deloitte fsi magazine #5

‘ Maintaining a competitive internal market is the only way forward’

FSI magazine | #5 March 2009

Balancing state aid and competitionInterview with Irmfried Schwimann, Director Financial Services (DGC), European Commission

Will bank branches survive?How to reconnect with retail bank customers

High hopes, low expectationsForeign retail banking opportunities in China

' Banking is the love of my life'

Portrait of Józef Wancer, CEO of Bank BPH

The cost of cashHow the economic turmoil impacts cash usage

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Towards a new reality

An unprecedented global crisis has now extended its reach to all geographies and sectors of the economy. The discussion today focuses on how long it will take for the economy to

recover, and what can be done to move it back in the right direction.

With regard to the financial services industry, it is still unclear to what extent the sector itself has sta-bilised. But what is clear at this junction is that both the banking and insurance businesses will have to absorb and digest the negative impact of the severe slowdown in the real economy.

It is equally clear to all observers that the bank-ing and insurance businesses will have to face a new reality in the months and years to come. The industry is likely to be restructured around four key themes:

Ownership: Most banking and insurance compa-nies have seen the government entering into their shareholder and decision-making structures; some institutions have even been or are about to be nationalised. This will undoubtedly have major consequences for the industry itself.

Business and operating model: All the actors in the financial services industry will have to rethink

their ambitions in terms of both their geographical spread and their range of activities (banking, insurance, asset management). They will all have to get an aware-ness of where the true synergies are, and be realistic in their promises to the markets.

Regulation: If all observers agree that regulation has not helped to avert the current crisis, it is also clear that regulation will be only a part of the solution. There are bound to be major initiatives on the regulators’ side, obviously at both international and national levels.

Clients: Clients must by all means regain their place at the centre of the debate. This calls for a thorough revi-sion of the value proposition offered to the market. The financial services industry will be able to find and assume its new role in the global economy only by focusing on its clients.

All observers agree that the financial services industry is facing a new reality. Some even believe that we are now on the brink of a total transformation of our society. What is certain, at any rate, is that we are in for very exciting times.

Deloitte SE FSI Leader

PrefaceIn this issue

News & Research

Balancing state aid and competitionInterview with Irmfried Schwimann, Director Financial Services, DG Competition of the European Commission

Will bank branches survive?

Gains of the credit crisisColumn by Harry Smorenberg

UCITS risk management under construction

Only strong and trusted brands will survive

Foreign retail banking opportunities in China

Polish banking leaders caught in the lens

‘Banking is the love of my life’Portrait of Józef Wancer, CEO of Bank BPH

Financial crisis changes the regulatory and supervisory landscape

The cost of cash

Managing reputational risk

Solvency II: Dealing with operational risk

Towards a more transparent tax position

Unprecedented action by the IASB

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This is not the first time individual firms or the financial services industry have experienced a downturn. But the magnitude of the losses and the number of firms involved make this market collapse different. It is more important than ever for the financial services industry to take stock of the lessons learned. In its recently released report, 'Risk Management in the Age of Structured Products', the US-based Deloitte Center for Banking Solutions explains, with the benefit of hindsight, how firms can improve their risk management so that they can come to a better understanding of their aggregate risk exposures.

These lessons fall generally into four areas:1. Revamping governance, risk oversight and risk

management2. Integrating both risk and return into decision-making3. Building capacity to understand and manage risk4. Revisiting the need for improved transparency and

disclosure

Governance, risk oversight and risk managementA key issue in the credit crisis relates to the role of senior management and the board. In some cases, it appears that senior management and the board were not adequately informed of the risks their firms faced in structured products and of the aggregate risk contained on their balance sheets. Risk management culture and approaches were, in some cases, not sufficiently embed-ded throughout the organisation. Because of that, risk and reward perspectives were not brought together in a way that would have allowed a more accurate, enter-prise-wide understanding of the firm’s risks. This lack of understanding across the organisation of the true magni-tude of its risks laid the groundwork for failure.

