly to survive. Customer choice and fierce competition has sealed the fate of those slow to respond. In the 21st Century, data is the lifeblood of an organisation, and this is no more the case than for banks. With the deployment of new technologies, banks trade across global markets, whilst customers access financial services through smart-phones and other mobile devices. This unbounded exchange has unleashed an unprecedented volume of data across the internet and into financial systems. Recent strategic investments by banks have mainly concentrated on infrastructure and operational environments but this is no longer the priority. Banks need to understand their customers more than ever. Insight and foresight are the keys to better serving each individual customer. That is the expectation, to be treated as an individual! Banks are on a path to realizing this potential both through the modernisation of their decision-making process and ability to harness the sheer volume of data which continues to grow exponentially. But there are still challenges ahead. At SAS, our leading Analytics gives organisations such as banks, the power to know their customers, their markets, their risk exposures and ultimately determine their success. We would like to share with you our experiences and those of other thought leaders as the banking industry looks to embed itself within the digital age, with all the possibilities and perils that it brings. We will continue to help transform the way the world works through Analytics.

Jim Goodnight Chief Executive Officer SAS

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THE TRANSFORMATION OF THE BANKING INDUSTRY

Contents
BRAVE NEW WORLD: As the banking industry enters a period of profound and probably difficult change, not only do the worlds banks face a tidal wave of post-crisis regulatory initiatives and restructuring, they also face widespread loss of public confidence. But new pressures bring new ideas and new opportunities.

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The humble chequing account: a key to liquidity, funding and more


Howard Atkins, CFO of Wells Fargo & Company, cites that chequing accounts can be a secret sauce in a recipe for success, providing the customer has a positive experience. This includes giving the customer confidence, convenience and choice via a strong brand that includes good serviceoriented people.

What should banks be for?


Antnio Horto-Osrio, CEO of Lloyds Banking Group, writes that the time has come for banks to win trust back by returning to the basics of banking, receiving money from different sources and maturities, transforming deposits into prudent loans.

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High performance banking technology


Dr. Jim Goodnight, CEO of SAS, examines how use of high performance technology will allow banks to become more agile in establishing their risk profiles across the business, which will be of critical importance in times of uncertainty.

Ensuring financial inclusion should be part of business as usual for banks


Vikram Pandit, CEO of Citigroup, is concerned that those in most financial need are not shut out of the system and challenges bankers and regulators to work together on lower-cost structures that make it viable for banks to serve the less affluent, fairly.

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Standing up to self-interest
Benny Higgins, CEO of Tesco Bank determines that risk management must, above all else, protect the interests of customers, the appetite for which is promoted by an organisations executives.

ANALYTICS: Navigating the New Digital World: Analytics has opened up the world to new possibilities and consumers expectations are changing. Banks must adapt in the post-crisis environment by looking at their customers more closely and using data to gain further insights, giving them the power to know.

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Connecting with customers in a multi-channel world


Jim Davis, SAS chief marketing officer, argues that customer behaviour is changing, but new marketing technologies are available for banks to better target their customers and improve relationships.

THE TRANSFORMATION OF THE BANKING INDUSTRY


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nk fraud: finding the right 28 Mitigating baan independent consultant at strategy Chris Swecker,
Swecker Enterprises, says data is key for banks to protect themselves and their clients from fraudulent activities.

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From emerging to dominantThis is Chinas decade


Dr. Gerard Lyons, chief economist and group head of global research at Standard Chartered Bank, argues that the global economy has entered a super-cycle of high growth. His analysis includes breathtaking illustrations of the full potential and implications of Chinas emerging economic might.

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performance: risk 32 Transforming Nobel Laureate, the evolution of SAS Myron Scholes, and Alastair Sim,
senior director of marketing, reveal that risk management remains high on banks executives minds. They also discuss new approaches to traditional techniques.

SHIFTING GLOBAL OPPORTUNITIES: With little end in sight for economic troubles in developed countries, hopes for sustained global economic growth are being pinned on Brazil, Russia, India and China, the so-called BRIC countries. Global banking institutions have known for a long time that economic influence was shifting in favour of the BRIC countries but over the next decade the effects of this shift will become even more apparent in the domestic markets of developed countries. success 36 The secrets of Brazilsout-going governor of Brazils Henrique Meirellles, the
central bank, gives a detailed analysis of factors underlying the countrys economic resilience during the crisis, including and overview of Brazils generally conservative approach to bank regulation and supervision.

RUNNING AN ISLAMIC BANK: With compound annual asset growth of 23.5% over the past five years, Islamic finance is finally getting the attention it deserves. Banks in geographies with Muslim populations must now consider adding sharia-compliant services or partnering with an Islamic institution.

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Strengthening the risk management framework


Dr. Sunando Roy, advisor to the Central Bank of Bahrain, takes an honest look at some of the significant challenges for Islamic banks, including lack of standardised products, insufficient price data, a lack of liquid instruments and transparency.

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Further reading you may also be interested in Acknowledgements This selection of articles has been compiled with the kind permission of FT Business from their publications: How to Run a Bank 2010 and 2011.

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What should banks be for?


By transmitting wealth and supporting economic growth, banks remain at the core of our economic system. Now that recovery is under way, it is in everyones interest that they are strong, stable and trustworthy.

Antnio Horta-Osrio Chief Executive Officer Designate, Lloyds Banking Group

his supplement to The Banker is entitled How to Run a Bank. Perhaps a relevant question to ask before that would be: What should banks be for?

For customers, the priority is the assurance that their banks are stable and sound while providing good service and products at reasonable cost. For politicians, understandably, the priority is to see the resumption of growth and ensure that banks are playing their full part in both lending to the domestic economy and enabling successful exporters to build their sales to fast-growing markets in the global economy. Regulators want to be assured that taxpayers are no longer called on to save individual institutions. Rightly, everyone wants to see highly competitive markets.

is to make payments, take deposits and ensure the flow of credit to the economy together with sound and prudent advice to customers. We take in money of different maturities, sources and purposes, and transform it into prudent lending in forms that suit the different needs of customers. Performing maturity transformation prudently and efficiently is one of the fundamental reasons for our existence. It is essential for societys economic well-being.

Interconnected
In some ways, the recent crisis has been so far-reaching because financial services around the world and the global economy are more interconnected than ever before. The recovery is under way, but it is still fragile in the Western world and will remain so for some time ahead, given the significant deleveraging still to happen and the need to address public deficits and debt. Some markets and regions were hit much harder than others. Global imbalances remain. Economic power will

Core purpose
For me, the core purpose of the business of commercial banks that is, banking for retail clients, small and medium-sized enterprises and other corporate customers

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Contents Brave New World
Banks, particularly in the UK and US, are now much better capitalised than they were before the crisis. The international consensus that has been forged through the G-20 and the Basel process is a good basis going forward. But few have been surprised that it falls short of the comprehensive global framework that the authorities sought in the immediate aftermath of the crisis. The key task now is the effective implementation of that global framework in the main national and regional markets. We cannot afford regulatory tests that are those of the lowest common denominator. At the same time, the authorities need to be careful not to get so far ahead of the international consensus that they impose significant super-equivalent regulation. This would risk undermining the sectors ability to support recovery and growth in the wider economy. The new international framework also needs to enable multinational banks and the authorities to isolate and contain cross-border problems if they occur in future. We may need to move to an era of stronger and more effective subsidiarisation, so that problems can be better contained where and when they occur.

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continue to shift to the East. Many countries are still contending with the aftermath of the crisis, with the ongoing challenge of sovereign debt. Other economies, which have been the motor of global growth in the past few years, are facing the challenges of preventing their economies from overheating. The banks, which remain the core transmission system of wealth and growth, must navigate their way through these conflicting currents; and at the same time rebuild their own strength and robustness to future shocks. The three years since the crisis have seen extraordinary change in our industry in prudential supervision, capital and liquidity levels, incentive structures and bank resolvability.

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Earning societys trust


Regulation and effective supervision set the boundaries. But it is what we do, as bankers, within those boundaries that determines whether we can again earn customers and societys trust.