Recommendation: A firm should have, in writing, a clear, detailed, board-approved risk management charter or framework that defines risk management roles and responsibilities. This charter or framework should be clearly communicated throughout the organisation.

Building risk and return into the business practiceFocused as they were on generating revenues, a number of financial institutions did not fully understand the structured products that generated the losses. It is time to build risk and return more effectively into the business practice.

Recommendation: Senior management – with board input and approval – should define the institution’s risk appetite as part of its written risk framework.

Capability to identify, measure, monitor and control risksIt has been widely reported that management’s response to the credit crunch was delayed largely because institu-tions lacked sufficiently sophisticated analytical systems

and a clear methodology for assessing liquidity risk. It now appears that valuation and measurement systems did not fully capture risk at the product level, making it hard to get a complete view of the financial institution’s aggre-gate exposure.

Recommendation: A firm should be able to measure the risks associated with all transactions. To do this, it should have a consistent set of models, data and related systems for pricing and risk management that fully captures, to the extent practicable, all relevant drivers of value and risk. Moreover, it should have consistent approaches to data, models, and processes. A financial institution hoping to compile an aggregated, enterprise-wide view of its risk must make sure that its technology and data are consist-ent across business units and across specific risk functions.

Transparency and disclosureDue to the limitations of the risk management infrastruc-ture, plus the complexity of structured credit products themselves, essential risk-related information often did not reach the right levels or enter into key decisions regarding risk, at either the business or the corporate level. And given the problems in internal communication regarding risk in some firms, it is not surprising that exter-nal disclosure was incomplete.

Recommendation: The firm should demonstrate clear intent to provide transparency and appropriate disclosure at all levels, both internally and externally.

The 6th Annual Global Security Survey, which benchmarks IT security and privacy in the financial services industry, was published in February 2009.

In 2008, financial institutions saw a decline in the number of both external (47% vs. 65% in 2007) and internal (27% vs. 30% in 2007) security breaches. The top three information security priorities of financial institutions are: security regulatory compliance, followed by data protec-tion and information leakage, and access and identity management.

Some other findings include:• Peoplearebothanorganisation’sgreatestasset

and its weakest link. But security vigilance is even more important in hard economic times, when the increased stress levels can lead people to behave in atypical ways.

• Eventhoughbothinternalandexternalsecuritybreaches at financial institutions worldwide have declined in number over the past twelve months, employee misconduct is a growing concern.

• Thegrowingpopularityofsocialnetworksandtheproliferation of mobile media, such as USB keys, MP3 players and PDAs, all cause an extra load on internal and external security. These devices present oppor-tunities for unauthorised download and storage of confidential information in an unprotected medium. This is one of the factors that has contributed to the sudden rise of data protection and information leak-age as a top priority for financial institutions – tied at second place with access and identity management.

• Theleadingdriversforfinancialinstitutionstoprotectthe privacy of their clients' information are privacy regulatory requirements (79%) followed by reputation and brand concerns (70%).

Global Security Survey 2009

Protecting what mattersRisk management in the age of structured products:

Lessons learned for improving risk intelligence

Shaping the new financial services marketplace'Risk management in the age of structured prod-ucts' is the first of a series entitled 'Shaping the new financial services marketplace', in which the US-based Deloitte Center for Banking Solutions will examine the rules, regulations, and operating models that evolve as the industry sails uncharted waters.

For a hard copy of the report, or for more information about this topic, please contact Frank De Jonghe ([email protected]).

For the full survey, please visit www.deloitte.com (search for: Global Security Survey 2009).

News & Research

News & Research

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What were the greatest challenges and achievements of the European Commission’s competition depart-ment (financial services) in 2008?We’ve been working very hard in recent months to help EU member states restore confidence in the market and protect their financial stability. Our aim has been to pro-vide immediate assistance to member states on state aid issues in order to help them deal with the problems they face in the rapidly changing circumstances of the crisis.

On 13 October 2008, the Commission adopted guidance on the criteria to be used to assess national measures for supporting financial institutions. In early December we also published a communication on the recapitalisation of financial institutions. This provided detailed informa-tion on how we would approach bank recapitalisation measures.

Over the past four months, the Commission has adopted nearly 40 decisions on state aid in the financial services sector. These provide clarity and legal certainty for mem-ber states. We believe our state aid policy represents a pragmatic and responsible reaction to the evolving market conditions. These decisions cover a range of measures, including guarantees, asset purchases, pure recapitalisa-tions and general schemes combining all of the above.

Our main aim has been to achieve the right balance between allowing aid to the extent necessary in order to maintain financial stability and seeking to ensure a return to normal market functioning, while at the same time making sure that state support does not unduly distort competition between banks and worsen the financial crisis.

What lessons can be learnt from the financial crisis, and what role can the Commission play in establish-ing a more stable economic environment? The crisis has demonstrated the importance of the EU state aid rules. Without controls on state aid, govern-ments would be tempted to support national banking institutions to the detriment of their European competi-tors; strong companies would be penalised and necessary reforms might be postponed, all of which would delay recovery.

Even though the support schemes for the financial sector remain in the hands of the member states, the Commission provides a framework, through the implementation of the EU state aid rules, that ensures consistency in national responses throughout the EU.

Our role in establishing a more stable economic environ-ment for the future is, however, limited. What we can do is to help member states by ensuring that the state aid rules preserve a level playing field, while at the same time giving them legal certainty and sufficient flexibility to take timely measures in support of their financial institutions.

What developments can we expect in 2009 and what are your plans for dealing with them?In 2009 the Commission is going to be working on addi-tional financial support measures proposed by member states, and will also need to review existing measures. We may need to make adjustments in response to events as they evolve, and make sure that aid continues to be minimised. The Commission will also report to the Spring European Council on the financial reform package and present the initiatives that the Commission is currently working on.

The Commission also adopted a temporary framework last year that provides member states with additional ways of ensuring access to finance for both strong and vulnerable non-financial enterprises in order to help the ‘real’ economy cope with the recession. This framework, which will apply until the end of 2010, is designed to ensure that member states can offer consistent help to a wide variety of businesses.

The Commission will also have to examine a second wave of recapitalisations this year. It will have to consider how effective the present recapitalisation model has been and decide how best to deal with banks that need further recapitalising. Finally, the treatment of toxic assets and their potential acquisition by member states will need to be addressed under the state aid rules. How such assets are treated is a particularly complex issue, with direct implications for the assessment of state aid.

State aid rules are at the centre of the European Commission’s response to the financial crisis, but as Irmfried Schwimann, Director of Financial Services at the Commission’s competition department, tells FSI Magazine, maintaining a competitive internal market is the only way forward.

Balancing state aid and competitionBy Jon Eldridge

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How do increased state aid measures and widespread nationalisation of banks impact on the level playing field, and what are the essential criteria for a well-balanced European financial services industry?The financial crisis has undoubtedly led to unprecedented changes in the EU member states. The situation is evolv-ing, and so are our rules for dealing with the changing market circumstances.

The Commission does not question the need for national support schemes in order, for instance, to avoid bank fail-ures that could have far worse consequences for the real economy. However, by applying our state aid policy, we have been able to maintain a level playing field while deal-ing with the crisis.

Our state aid policy is based on two fundamental princi-ples: any distortion of competition must be in proportion to the objective of the aid, and any state aid measures should be temporary. Before approving proposed state aid measures, we ensure that in each case the aid granted does not exceed what is strictly necessary to achieve the legitimate purpose, and that distortions of competi-tion are minimised. If this is not the case, member states are asked to change their schemes before they can be approved. The conditions imposed, for example, on the pricing of these schemes and the review mechanisms in place to re-evaluate the need for such schemes six months later ensure that the Commission can help tackle the crisis, while also avoiding harmful economic imbalances between banks and member states.