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The most crucial issue is the need to rebuild trust. Trust and confidence are the bedrock of banking.
We need to ensure that the best people, the ones with the highest ethical standards, most capable and with strong independent judgement, are on the boards of banks and in senior positions throughout the company. We must embed effective and robust risk management at the top of banks not just in systems but rooted in the banks culture. We must guard against a return to a highly geared and target-driven sales culture. And we must continue to move towards stronger liquidity positions, funded by retail and stable deposits, reducing our collective reliance on short-term wholesale markets. Trust in the banks will be rebuilt, patiently, through deeds not words. It requires us to support the UK economy through responsible lending, to give attentive, meticulous customer service to clients and to provide value-added products that are straightforward and comprehensible to customers. Our prices must be transparent; and we must allow customers freely and easily to change their provider if they believe they can get a better deal elsewhere. Individual banks should, and in a competitive market must, develop their own positioning and strategic plans in each of these areas in a cost-effective way. But it also requires greater leadership from all of us to provide a collective system that truly puts the customers interests at the heart of our businesses.

Exciting time
At a personal level, this is an exciting time to be taking the helm at Lloyds Banking Group, the UKs leading domestic bank, home to some of the longest-established, bestknown brands in the market. I suspect that many of the issues in my in-tray will be common to most banks. The most crucial issue is the need to rebuild trust. Trust and confidence are the bedrock of banking; trust in our integrity; trust in our competence to do what we say we will do. For me, nothing is more important than this.

Constructive dialogue
As an industry, we also need to create a more constructive dialogue with government and regulators. We all need to do a better job of communicating what we do and the value we help create. We also need to explain the importance of the City of London to the wider economy and protect the importance of the citys role as one of worlds leading financial centres.

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Key Ideas
Reinvigorating banking Customers interests must lie at the heart of our businesses. Trust and confidence are the bedrock of banking. Maturity transformation: taking money of different maturities and sources, and providing prudent lending are fundamental reasons for banks existence. Global imbalances remain and economic power will continue to shift East. Risk management must be embedded at the top of banks not just in systems, but rooted in the banks culture. Our challenges as an industry are therefore significant and are inextricably linked to the future of the economy. There are no strong banking sectors without a strong economy, and a strong banking sector is key to fostering economic growth. By restoring the bond of trust and explaining the value our sector delivers to the economy, we can reinvigorate our businesses and ultimately build a better banking system to the benefit of us all. Antnio Horta-Osrio took up his new role as chief executive officer of Lloyds Banking Group in March 2011. He was chief executive of Santander UK, formerly Abbey, since 2006. Incentives: we must guard against a return to a highly geared and target driven sales culture. Stronger liquidity positions need to be better funded by stable deposits, reducing banks reliance on short-term wholesale markets. Prices must be transparent and customers must be allowed to freely and easily change their provider.

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Ensuring financial inclusion should be part of business as usual for banks


Financial inclusion is vital in advancing human rights and democracy, yet 2 billion people have no bank account. Regulators and banks must work together to balance systemic stability and access to credit.
Vikram S Pandit Chief Executive Officer Citigroup

anks are an integral part of every economy and every society. Their role is not merely to further peoples material well-being though that is vitally important. The value of banks runs deeper. Human rights and democracy reach their full potential only where there is economic inclusion for all. That in turn requires financial inclusion access to basic financial products and services that people in every advanced society take for granted. Yet in the world today, 2 billion people are unbanked they lack access to these vital services.

new financial regulation. The second is the tendency of bank management to silo financial-inclusion efforts under the auspices of corporate social responsibility, walling them off from business operations. The recent financial crisis spurred a new wave of regulations. In the US, the Credit Card Accountability, Responsibility and Disclosure (CARD) Act and Dodd-Frank legislation include provisions to protect consumers and while their impact is largely felt in the US, they could inspire reforms in other countries. The new US regulations are sensible reforms that we at Citi supported. The new rules strengthen consumer rights a necessary change. But the gains in consumer protections do not come without costs. First, available credit is shrinking: $1500bn in credit card lines were cut even before key provisions of the CARD Act took effect in 2010, and more is being cut every day.

Core mission
Promoting financial inclusion should be a core mission of the banking industry and of banks around the world. This mission is all the more important in the wake of the financial crisis, and banks would do well to ensure that they commit resources to this critical responsibility. There are, today, two principal threats to greater financial inclusion. The first is the unintended consequences of

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new model with lower-cost structures that make it economically viable for banks to serve the less affluent fairly. Innovation and technology will be key, enabling us to provide the same services at far lower costs. Nations considering new consumer protections would do well to take the lessons of the US experience to heart, and consider the full impact of any new rules. While these concerns are serious, there is no doubt that they are also surmountable. The financial services industry and its regulators must work together to ensure all sides understand the implications of our collective actions. Regulations at both the national and international levels must strike the right balance between systemic stability and access to credit for those who need it most. This collaboration can bring the benefits of the global financial system to more people than ever before.

Some of that is understandable belt-tightening following the financial crisis, but some is the result of new rules that make serving the less affluent less economically viable. We can expect a further contraction of credit as the system adjusts to the new reality. As always, the least affluent will feel this credit pinch the most indeed, they already are. Second, as old revenue streams from overdraft and interchange fees (paid by merchants to bank card issuers) shrink, retail banks will have to reinvent their business models to remain profitable. Banks may respond by not serving less-profitable communities and customers, or by serving them less. We could see the retail branch footprint of some banks shrink particularly in lower-income and rural areas. Many could suddenly find themselves shut out of the system. At Citi we consider this a call to action for our industry. The challenge is to work with regulators to develop a

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Need for integration


The tendency for banks to segregate financial inclusion from the rest of their business is also important to address. Many bankers understand the importance of working to broaden inclusion but do not see a clear business rationale. But for these efforts to be most effective, they must be integrated into banks core business practices. Banks must do away with the silo approach. We at Citi have learned from experience. Efforts to reach into the most under-served neighbourhoods to provide capital to businesses, charter schools and other community organisations can engender a healthy bottom line. Citi recently worked with two non-profit partners to create the

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Many bankers understand the importance of broadening inclusion but do not see a clear business rationale.
Communities at Work Fund at $200m, one of the US largest vehicles for connecting private capital with underserved communities. We leveraged Citis financing capital and expertise to create a sustainable and ultimately profitable social enterprise. The creation of new sustainable business models is a priority for Citi and should be for the entire industry. Banks are profit-making enterprises; strategic philanthropy is important but, on its own, is not enough. For banks to maximise their impact, they need company-wide efforts to deliver for communities through their primary business functions. It is an elementary business principle that underserved markets are often opportunities for profitable growth. Banks know something about finance and development. It is a natural fit for us to put our money, talent, experience and products to work in communities where access to financial services is limited, and to strive to include more people in the financial system. crisis was that too many people did not understand how best to secure their financial futures. That is a skill that can be learned and it is vital, no matter how big or small your bank balance. The integration of corporate citizenship into our core business practices has implications far beyond the immediate impact of individual initiatives. It is a powerful tool for cultural change, and influences corporate strategy and operations. Corporations that achieve this synergy attract talent with the right skills and values, reduce risk, increase revenue and of course achieve a positive impact on their reputation all key ingredients to success that in turn allow us to do even more for our communities. In the future, I believe the companies that succeed will be those that develop a culture that places social responsibility at their core, and that see corporate citizenship not as charity, but as business as usual. At Citi, we are doing just that through our renewed commitment to responsible finance. Creating financial opportunity for everyone is at the core our mission, and we are committed to putting the full force of our people and resources to work to drive financial inclusion. Vikram S Pandit is chief executive officer of Citigroup.

Financial literacy
In particular, we should put our expertise to work to increase financial literacy. It is impossible to overstate the importance of financial education: in many ways, how people manage their money is more important than how much they have. One contributing factor to the financial

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CEO Agenda
1. Crisis fallout: tougher regulation and a tightening of credit availability introduced in the wake of the crisis risk damaging financial inclusion. 2. Technology: new technology offers one method of giving banks lower-cost business models while opening up banking to unbanked populations. 3. Integration: financial-inclusion efforts must be integrated into core business operations rather than being segregated. 4. Financial literacy: educating people in managing their finances is a key priority to avoid future financial crises and advance economic inclusion.