One of the main criteria for a well-balanced European financial services industry in the future is that banks need to be adequately capitalised and to be well placed to provide finance and play an intermediary role in the econ-omy. In order to arrive at this point, the level and form of state aid provided may need to vary from one country to another. We are currently striving to establish a solid starting point. And the Commission's role is to ensure that state aid gets us to that point.

How effective has the Commission’s state aid policy been, and how can it be improved?Since the very onset of the financial crisis, the Commission's role in the field of competition policy has been to underpin public authorities’ efforts to support financial stability and sustain lending to the real economy by swiftly providing a legal framework for applying state aid rules, in exceptional crisis conditions, so as to ensure co-ordinated and effective action by member states.

State aid rules are sophisticated enough to cope with the differences between member states, and strong enough to cope with the difficulties. We allow national govern-ments freedom to tackle the root causes of the crisis, but prevent them from taking action at the expense of other member states or taxpayers.

The crisis has been a valuable learning experience, both for the Commission and the member states. If market conditions change quickly, we have to be ready to adapt our rules to the changed circumstances in order to pro-vide an adequate response to member state interventions.

The Commission wants to adopt a ‘collaborative’ rela-tionship with member states for the approval of state aid packages. What are the threats to this relation-ship, and are you optimistic about the future?We have always tried to maintain a constructive dialogue with member states in order to ensure that any measures are shaped in line with our rules. This is the best way to ensure we can approve measures quickly and avoid prob-lems at a later stage.

By working as partners when approving state aid meas-ures, we can make sure that resolving problems faced by one member state does not have a negative impact on neighbouring countries. We clearly need a coherent response if we are to protect our economies and ensure jobs, stable business conditions and value for money for consumers.

I am confident that all member states acknowledge the risk of a subsidy race and the need for a neutral arbitra-tor to ensure that aid schemes do not unduly distort competition.

What were the main aims of the communication on recapitalising banks? Given the legal challenge to the Belgian government’s role in the rescue of Fortis, could the Commission have done more to ensure greater regularity?The main aim of the communication was to respond rap-idly to the need for guidance on whether specific forms of recapitalisation complied with state aid rules. The com-munication sought to provide a co-ordinated framework, legal certainty and a possibility for rapid implementation of the required measures in order to reflect the varying scope and conditions of recapitalisation schemes.

The communication also recognises that fundamen-tally sound banks should be included in recapitalisation schemes so that they do not de-leverage their balance sheets too much in a short period of time, but also main-tains the need for caution, so as to ensure that schemes are properly designed to achieve the objective of lend-ing to the rest of the economy and avoid distorting competition.

The communication also requires schemes to include incentives for redeeming state capital once market condi-tions return to normal. The Commission is only competent to assess action taken under the state aid rules. This means that its role in cases such as Fortis has focused on safeguarding the above objectives in a situation of great complexity, involving three different member states, and of extreme urgency for the Belgian government.

How great a threat is protectionism, and is the Commission prepared to get tough with member states that flout EU rules?Protectionism may be a threat, but we all share a respon-sibility to avoid falling into this trap, which would result in a decline in world trade. Finding a solution to the crisis should, in my view, involve scaling up the regulatory proc-ess in a way that preserves the dynamism and innovation that comes from free competition.

Our experience so far shows that members states acknowledge that a subsidy race is in noone's interest. They clearly understand that the Commission is deter-mined to apply the state aid rules. Until now, there has

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been no need for the Commission to open the formal investigation procedure, but in many cases discussions with member states have resulted in plans being amended or in the member state providing the Commission with a series of undertakings before the scheme could be approved.