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Risk management: standing up to self-interest


Understanding and assessing risk correctly is fundamental to the financial services industry. The failure to do so has been highlighted by the crisis and banks need to prioritise customers needs to ensure their future success.
Benny Higgins Chief Executive Officer Tesco Bank

rom the vantage point of 1931, F Scott Fitzgeralds words from his seminal essay Echoes of the Jazz Age resonate almost 80 years later: Somebody had blundered and the most expensive orgy in history was over. It ended two years ago, because the utter confidence which was its essential prop received an enormous jolt and it didnt take long for the flimsy structure to settle earthward. The post-modern version of blundering was enabled and perpetuated by the macroeconomic policy of an unprecedented era of low real interest rates and excess liquidity. The crisis was perhaps exacerbated by the exponential growth of synthetic derivative markets, which as confidence plummeted, were a major contributor to liquidity contagion and gridlock. Furthermore, the sustained sang froid of governments and regulators in the face of gravitydefying asset inflation did not help. Ultimately, an essential question remains regarding the quality of strategic risk management decisions taken by the leadership of financial services businesses.

Let us define, for this discussion, a strategic risk management decision to be one that puts an enterprise in jeopardy. We must distinguish between high quality decisions that produce undesired outcomes versus poor quality decisions regardless, frankly, of their outcomes.

Understanding risk appetite


There is an interesting discussion to be pursued with respect to quality systematic decision-making at a time of discontinuity. In particular, the over reliance on models anchored in historic data is worthy of dispute. The more interesting debate, however, is why senior management of a firm might knowingly use a flawed process of assessing risk. The first possibility, which may seem unlikely, is incompetence. There are two distinct versions; the more common category is based on a genuine lack of understanding and the other is based on a reasonable level of insight, but a misguided, well-intentioned execution of policy of which there were few, if any failures. However, for some leaders, excessive risk taking is largely intentional.

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Contents

Any organisation which aspires to achieve sustainable success, must regard customers interests as their overriding priority.

Brave New World Analytics - Navigating the New Digital World

The question at the heart of this analysis is what propels a firms leadership to take such risks? All too often, self-interest transcends the risk to the enterprise and its customers. A classic example of the prisoners dilemma is played out, where leadership enjoys and presides over others enjoying the short-term benefits of taking disproportionate risks. An alternative diagnosis for some leaders is that they lack the courage to defy the self-serving majority. At the core of leadership lies courage. In an environment in which self-interest prevails contrary to the greater good, courage is essential but it can also be a burden. It is a burden insofar as it drives an individual to make declarations that are inconvenient truths. It is easier to avoid doing the right thing when the immediate consequences are adverse.

Putting customers first


A great deal of recent public analysis has focused on the obligations of non-executive directors (NEDs) and regulators. It is indeed paramount that NEDs are presented with adequate reporting that satisfy exacting standards of completeness and accuracy. It is also essential that the regulatory framework protects customers interests. It is crucial however that the nature of supervision does not divert businesses creative energy from being aimed firmly at meeting customers needs. It is also the case that insufficient convergence of regulation across territories will give rise to unproductive regulatory arbitrage. The most important dramatis personae in the management of risk, however, are the executives. Other players

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All too often, self-interest transcends risk to the enterprise and its customers.

dictate, to some extent, the degrees of freedom enjoyed by executives, and they impose some safeguards. But, it is the culture promoted by the executives and cumulative impact of their decisions which determine the risk appetite of an enterprise. I recall, as a young actuary working for Standard Life in Montreal, a corporate strategy session when the local president implored his colleagues to take risks. He said We are an insurance company. We take risks. A man who was a great influence on me, the then group CEO Scott Bell, intervened in his characteristically prosaic, precise and staccato style to say, We dont take risks. We manage risks. His words remain with me today.

crisis of the 21st century has highlighted the essential importance of risk management. A valuable consequence of failure is learning, but only if we are prepared to grasp the opportunity. We can be sure other challenges await which will differ in form but not in substance. As Fitzgerald closed his greatest work, The Great Gatsby, so we beat on, boats against the current, borne back ceaselessly into the past. Benny Higgins is the CEO of Tesco Bank. Before joining TPF, Benny served as CEO, retail business of HBOS Plc. Between 1997 and 2005 Benny was CEO, retail banking at The Royal Bank of Scotland where he was responsible for personal, affluent and SME businesses across both NatWest and RBS. He led the successful integration of NatWest Retail Banking within RBS. Before joining RBS, Benny was at Standard Life for 14 years where he held a range of senior positions, including being a member of the group executive.

Looking ahead
Any organisation, which aspires to achieve sustainable success, must regard customers interests as their overriding priority. The management process for managing risk must be constructed around this tenet. The first financial

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Contents Brave New World Analytics - Navigating the New Digital World

CEO Agenda
Risk Management must, above all else, protect the interests of customers. 1. Executive self-interest must not transcend the interests of the enterprise or its customers. 2. The risk appetite of an enterprise is determined by the culture promoted by its executives and by the cumulative impact of their decisions. 3. At the core of leadership lies courage.

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The humble chequing account: a key to liquidity, funding and more


Banks that are ambivalent towards the chequing account are missing out on myriad benefits, most importantly the chance to establish a deep, loyal relationship with customers.

Howard Atkins Chief Financial Officer Wells Fargo & Company

he humble chequing account is sometimes maligned as an unsophisticated, low-return product. Some financial institutions ignore or even scoff at this most basic service, turning instead to more complex and higher-fee-producing products. After all, collecting operating accounts requires significant investment. For a company without a competitive, extensive and deep distribution system, that can be a barrier to entry. Revenue is earned in dollars and cents, not in multimillion-dollar fees. Yet, at Wells Fargo, we have a consistent commitment to attracting and retaining chequing accounts from both our consumer and business customers because they offer stellar benefits: superior liquidity, lower cost of funds, stable annuity revenue and most important the foundation of a cross-sell strategy that opens the door to deep and long-lasting customer relationships. With 10% of US deposits, Wells Fargo views a growing base of stable customer deposits as a critical part of

building liquidity for growth, and we benefit from having a much greater percentage of our total liabilities in the form of deposits than any of our large peers, as shown in Chart 1. This lower reliance on debt markets for financing makes our funding much less susceptible to disruption in shortterm debt markets. Thats because deposit customers tend to keep their operating accounts rather than frequently switch banks, if they get the service they expect especially when the customer has invested time in setting up online banking tied to the operating account.

Cost advantage
Customer deposits can also provide a significant cost advantage over purchased deposits as a funding source. Not all deposits are equal, and it is well worth the effort to attract operating accounts by providing top service and convenience, as we do at Wells Fargo. Our relationship-based customer strategy means we have the highest proportion of low-cost core deposits (domestic chequing, liquid savings and money market accounts)

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Contents Brave New World Analytics - Navigating the New Digital World

of any large US bank, as shown in Chart 2. We largely avoid high-priced customer deposits and other hot money. As a result, our net interest margin was the highest among all large peers in each of the past 10 years, as shown in Chart 3. While strong, stable liquidity and an advantageous cost of funds are significant benefits, the greatest value chequing accounts offer is the starting point for deeper, more loyal customer relationships and the opportunity to sell more products. Cross-selling drives revenue growth, as shown in Chart 4. Our analysis indicates that households that have eight or more Wells Fargo products are likely to be

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three to six times more profitable than those with three or fewer products. Additionally, customers with more products tend to stay with us longer, resulting in stable revenue and profit streams. Chequing accounts can be the secret sauce in a recipe for success. So how does a bank attract them? Six factors are listed in the Key Ideas box.

Called into question


Even with the advantages, two topics call the worth of chequing accounts into question. The first is whether a bank can have too many deposits, especially in times of low economic growth. The key is profitably deploying the funds, which can be challenging in times of low loan growth. A diverse business mix is an advantage, as there are multiple opportunities to invest an abundance of deposits. Banks with fewer options may be tempted to deploy excess funds in higher-risk assets to achieve a positive spread. The second factor raising questions about the value of chequing accounts is new regulation, reducing the ability to collect fees associated with chequing accounts. Is it still worth the investment to attract and retain chequing accounts? Yes, now more than ever! These accounts continue to provide the most stable, efficient source of funding in a regulatory environment demanding increased rigour in maintaining strong financial condition. And, most

important, chequing and operating accounts are highvalue products to customers. By providing customers with this essential product, a bank plants a seed that can blossom into a strong and durable relationship. Howard Atkins is the chief financial officer of Wells Fargo & Company.

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Key Ideas
Attracting accounts Safety and soundness are required. The crisis reminded us that even large institutions can fail and customers will move funds when confidence falters. A strong brand is a huge asset in bringing customers in the door. Convenience matters. Customers want it to be easy to do business with their bank when they are at home or travelling, day or night. Proximity to customers is an important competitive advantage for Wells Fargo. Positive customer experience increases customer loyalty. It is more expensive to acquire new customers than to keep existing ones. Once youve invested in winning a customer, it is important to deliver the customer service that encourages loyalty. People are a competitive advantage. Even with all the technology offered today, banking is still largely a person-to-person business. A customers impression is only as good as the last interaction. Thats why good systems, great locations and strong financials are not enough. Engaged, committed team members deliver the best service. Customers want choices. Twenty years ago, bankers envisioned a shift from brick-and-mortar banking to telephone and online banking. Instead, many customers use all the channels we offer. Customers also want options when choosing products.

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Wells Fargo & Company has 82% of its deposits in chequing or savings accounts.

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High performance banking technology


Linking technology flows allows firms to assess their relative exposures. New techniques are providing financial institutions the ability to model real-time data as they strive to meet new regulatory requirements.
Jim Goodnight Chief Executive Officer SAS

n a recent conversation with the head of risk analytics for a large global bank, a comment was made that it was a very good thing that the Dubai debt crisis of November 2009 happened over the US Thanksgiving holiday the banking executive (who is located in the US) was thankful he was able to call all his employees back into the office on that Thursday. The Thanksgiving holiday and the following weekend were used to prepare a detailed, cross-firm analysis of the entire banks global exposures, liquidity and capital available. It took an army of executives selected from various business units, risk teams and technology support groups three gruelling days to consolidate the exposures, stress test the portfolios across all products and validate the capital position. What typically took two weeks to compute was compressed into four days. Teams of people worked in round-the-clock runs of technology systems to calculate new views of risk and exposures. Hours of technology processing were required to recalculate the

updated market pricing formulas with new factors, run new market scenarios and sensitivity analysis and produce reports. The team barely made the deadline set by the CEO for a review on the Monday following the holiday.

Managing information
Not being able to wholly integrate the full cycle of credit management, combined with the failure of market portfolio management to truly understand the performance of the capital available to a bank, has caused bank managers to either aggressively extend credit or to not participate in the market due to a lack of information. Due partly to the limitations of traditional reporting and computational technology, banks have only been able to increase their use of analytics within certain silos of product offerings, but have not yet reached the goal of having ondemand firm-wide capabilities. The ability to do cross-product scenario, stress-testing and firm-wide analysis of required liquidity for funding

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Contents Brave New World

of products and analyse impact to capital required for economic growth and to meet regulatory requirements is still a goal many banks and financial services firm are striving for. Market events such as the Dubai debt crisis or even the Lehman bankruptcy have left banks and other financial firms scrambling to answer the questions of what exposures do they have on hand? What will be the impact on capital? How can I stress test the firm-wide view of what assets are currently on the balance sheet to determine if additional losses are impending?

of new factors and to compute in realtime the next iteration of the answer to the question being asked.

Analytics - Navigating the New Digital World

New technology
Radical new technology exists right now that goes beyond the computational advances that GRID technology represented a few years back. Advanced technology that integrates the computational matrices for sophisticated analytics directly on to a CPU rich processing environment is a reality for todays banks. Entire data centres of traditional servers can be replaced with an appliance type of technology that provides integrated software and hardware providing an analytics analysis machine reducing days to minutes. Business decisions are made within established methods focus on getting the key factors to support decision processes in place do not focus on having all data available. The traditional transaction and reporting approach that has been a part of the banking industry is

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Finding the answer


A high-performance banking technology framework is the answer. Key elements include computing what you need to know today questions asked today cannot be answered with stale information that was computed yesterday. Some historical factors need to be archived and utilised for the back testing of assumptions but a highperformance banking technology solution relies on the ability to combine historical events, allows for the insertion

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Well-made business decisions are backed by analytics that extract relevant and insightful factors needed to assist decision-makers.

still a necessary part of the banking business. Operational reporting is different from the predictive analytics used for helping business leaders make todays decisions. Well-made business decisions are backed by analytics that extract only the very relevant and insightful factors needed to assist the decision-maker in their business. Advances in analytical model development technology and methods exist today that keep sophisticated models fresh with the principle factors to make better decisions. Model variables can be optimised in realtime as market conditions change. The impact of a local business unit decision can only be accessed for firmwide impact when provided the capability to aggregated information in real time. Transactional systems and the reporting available from these systems has evolved to the extent that with the use of proper data quality and monitoring tools, confidence can be applied to the data used for decision-making. What a

high-performance technology approach allows for, is not only the rapid integration of these data sources, but also the real-time aggregation of the results of computational and analytical models. Traditional cube technology still takes hours and days to update once the results from the analytical models have been computed. Advanced technological methods are available today in an on-demand manner to provide results to business users as dynamically, updated analytical information is produced. Dr Jim Goodnight is CEO of SAS, the worlds leading business analytics software vendor. Dr Goodnight has been CEO of software vendor SAS since its incorporation in 1976. He is an active speaker and participant at the World Economic Forum.

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Contents Brave New World Analytics - Navigating the New Digital World

CEO Agenda
1. Modernisation the pace of change in market conditions has dictated a step change in the desire to integrate risk types across the business. 2. Better business decisions are based on an ability to see current state and remodel for future states in a high-performance environment. 3. High-performance technology combining model accuracy, integration, volume and speed. 4. Optimised advances in analytical model technology allows real-time optimisation of risk. 5. Competitive advantage high-performing banking technology concentrates on increasing the value delivered to people who make decisions.

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Connecting with customers in a multi-channel world


Banks that have performed well throughout the crisis have understood their customers needs. But there are still opportunities in the marketplace.
Jim Davis Chief Marketing Officer SAS

inancial institutions have certainly demonstrated their resilience to challenging economic events and pressures over the course of modern history. However, the current period of global economic upheaval has proven to be one of the most complex evils the financial industry has ever faced, making the road to recovery less of an uphill trudge than an endless ride on an anxietyfuelled rollercoaster. While some stability has returned to the banking industry following an intense period of financial institution collapse and consolidation, regulatory rigidity and the slow-torecover economy have severely constrained a banks ability to grow its revenue and profits, forcing many to reengineer their processes to make them more efficient and cost-effective. Nowhere is this more apparent than in retail banking, where institutions must refocus their efforts on improving customer service and retention efforts while increasing each customers lifetime value.

Understanding customer needs


Retail banks that will survive and thrive in the current economic climate are using new technologies and channels to grow revenue from basic services, such as deposits and loans, by understanding customer needs, providing relevant products and services cost-effectively and calculating the unique lifetime value of customers to the institution. Further emphasising of analytically supported decision-making, related to multi-channel marketing optimisation and client service, will be critical to improving customer experience, loyalty and profitability. To illustrate this, one US financial institution is incrementally generating $250m in revenue by using behavioural models and predictive analytics to comb through more than 19 million transactions per day from more than 17 million customers. With the insight it derives, the bank delivers consistent messages to customers across all touch points and channels. The solution also helps the bank understand and anticipate future customer needs,

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using event-driven technology to alert representatives when significant behavioural changes occur so that the bank can intervene immediately to address a new customer requirement or save an at risk relationship. Consumer and business depositors will be more valuable to the banks than ever before; failure to communicate with these customers at the right time, through the right channel, with the right offer will slowly wear away the client base. Customer communications must be personalised and interactive and offer tailored products and services. This requires sophisticated analytics and marketing automation technology to create customer insight, increase

interactions across channels, and monitor and respond to changes in customer behaviours.