What do you see as potential growth areas for the financial services industry? Does the recent finan-cial crisis represent an opportunity for innovative companies?The financial crisis might represent an opportunity for banks that have managed their risks well and compa-nies that have dealt with their problems promptly and factually. Thanks to the substantial changes that the Commission has made in the state aid rules over the past few years, and providing member states meet certain criteria, states can now give aid designed to meet certain objectives specifically linked to improving the competi-tiveness of Europe's economy, without having to notify the Commission in advance. These include promoting research, development and innovation and making risk capital available to SMEs and start-ups.

The Commission has also approved a temporary frame-work that opens up additional ways for member states to provide access to finance for businesses in the real economy and encourage them to continue investing in a sustainable future. This framework allows member states to increase the amount of risk capital that can be offered to each SME to €2.5 million a year, and reduces the percentage of this capital that must come from private sources from 50 per cent to only 30 per cent.

Are we likely to see more mergers and greater market consolidation?The financial turmoil may have an impact on the global structure of the financial services sector. In principle, mergers and acquisitions can make a valuable contribu-tion to the consolidation of the banking industry, with a view to achieving the objectives of stabilising the financial markets and ensuring a steady flow of credit to the real economy.

If a financial institution falls victim to the crisis, the solu-

tion is sometimes for it to be taken over by a more stable financial institution. Such a takeover will fall under EU merger control, and the normal merger review principles will apply. But the Commission will also take account of the changing market conditions and, where applicable, a ‘failing firm’ defence.

Some member states may be uneasy about the restriction on aggressive commercial behaviour of banks benefiting from state aid. This restriction is not designed to hamper the consolidation of the banking sector, but rather to ensure that recapitalisations at excessively favourable conditions do not lead to takeovers to the detriment of non-recapitalised competitors.

Is there a need for a new EU Financial Services Action Plan when the old one expires in 2010 and, if so, what should this new plan focus on?The Financial Services Action Plan was designed to create a single market for financial services in the EU. It consisted of a set of measures intended to fill gaps and remove remaining barriers so as to provide a legal and regulatory environment supporting the integration of financial mar-kets. The Commission will have to assess the need for a new Action Plan nearer the expiry date of the old one.

What is the outlook for the Single Market? Are free market principles under threat? What is the Commission’s long-term strategy?The current global crisis has forced us to go back to basics. Few people would dispute that markets must play a key role if we are to maintain and extend our prosper-ity. But governments may need to intervene and provide better regulation, while still maintaining free competition. This is the only way forward, and it’s the basis of our long-term strategy.

Given the current financial markets, can EU countries expect Competition Commissioner Neelie Kroes to be more lenient?The Commission accepts that the current crisis is excep-tional and warrants an exceptional response. Clearly, however, leniency on state aid rules would risk a disinte-gration of the European Single Market for banking and financial services and simply store up problems for later.

As our commissioner has repeatedly explained, state aid rules are part of the solution, not part of the problem.I am confident that member states have by now realised that a co-ordinated response to the crisis is the only way forward.

Jean-Claude Trichet, Chairman of the European Central Bank, recently said, 'We need a paradigm change for the global financial system.' Do you agree, and what contribution can the Commission make? Changes are obviously needed if we are to deal with the root causes of the crisis and avoid facing the same problems in the future. The Commission is already tak-ing steps to bring about the restructuring of the financial sector, which is essential to ensure its long-term viability. The independent High Level Group on financial supervi-sion chaired by Jacques de Larosière will report to the Spring European Council and make recommendations to the Commission on strengthening European supervisory arrangements.

The Commission’s Internal Market and Services Department is also working on a communication that is likely to address the supervision of the EU financial sector (responding to the recommendations of the de Larosière Group), regulation and overview of EU financial institu-tions and markets, consumer and investor protection, market transparency, the accountability and integrity of market participants and international co-operation.

Irmfried SchwimannDr. Irmfried Schwimann is Director of the DG Competition’s Financial Services unit, dealing with antitrust matters and state aid. Mrs Schwimann was previously Head of the Financial Services Policy unit of the DG Internal Market and Services. Before that, Mrs Schwimann worked in the unit dealing with Retail Issues and Payment Systems within the DG Internal Market and Services. And subsequently in Commissioner Bolkestein’s Cabinet, where she was responsible for financial services issues. Mrs Schwimann studied law at the University of Linz in Austria as well as political science at the Institut d’Etudes Politiques in Paris. Before joining the Commission, Mrs Schwimann worked for the Austrian Ministry of Foreign Affairs and an Austrian Insurance group.

‘ Restructuring the financial sector is essential to ensure its long-term viability’

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In uncertain times it is crucial for banks to main-tain a competitive market position. This may mean refocusing their customer and channel strategies. The currently restricted availability of capital means that both management and stakeholders are demanding that strategic

decisions are underpinned by fact-based evaluations of the alternatives. Although large amounts are being invested in branches, do banks really know what their customers want? Branch design and layout are clearly part of the customer experience, but they are not the most important differentiating factors for customers. The Deloitte survey summarises customers’ experience and levels of satisfaction with retail bank branches, while also analysing the Belgian and Dutch retail markets and draw-ing conclusions for branch strategies.

Shifting paradigmsThe retail distribution landscape is shifting from a branch-dominated paradigm to one of integration and balance between multiple channels. Nevertheless, the branch remains a key channel for Belgian and, to a lesser extent, Dutch retail banking customers. The new paradigm demands a fundamental shift in the position and role of the branch.

Importance of face-to-face contactOur customer survey confirms that the branch is still highly valued by Belgian customers. Although Dutch branch visits are declining in favour of the internet, most Dutch customers would not apply for complex products entirely online.

The survey indicates that both Belgian and Dutch retail customers demand face-to-face contact and will continue

How to reconnect with retail bank customers

Will bank branches survive?Every new technology prompts predictions of the end of retail bank branches. Emerging channels such as the internet, ATMs, self-service banking, call centres and mobile phones have always triggered questions about whether the 8,000 branches in Belgium and the Netherlands can survive. A Deloitte survey clearly shows that branches are here to stay, providing banks adapt their branch and channel strategies and focus on increasing customer satisfaction.

By Patrick Callewaert, Emeric van Waes and Alexandre Gangji

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to visit their branches. However, they are not very satisfied with the services provided by their current branch and bank.

Better customer service and access The survey highlights that customers are not satisfied with branch services and access. The results are surprisingly similar in Belgium and the Netherlands, although Dutch customers are more negative about the current perform-ance of the branches.• Adviceprovidedatthebranchfailstosatisfy1in

3 customers in Belgium and 2 in 3 customers in the Netherlands 27% of personal and 30% of business customers in Belgium and 62% of personal and 71% of business customers in the Netherlands are not satisfied with the quality and promptness of advice provided.

• Accesstothebranchistoolimited

Key findings in Belgium Key findings in the Netherlands

Branches are still visited.79% of personal and 89% of business customers visit their branch at least once every 6 months, compared to 59% and 84% using internet banking and 65% and 44% for self-banking.

In contrast to Belgium, branch visits in the Netherlands are declining.41% of personal and 45% of business customers visit their branch at least once every 6 months, compared to 93% and 96% using internet banking

The internet is used for getting information on finan-cial products, while visiting branches is the preferred channel for buying and getting after-sales service.71% of personal and 79% of business customers see the branch as their preferred sales channel.

The internet is the key channel for getting informa-tion on financial products and after-sales.92% of SME customers and 90% of personal customers see bank websites as the key channel for information.Only 47% of personal and 30% of business customers consider the branch to be their preferred sales channel.

Most customers would not carry out complex transac-tions or apply for complex products entirely via direct channels.72% of personal and 65% of business customers would certainly not apply for complex products entirely online.

As in Belgium, most customers would not apply for complex products entirely via direct channels.70% of personal and 60% of business customers would probably not or certainly not apply for complex prod-ucts entirely online.

Most customers would like their banks to review their financial positions and proactively propose relevant offers to them.80% of personal and 65% of business customers expect more proactivity from their banks.