New channels
Social media is one evolving channel that will help banks to generate insights on customer attitudes and preferences, which can be used to inform marketing campaigns and help deliver better customer experiences. However, an August 2010 study, conducted by Harvard Business Review and SAS, shows that banks lag behind other industries by 10% when it comes to using social media to understand and communicate with customers. In fact, 57% of bankers polled admitted that their social media efforts were ineffective, compared with 43% of those polled from non-banking industries.

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Banks have to meet customers where they work and play on the web, through mobile devices and social media sites.

For banks, social media has its pros and cons. One influencer can drive thousands of potential customers to a website. However, that same influencer can spread his or her dissatisfaction, causing erosion in brand equity and profitability. Regardless, embracing social media is not a choice for banks; it is an imperative. Fortunately, as social media has evolved, so too has the technology to understand users and their networks. The myriad benefits that come from analysing social media data include product and service quality improvements, assessing customer sentiment and uncovering fraud rings.

Collect meaningful customer data from all channels, including social media, in one place. Apply advanced predictive analytics for more accurate forecasting and insight into customers and households. Match individual customer profiles to the most relevant offers. Run intelligent campaigns that account for different customer interactions. Learn from campaign results and build lessons back into the process to improve future marketing and customer service efforts. In addition to the belt-tightening effects of the recession, consumer behaviours and expectations have radically changed in recent years, requiring banks to improve outreach to customers and earn their trust and good old-fashioned loyalty. To accomplish this, banks have to meet customers where they work and play on the web,

Improving value
With the increasingly sophisticated customer analytics and marketing automation technologies that exist today, retail banks have the perfect opportunity to improve the value of customer relationships through closed loop customer marketing processes with a complete view of customers and include the ability to:

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through mobile devices and social media sites. They can then use the wealth of customer intelligence that is generated to create new product and service offerings, acquire and retain customers, and maximise the profitability of each relationship. Jim Davis is senior vice-president and chief marketing officer at SAS, overseeing various strategic and operational functions. Mr Davis co- authored the book Information Revolution: Using the Information Evolution Model to Grow Your Business.

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Mitigating bank fraud: finding the right strategy


Banks can now connect with clients through a number of communication channels. But fraud remains a huge problem and banks must stay one step ahead to protect their customers.
Chris Swecker Independent Consultant Swecker Enterprises

inancial institutions are leaders in delivering of a wide range of services and products via the internet and mobile communication channels. Unfortunately, electronic crimes targeting consumers and businesses have become the most pervasive crime problem of this millennium. Financial institutions must realise that fraud undermines customer confidence in the banks ability, or willingness, to protect its customers. Fraud rings have proliferated because being a professional fraud operator is easy, profitable and presents low risk and high reward. Ironically, institutions that pride themselves on fostering collaborative environments are being out-networked by the bad guys, who work in a communal ecosystem devoted exclusively to committing fraud around the clock. They are adept at exploitation of gaping vulnerabilities caused by compartmentalisation of fraud detection units and the schism between the lines of business and fraud components, including inefficient management and use of data. Sadly, a recent survey of 230 banks

by the Information Security Media Group revealed that only 23% learn of fraud incidents through their own auditing processes.

Finding the weak links


Consumers, retail merchants and business are weak links when it comes to virtual security. They respond to phishing schemes that solicit their most sensitive information, allow already imperfect anti-virus and spyware software to expire or disable the programs, use vulnerable passwords and dont cover their PIN numbers when using an ATM. They are ill equipped to counter botnets, worms, malware and viruses such as the Zeus strain, which has stolen more bank credentials than any other virus and is linked to more than $100m in losses worldwide. These exploits spontaneously mutate to stay ahead of the latest detection software. The latest battleground is business account takeovers. These accounts typically hold higher balances to meet

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The FBI warns that professional fraud networks, not opportunistic individuals, are inflicting the greatest damage. These networks exploit the one fraud at a time detection tools and technologies. Balkanisation of fraud detection components based on product lines and delivery channels, technology architecture that resembles a patchwork quilt and overall fragmentation of antifraud efforts severely hinder the ability to identify ring activity and deploy effective loss prevention strategies. Finally, industry co-operation must be established. Identity impersonations account for more than $50bn in losses and directly affect close to 12 million people annually. Customers expect banks to protect them from this nightmare. Consider the highly publicised Heartland Payment Systems/ TJ Maxx hacks, in which more than 140 million credit/debit card transactions were compromised, affecting more than 500 banks and countless customers.

payroll and daily expenses, and often the business customer has weak internal safeguards. Businesses are not afforded the same protections as individuals and thus are often held responsible for losses when their accounts are compromised. Businesses are especially vulnerable because their information security, online banking protocols and technology configuration are seldom as good as they need to be. One important enabler is that fraud receives scarce attention from top executives unless a significant negative media event occurs. Revenue growth and business expansion are paramount; when it comes to risk programmes, credit, market, counterparty and regulatory risks trump all others. As a result of scarce antifraud resources and failure to deploy the most effective analytical tools available, fraud rings are able to exploit the banks inability to connect the dots.

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Banks must break down the traditional separation between anti-money laundering and fraud.

Using data to prevent fraud


From the perspective of bank risk executives, anti-fraud programmes are low priority because a lack of positive revenue and losses are built into budget projections. They discount the impact and reputational risk presented by a well-publicised negative experience on a mass scale. They should view anti-fraud strategies as a priority, not because of the monetary losses that are acceptable from a balance sheet perspective, but rather because current and potential customers feel vulnerable and exposed. Banks that fail to protect customers will lose them to competitors that grasp the problem and the potential opportunity. Fortunately, the banks themselves hold the most powerful weapon to predict and prevent fraud data. Banks hold a rich trove of information about customers, transactions, accounts and broader trends and patterns. The effective use and analysis of that data real time and batched can identify fraud patterns, anomalies and common data points that reveal associations between fraudulent accounts and group fraud activity. One best practice is to

form a small ring identification team to proactively identify the malignant social networks. Also, the consolidation of fraud detection and investigative components into a single platform and creation of a shared database of historical alerts, red flags, investigations, watch lists and customer claims can help combat fraud. Components that cannot be consolidated should at least share a case management system.

Prioritising the customer


Once and for all banks must break down the traditional separation between anti-money laundering and fraud. As the chief of FinCEN has pointed out, fraud and money laundering are co-dependent. An effective anti-fraud strategy should focus on expending resources on the greatest problems, not just the next alert or case that shows up in the case management system. The organisation must prioritise and direct scarce resources toward events that present the largest losses in the aggregate, such as ring activity, and the greatest potential for recovery and prosecution.

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Ironically the tools and capability to more effectively prevent and mitigate these losses are available. Banks must develop a sense of urgency because their customers will continue to be easy victims without decisive action. The ranks of fraud thieves are increasing every day due to internet networking opportunities and the low risk of prosecution. Fraud has become viral and will never be solved by law enforcement. It is an industry solution dependent on the awareness and sponsorship of bank executives at the highest levels. They must deploy the most powerful analytics available, consolidate data and various fraud components, and make use of multilayered detection technology. It is not about the money; it is about the customer. The customer must feel important and protected. After all, it is just good business to protect your most important asset.

Chris Swecker is a practising attorney and independent consultant for Swecker Enterprises, specialising in financial crimes and money laundering mitigation strategies and is a frequent guest expert speaker. He has 30 years of experience in law enforcement, national security, legal, corporate security and risk management positions including the third highest executive position in the FBI and chief security officer for Bank of America.