Very similar to Belgium, most customers would like their banks to proactively propose relevant offers.75% of personal and business customers expect more proactivity from their banks.

Some customers are even willing to pay for face-to-face contact and professional advice.23% of personal and 35% of business customers are willing to pay for professional and personalised advice.

Similar to Belgium, some customers are willing to pay for face-to-face contact.15% of personal and 23% of business customers are willing to pay for professional and personalised advice.

38% of personal and 41% of business customers in Belgium and 27% of personal and 41% of business customers in the Netherlands consider the opportu-nity for appointments outside office hours to be the main area in which branches can improve.

• Morethan1outofevery2customersbelievethatbanks act in their own interests 50% of personal and business customers in Belgium and between 50% and 64% of personal and business customers in the Netherlands think that banks act pri-marily in their own interests.

• Bankdonotknowtheircustomerssufficientlywell, especially in the Netherlands 50% of personal and 39% of business customers in Belgium and more than 80% of personal and business customers in the Netherlands do not think that their bank knows their history and current situation suf-ficiently well.

Strategic Positioning Universal Bank Community Bank Discount Bank Direct Bank

Distribution Strategy Integrated Multi-channel Strategy Direct Channel Strategy

Branch roleThe branch manages customer relationships, provides advice, completes sales of complex products and proc-esses quality leads stemming from direct channels.

Branch roleThe branch should be seen as a trust contributor. It is a physical presence that reinforces the branding of the Bank.

Integrated ChannelBranch is part of a multi-channel strategy

Not a ChannelBranch is a physical presence

Key succes factors• Strongmulti-channelcapabilities• Peoplewithrightskills(advisors,experts,...)• Appropriatesellingapproach• Easyaccessandconvenience

Key succes factors• Keylocalisationofthebranch• Easeandflexibilitytomakeappointmentsacross

channels• Closecollaborationwiththemobilesalesforceto

enhance reach

Branch Strategy

Customers Customers

Figure 1: Branch and channel strategies

Banks will have to address these issues if they are to reconnect with their customers and control the churn. According to our survey, more than 10% of personal and over 12% of business customers intend to change their main banks in the next six months.

One model does not fit allBanks need to adapt their branch and channel strategies according to their strategic positioning. Our analysis has identified two groups of banks:

1. Universal banks and community banks Universal banks and community banks need to imple-ment a multi-channel strategy that fully integrates their branches

2. Discount banks and direct banks In the discount bank and direct bank models, the branch is seen as a trust contributor rather than a

Customers demand face-to-face contact and will continue to visit their branches, but are not satisfied with the services provided by their current branch and bank

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About the researchThis article is based on the results of a quantitative survey among 1,400 branch-banking customers in Belgium and the Netherlands in summer 2008. The aim of this research was to understand what cus-tomers expect from their branches and how these expectations will evolve in the future. It specifically looked at primary customers’ likes and dislikes about their branches. The answers to these questions have far-reaching implications for retail banks in terms of how they can improve the customer experience at branches. The research covered all retail financial institutions operating in Belgium and the Netherlands and sampled personal and SME business customers. The survey was conducted before the start of the cur-rent banking crisis. It would seem safe to assume that recent events will have further reinforced the threats identified, such as low customer loyalty and lack of confidence in banks, and reduced levels of trust even more.

About the authorsPatrick Callewaert is a partner in Deloitte Belgium, Emeric van Waes is a director of Deloitte Netherlands and Alexandre Gangji is a Senior Manager at Deloitte Belgium.

Day after day, doom scenarios are paraded past us by a host of lead-ing economists, now familiar TV personalities. All repeat the same message, and it isn’t a pleas-ant one. Consumers “on strike”,

mounting inventories, zero growth and even total eco-nomic seizure are what they predict. The year 2009 looks unpromising indeed. The feed-through of bankers’ woes to the real economy was fast, far faster than anybody imagined. The sudden halt of economic activity has taken us all by surprise and hit us hard.