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Transforming performance: the evolution of risk


Risk has emerged as an important part of the executive board, and banks need to move away from traditional techniques and adapt to the new environment.
Myron Scholes Nobel Laureate Alastair Sim Senior Director Global Marketing, SAS

s a result of the recent market shocks, banks, capital markets firms and asset managers are rethinking certain issues and focusing on integrating risk and reward trade-offs. To do this, they are using portfolio theory and planning for market shocks and the resulting impact on the business and its divisions. Leading financial entities are linking their portfolio risk with the return on capital and integrating market liquidity into their analyses in an attempt to gain a more complete view of risk and return. As a result, optimisation of capital deployed rather than just a single view of risk exposures has become the new role of risk management. A recent survey of senior executives from more than 300 global financial services institutions, carried out by the Economist Intelligence Unit on behalf of SAS, revealed that one of the most important concerns of executives was a desire to restore credibility in institutions, systems and the industry. In the resulting report, Rebuilding Trust, strategic changes were identified. Better communication and analysis of information across the firm

and communications between the executive team, the risk function and the business was seen to be of great importance. Management of risk needs to be seen as everybodys concern and there needs to be a greater role for the risk function on the executive board. Ownership of the cultural change required to embrace risk across the institutions going forward has to be driven by the CEO. Only then, by determining the tone at the top, will the elements of this complex puzzle begin to come together. So what have been the elements used to manage risk and how should risk management evolve?

Risk and return


Risk management has traditionally relied upon expert judgement coupled with a narrow use of quantitative techniques. These techniques are being replaced by sophisticated analytics that make traditional quantitative techniques more transparent and available to decision-makers by combining them with an analytic decision framework that is optimised for exposures and capital return.

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the impact of sovereign nation debt has also constricted the flow of capital. This has the potential to heighten the impact of market volatility, and with unanticipated events, we are anticipating that there is the potential for an amplification effect of the volatility and market shocks. The ability to acquire capital for investment or to liquidate a position may accelerate more default events over the next few years as markets adjust to systemic changes in the market structure. Although most firms use dynamic measures such as VaR to gauge the sensitivity of results to short-run market

Predictive, on-demand scenarios provide an up-tothe-minute, scenario-optimised view of risk and return, allowing executives to understand and integrate capital to various asset classes and divisions of the firm. By incorporating all elements of the risk and reward equation exposures, return, capital reserves, capital deployed in various forms, firm liquidity and market liquidity we now have the opportunity to provide and grow high-performance risk management capabilities within firms. As we continue to emerge from the global financial crisis, not only have banks had to boost capital reserves, but

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Traditional techniques are being replaced by sophisticated analytics which bring transparency.
factor movements, they realise that they need to overlay these measures with additional capital and static reserves to handle shocks. Correctly, entities realise that short-term measures are inadequate. However, new work is needed to measure the size of needed risk reserves or cushions; that is, how to dynamically adjust them and partition the cushion among the various asset categories within an entity to make more accurate risk and return tradeoffs. This is a new direction for research. The ability to enhance risk methodologies is due to advances in technology, such as the SAS highperformance computational environment, that remove the computational complexity associated with multifactor, cross-firm, full-valuation methods. relied too heavily on a limited set of quantitative techniques to measure and to plan on how to react to unexpected market conditions. They also relied extensively on external monitors, such as the rating agencies, to validate risks. The rating agencies failed to incorporate multiple, simultaneous failures in their models; they also overlooked the fact that recent market event data might not tell the complete story, or that the quality of the composition of structured products might deteriorate over time as entities reverse-engineered them to just pass to receive a rating of AAA. Therefore, the problem is that firms simply maximised along a truncated view of possible investment paths, assuming that recent volatilities and observed correlations were the best indicators of future volatility and correlations. Additionally, firms viewed planning for shocks and changes in the opportunity set as unnecessary or of little value. Risk had been tamed, and risk officers had cried wolf too many times to be heard. It turns out that observed low portfolio volatilities largely contributed to low observed correlations. As a result, regulators and market participants believed that the risks observed years ago were the risks of the past; risks today were understood and would remain as such into the foreseeable future. Market participants responded to this belief by

Advantages of diversification
Moving from theory to implementation issues, market participants relied too heavily on recent market experience (during the 1990s and 2000s) to frame their views on risk and to calibrate their models. They concluded incorrectly that the likely need and the resultant cost to adjust their holdings and to reduce risks in light of shocks and lack of liquidity in the market were extremely low. They relied almost exclusively on the advantages of diversification across uncorrelated firm activities and concluded that risks were controlled within the isolated portfolios; they

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increasing their own risks through leverage, concentrating holdings (becoming less diversified) and holding riskier positions, and reducing contingency reserves for shocks. Contingency reserves were reduced because risk could be either diversified or distributed through securitised products. Flexibility planning in the form of capital optimisation became less necessary with reduced uncertainty.

advances in analytics and technology are applied. Todays high-performance computing transforms the ability to address complex and often volatile business problems. This is a new era in managing risk and business performance. Myron Scholes is widely known for his decisive work in options pricing, capital markets and tax. He is the co-originator of the Black-Scholes options pricing model, which earned him the Alfred Nobel Memorial Prize in Economic Sciences in 1997. Alastair Sim is a member of the global marketing board at SAS and responsible for the strategy and marketing in EMEA.

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Advances in analytics
If risk had been controlled, these were the correct planning decisions. In retrospect, relying too heavily on recent data and even ignoring recent minishocks was the wrong decision. We had gone through a long period of market quiescence; risk had not been tamed. The business cycle remains; datasets are too vast to understand all of the interactions necessary to tame risk unless

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The secrets of Brazils success


Brazils impressive economic performance over the past few years has been based on political stability, a sound macroeconomic policy and lessons learned from the crises of previous decades.
Henrique Meirelles Former Governor Banco Central do Brasil

razils economic performance in the aftermath of the recent global financial crisis was markedly different to its recoveries from the various crises that the country has endured during the past few decades. After a five-month recession in 2009, economic growth in Brazil returned to pre-crisis levels. Gross domestic product (GDP) and investment growth for 2010 are estimated at 7.3% and 20.9%, respectively. Furthermore, growth has not come at the expense of stability, either internal or external. Net public debt decreased from 42% to 40% of GDP since the start of the crisis. The countrys net external debt is negative and the central bank continues to increase the level of international reserves. Foreign direct investment remains strong, and portfolio investment has increasingly been concentrated in stocks and longer-term fixed-rate instruments rather than the short-term debt that has prevailed in the past.

Three-pillared foundation
This resilience is the outcome of political stability and a solid foundation of macroeconomic policy, built on three pillars. The first pillar is the strict adherence to the inflation-targeting framework for monetary policy, which proved to be instrumental in a country with a history of hyperinflation. It provides an effective anchor to inflation expectation, with a combination of flexibility to counteract supply shocks, accountability of policy-makers, and transparency to the public. The second pillar is the floating exchange rate regime, which helps absorb external shocks. Again, it should be remembered that Brazil has a poor track record of foreign exchange crises as a result of managed exchange rates. Substantial international reserves provided an additional layer of security and gave the central bank the freedom of action to smooth out volatility in foreign exchange flows when necessary.

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The final pillar is fiscal policy. Strong and sustained primary (before interest) fiscal surpluses, combined with declining risk premiums on Brazilian government debt, translated into a decreasing trend for net public debt as a percentage of GDP. However, we have learned that good macroeconomic policy is not sufficient in itself to avert a financial crisis. Brazils generally conservative regulation and effective supervision of financial institutions were also an important factor in Brazils success. The minimum required level of capital in Brazil is 11%, which is higher than the 8% level established in the Basel II accord. In part due to moral suasion, the actual level of capital in the system has hovered between 17% and 18%. The treatment of market risk is also more rigorous than Basel II standards. Loan loss provisioning takes into account expected losses, not just incurred losses.

Analytics - Navigating the New Digital World Shifting Global Opportunities

Finally, high reserve requirements provide a liquidity buffer for the financial system that was critical during the crisis, in particular in allowing the central bank to channel liquidity to the smaller financial institutions that were most affected by the crisis. The timely and targeted use of bank reserves is just one example of the advantages provided by the dual role of the central bank as both monetary authority and financial supervisor.

Unsung hero
There is also a less well-known reason for Brazils recent economic performance: the deepening and widening of Brazils credit and capital markets over the past decade. Since 2003, total credit to GDP has increased from a very low 25% to 47%, reflecting a solid and healthy expansion of the financial sector. Real interest rates have declined, as has the spread between interbank rates and the rates charged to borrowers.

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More has to be done to increase financial inclusion, especially of the new members of Brazils expanding middle classes.
The maturities of loans to both consumers and firms have lengthened significantly reaching to over 15 years at fixed rates of interest compared with the maturities of just a few months that prevailed in the past. Brazilian capital markets have also grown substantially in this period, whether measured by market capitalisation, trading volumes, number of derivatives contracts or volume of public offerings. The development of Brazils financial markets over the past decade was also a result of an ongoing process of improvement in financial regulation. Equally important were long-needed revisions to the countrys bankruptcy law and to the legal and regulatory framework for realestate lending. Access to banking services improved and competition was fostered, through measures to increase transparency of fees and interest charged and the portability of bank accounts. Congress has also recently approved a law allowing an expansion in the role of credit bureaux. the new members of Brazils rapidly expanding middle classes. Small and medium-sized enterprises also need improved access to credit. The growing economy requires significant investments in infrastructure that will need to be financed in the coming years. In particular, transportation and energy which includes the exploitation of the significant oil reserves recently found off shore will demand substantial investment. Finally, there is room for further reductions in real interest rates, as responsible macroeconomic policies continue to lead to reduced premiums for inflation, exchange rate and fiscal risk. In the aftermath of the financial crisis it is clear that the globalisation of financial services is here to stay. After the retrenchment brought on by the crisis, the worlds major financial institutions are once again looking to invest abroad, and Brazil will continue to receive and welcome foreign investment in the financial sector. Currently, 21% of the net worth of the banking system is composed of foreign direct investment. Meanwhile, Brazilian banks have been charting their own course of international expansion. It should come as no surprise that Brazil is committed to the international effort

Challenges remain
For all that has been accomplished, many challenges still remain. Brazils financial system is still not as wide and deep as those of developed economies and even some emerging markets, particularly in east Asia. More has to be done to increase financial inclusion, especially of

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CEO Agenda
1. Brazils economic growth returned to pre-crisis levels after five months of recession in 2009. GDP and investment growth for 2010 are estimated at 7.3% and 20.9%, respectively. 2. Conservative regulation and effective supervision of financial institutions were an important factor in Brazils success. 3. The minimum required level of capital in Brazil is 11%, higher than the 8% level established in the Basel II accord. The actual level of capital in the system has hovered between 17% and 18%. 4. High reserve requirements provided a liquidity buffer for the financial system that was critical during the crisis. 5. Market risk is treated more rigorously in Brazil than Basel II standards. Loan loss provisioning takes into account expected losses, not just incurred losses. 6. Total credit to GDP has increased from a very low 25% to 47%, reflecting a solid and healthy expansion of the financial sector. Real interest rates have declined, as has the spread between interbank rates and the rates charged to borrowers. 7. Brazils growing economy requires significant investments in infrastructure, in particular transportation and energy, including the exploitation of significant oil reserves recently found offshore.

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under way to design stronger global regulatory standards and to ensure that these standards are implemented consistently by national authorities. To this end, Brazil has played an active role in the G-20, the Financial Stability Board, the Basel Committee in Banking Supervision, and international standard-setting bodies. As the oftmentioned level playing field in finance becomes a global reality, the challenges discussed also represent valuable opportunities for the international banking and finance community. Mr Meirelles retired from his post as the longest-serving governor of Brazils central bank at the end of 2010. He was previously president of BankBoston and head of commercial and investment banking at FleetBoston.

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From emerging to dominant ... This is Chinas decade


Chinas emergence on to the world stage over the past decade was just the start. By 2020 it will be the worlds dominant economy, with very possibly the worlds dominant currency.

Dr Gerard Lyons Chief Economist & Group Head of Global Research Standard Chartered Bank

ade in China these three words have characterised the past decade. China has become the manufacturing centre of the world and its economic muscle has continued to grow. The next decade may be characterised by three additional words owned by China as its firms go international. And, as we move into the 2020s, those words in turn are likely to be replaced by three more paid in renminbi as its currency then begins to challenge and perhaps even displace the dollar. In Standard Chartereds view, the world economy is in a super-cycle: a sustained period of high economic growth, lasting a generation or more. This probably started around the turn of this century and has a long way to run. The world economy is twice the size it was a decade ago and is already above its pre-recession peak. A central feature of this is a shift in the balance of economic and financial power, from the West to the East, led by the emerging might of China. At current rates of growth, and with a

stronger currency, China could even displace the US as the worlds major economy as early as 2020.

A global magnet
As Chinas economy has grown, its demand for resources has surged and it has become a magnet for the rest of the world, attracting intense interest, receiving inward investment and increased imports. The next stage is likely to see further evidence of Chinas financial muscle. I am often asked: Is China a bubble economy?. The answer is no. But it is an economy prone to bubbles. This is because it has an under-developed financial sector. Individuals can put their savings in bank deposits paying little interest; into equities, where corporate governance is opaque; or into property, where rising prices could correct. China needs to avoid the lethal combination of cheap money, one-way expectations and leverage, particularly in property. Furthermore, Chinas imbalanced economy is highlighted by the high level of investment in relation to

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institutions held up well. But now they need to develop further to keep pace with the economys transformation. If there is a set-back in China it should be seen as a buying opportunity and not a reason to doubt the economys rise. The business cycle exists in China, as it does in other countries. The trend is clearly up, albeit with volatility along the way. Thus, the risks facing China, particularly inflation in the near-term, need to be taken seriously but they must be kept in perspective. Moreover, at a time when fiscal problems are evident across much of the world, Chinas budgetary position is relatively healthy, and thus the authorities have the ability to use fiscal policy as a shock absorber if needed. Its banks are well capitalised and liquid. High currency reserves at $2650bn, the worlds largest and Chinas sovereign wealth fund are other signs of its financial might.

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An industrial revolution
gross domestic product (GDP). Any dent in confidence could hit investment, knock GDP and, in turn, add to the present low level of bad loans. As a result, one should not be surprised if there are set-backs, either as things get out of hand, or as the authorities take action and intervene. As the economy and private sector grow, it becomes harder to run things from the centre and more important to have the right tools and institutions in place. The remarkable feature of recent years is how well-run policy has been in China. In the aftermath of the global financial crisis, Chinas policy The underlying story is a profound one. China is experiencing an industrial revolution. The pace and scale of change is breathtaking, as a visit to Beijing, Shanghai or other regions of the country would reveal. The economy has enjoyed a dramatic transformation over the past three decades, catapulting it to become the second largest in the world. Yet, for a country that is now the biggest growth market for luxury goods and branded products, its income per head is low. There is still a long way to go in Chinas growth story. The next phase of Chinas expansion will be evident in 2011 as it unveils its 12th five-year plan. The plan is expected to trigger

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renewed spending and give another kick-start to the economy. Yet, the main story is about commitment to the reform agenda and to further opening up the economy. China, like many economies across Asia, needs to move from export-led to domestic-driven growth, moving up the value-curve. Stronger currencies are only part of the story. There is a need to develop social safety nets to discourage personal saving; provide aid to small and mediumsized firms which are key to job generation; and deepen and broaden bond markets. The latter is particularly so for China, where corporate as well as personal savings are high. High corporate savings should encourage firms to pay higher dividends. Deepening and developing the financial sector will go alongside boosting domestic demand. People need a greater choice of savings instruments, as well as being able to borrow against future income. Microfinance can also play an important role. Meanwhile, firms need to have an incentive to save less, in the knowledge that they will be able to finance themselves from the markets. Over the past decade, nurturing the development of domestic bond markets has become a major focus for many emerging economies. For some though it has been more talk than action. Not in China. Chinas bond market

has grown from $202bn a decade ago to $2700bn. However, corporate bond issuance is still low. The number of Chinese firms that are international household names is small. But then this should not be a surprise. Many are, and will stay, focused on Chinas growing domestic market. But in time, it would not be a surprise if these firms used their strong domestic base to expand internationally, in the same way in which firms in the West have.

Renminbi concern
Whereas there is much international attention on the renminbi and rightly so from a domestic perspective it is the lack of flexibility of interest rates and their low level that is of greater concern. Whilst the central bank is now tightening, there is a need to allow interest rates to rise and to be set by the market.

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Contents

Key Ideas
Looking east Standard Chartereds view: The world economy is in a sustained period of high economic growth, lasting a generation or more, starting at the turn of the century and with a long way to run. Super-cycle economy: A central feature of the highgrowth global economy is the shift in economic and financial power from West to East, led by China. Is China a bubble economy? No, but it is an economy prone to bubbles, because it has an underdeveloped financial system. The growing importance of the Chinese currency internationally will also be another sign of its emergence as a financial power. China needs deep and broad capital markets to absorb future capital inflows, particularly if currency convertibility becomes a reality. One of the most significant developments in 2010 was the growth of the offshore Chinese currency market in Hong Kong, known as the CNH market. The desire across the world to hold the Chinese currency is immense. This offshore market is indicative of a longer-term shift in global savings and investment not just to China, but towards the emerging world. Despite near-term challenges and the risk of a set-back, Chinas economic and financial might looks set to grow. Dr Gerard Lyons is chief economist and group head of global research at Standard Chartered Bank Chinas budgetary position is healthy, so authorities can use fiscal policy as a shock absorber. Its banks are well capitalised, it has the worlds largest FX resources and a sovereign wealth fund are all signs of its financial might. The next phase of Chinas economic expansion will be evident in 2011 as it reveals its 12th five-year plan, expected to trigger renewed spending.

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RUNNING AN ISLAMIC BANK

Strengthening the risk management framework


Islamic banks must be careful to avoid taking a complacent attitude towards risks and need to address deficiencies in their risk management frameworks.
Dr Sunando Roy Advisor, Central Bank of Bahrain

he global banking system has entered a phase of significant transformation in its regulatory architecture and industry best practices to ensure resilience and soundness for financial systems. Islamic banks, being a small but rapidly growing part of the financial world, have not been excluded from this re-evaluation. While the Islamic sector has remained a relatively safe terrain, since its sharia compliance has prevented it from participating in speculative activities, the sector has faced risks from imperfections in its own markets arising from a lack of standardised products, higher transaction costs, inefficient price data, a lack of liquid instruments and less transparency. In the wake of global recessionary pressures, such inherent inefficiencies, coupled with significant risk concentrations in the business plans of Islamic banks, transformed material risks into actual losses. While Islamic banks enjoyed immunity from toxic derivative assets (governed

as they were by the tenets of sharia), they were exposed to other risks arising from a lack of liquid instruments and inadequate product diversification, among other factors.

Wake-up call
The real-life stress scenario has served as a wake-up call for many Islamic banks to strengthen their corporate governance and risk management framework. In comparison with conventional banks, the Islamic sector started late in establishing a risk management architecture. The process of implementing an enterprise-wide risk management framework was ushered in by the Islamic Financial Services Board (IFSB) in 2005, with the publication of the Guiding Principles of Risk Management for Institutions (Other than Insurance Institutions) Offering Only Islamic Financial Services. The IFSB initiatives triggered regulatory action and, consequently, there have been notable enhancements in Islamic banks

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Contents

The real-life stress scenario has served as a wake-up call for many Islamic banks.

Brave New World

risk management framework. Despite the progress, the unprecedented stress scenario presented by the financial crisis exposed significant deficiencies in Islamic banks risk management frameworks. The first deficiency that Islamic banks need to address in relation to their risk management framework may be termed integration deficiency. This can be described as an inability to integrate the efforts of the risk function into core business-line initiatives. In most institutions that suffered significant impairments during the crisis, risk management was not well integrated with the business decision-making process. The risk management function acted as an isolated analytical engine, while core decisions about business activity including growth strategy, new product development, new investment ventures and key credit decisions were taken without giving due consideration to the opinion of risk management.

In Islamic banks, just as in conventional banks, the risk function lacked the voice it needed to put forth words of caution. It did not have the required independence in terms of access to the board and senior management and, as a result, the risk management view was overridden when risk appetite exceeded prudent tolerance levels. In recognition of this limitation of the risk management framework, the October 2010 corporate governance guidelines from the Basel Committee emphasised the need for banks to have an independent chief risk officer.

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Overemphasis on Pillar 1
Apart from addressing the above issue, Islamic banks have to address an alignment deficiency triggered by an overemphasis on Pillar 1 of the Basel Accord (measuring regulatory capital for credit, market and operational risks). During the financial crisis, the adverse shocks to the banking system came from Pillar 2 risks such as liquidity constraints, real-estate concentration risks and strategic and reputational risks.

Running an Islamic Bank

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RUNNING AN ISLAMIC BANK

Prudent risk management involves b risk management framework failed t

While this alignment deficiency was common to both conventional and Islamic banks, the strategic design of Islamic banks and the underdeveloped markets for liquid instruments made Islamic banks more vulnerable to alignment deficiencies. Without proper alignment of Pillar 1 and Pillar 2 risks within the risk management framework, the banks risk function failed to provide proper guidance to management about the intensity and likely impact of key risks. The limited progress in the internal capital adequacy assessment process (ICAAP) under Pillar 2 deprived management of a holistic view of the sustainability of business strategy. One cannot, however, ignore the fundamental inadequacies in Islamic banks risk identification and measurement processes. In the first place, silo-centric risk measurement did not help the banks to assess the balance-sheet impact of multiple adverse shocks. Secondly, linkages between risks were not modelled in an efficient manner to arrive at bank-wide risk aggregation. Even in the larger

Islamic banks, the ICAAP was based on rule-of-thumb risk numbers rather than robust modelling. As a recent Basel paper on risk aggregation pointed out, the aggregation methodologies adopted by banks have been, at best, works in progress. At the same time, Islamic banks suffered due to their over-reliance on valueat-risk (VaR) numbers (or risk-weighted-asset numbers in the absence of VaR models) and a lack of emphasis on implementing robust stress testing. Where stress testing was performed, methodologies were based on simpler forms of sensitivity-based analysis. The relation of stresses to macro scenarios were less than well understood and did not successfully raise alerts in times of crisis.

Systemic deficiency
A further imperfection in Islamic banks risk management framework is systemic deficiency. This emerges from the micro focus of Basel II its spotlight on the risks faced

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CEO Agenda
1. Islamic banks started late in establishing a riskmanagement architecture. The crisis was a wakeup call. 2. Sharia compliance prevented speculative activities, but the sector had other risks a lack of standardised products, higher transaction costs, inefficient price data, a lack of liquid instruments and less transparency. 3. Inefficiencies, coupled with significant risk concentrations in the business plans of Islamic banks, transformed material risks into actual losses. 4. Core business decisions were taken without due consideration of risk management opinions. Institutions that suffered during the crisis were those where risk management was not well integrated into decision-making. 5. Links between risks were not modelled in an efficient manner to arrive at bank-wide risk aggregation and did not help banks assess the balance-sheet impact of multiple adverse shocks. 6. Corporate governance guidelines from the Basel Committee released in October 2010 emphasised the need for banks to have an independent chief risk officer. 7. Islamic banks failed to foresee the need to build up reserves. Basel III will introduce counter-cyclical buffers and limits to leverage ratios.

building reserves... In Islamic banks, the to foresee the need to build up reserves.

Brave New World

by a single institution in isolation from the financial system. This can develop into pro-cyclical behaviour by banks, thereby accentuating the intensity of cycles. Prudent risk management against such risks involves building reserves during good times to act as a buffer during crisis. In Islamic banks, the risk management framework failed to foresee the need to build up reserves. With Basel III, the Basel Committee has taken the initiative to build reserves and curb aggressive business strategies by providing a macro overlay to capital regulation, through the introduction of counter-cyclical buffers and limits to leverage ratios. Comprehensive assessment of risk profiles and addressing deficiencies identified in the past are critical to building a robust enterprise-wide risk management architecture for Islamic banks. Dr Sunando Roy is an advisor to the Central Bank of Bahrain. The opinions expressed in this article are the authors own and do not represent the views of the institution he represents.

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Acknowledgements
This selection of articles has been compiled with the kind permission of FT Business from their publications: How to Run a Bank 2010 and 2011.

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