Still, I’m not so pessimistic. In material terms, of course, this is no picnic. But in less than a year, the crisis has worked miracles. Some essential steps have been taken and new conditions have been created to structurally reshape our society. Let me mention a few.

From G8 to G20Justice has come at last for those other powerful econo-mies around the world. And recognition of the fact that a country’s say in global affairs is determined not by politi-cal tradition but by the economic facts on the ground. A strong signal to the BRIC-countries, this also highlights the reality that the world is One Open Economy!

New risk perspectiveRisk management is no longer a national or regional mat-ter, but will take place in an international playing field, where the rules must be strictly and uniformly imple-mented and monitored. This will leave no room for local politicking, and provide more protection and transparency for professional risk takers. Moreover, risk management has made its way into the top tiers of organisations with the appearance of independent CROs in company boards.

SustainabilityThe mass capital destruction going on at the moment is obviously unwelcome. But it is sobering, and should lead to a better balance between quality and quantity, an awareness that wealth isn’t everything, but stability is! The same goes for our approach to the climate. The wild

seesawing of oil prices – from $ 120 to $ 42 – is just a taste of what’s in store as the world’s resources dwindle. A wake-up call, if ever there was one, that we need to innovate and to find new, global ways to deal with short-ages based on fair sharing of energy and food.

Breakthrough projectsGiven the gloomy economic outlook, economic stimu-lus measures are high on the agenda of governments worldwide. In China, hundreds of billions have already been earmarked for public megaprojects in infrastructure. Perhaps President Obama can give the US automotive industry a boost by making clean energy the norm. This would greatly speed up developments in hydrogen and electric car technology. Meanwhile, the Russians, the Indians, the Chinese, the Americans and the Europeans are all separately staging trips to the moon, all five nations in search of the same potentially limitless energy resources.… Just think how much more they could achieve working together!

More self-reflectionExecutives in the financial sector are very much in the public eye, and the finger is easily pointed. Of course, things have gone badly wrong. There were rules, but not enough monitoring. People saw the risks, but were also blinded by the potential profits. It’s only right that financials and supervisory authorities should be called to account. But the individual, the client, cannot be held entirely blameless. All of us have contributed, directly and indirectly, to the present stalemate. We’ve been living in the era of “more and more” and need to begin an era of “more together”. Of sharing wealth and better balancing risks and rewards. Not only at home, but also between groups, countries and continents. Over the years, the imbalance between rich and poor has only grown. That, too, is a kind of indebtedness that poses huge risks for the future.

The current crisis, however serious, may turn out to be a painful lesson in building a global society on more posi-tive foundations. A society with more balanced priorities when it comes to people, planet, power and profit.

Gains of the credit crisis

[email protected]

channel: it is used as a window to deliver brand prom-ises and supplement the customer experience for highly profitable customers.

Our research also shows that customer needs and hab-its can vary dramatically from one country to another, certainly between Belgium and the Netherlands. Belgian customers value the relationships and advice they have in face-to-face branch contacts much more than their Dutch neighbours. In the Netherlands, the internet is the key channel for getting information on financial prod-ucts, with the branch channel playing a more supportive role in closing the sale. This dissimilarity means the roles and strategies for the branches in the Netherlands and Belgium are different.

Banks need to adapt their branch and channel strategies

Column

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The consultation is an attempt to address current limitations in European legislation regarding collective portfo-lio risk management, and forms part of the European Commission’s broader efforts to revise the UCITS Directive,

adding level-3 measures. In the paper, CESR proposes a risk management framework and identifies principles and elements essential to the risk management process. The consultation was closed on 17 October 2008. The final level-3 text was published in February 2009. The princi-ples will be complemented by a paper on the technical and quantitative issues related to risk management.

LegislationThe current European legislation regarding risk manage-ment for UCITS can be found in the UCITS Directive and the 2004 Recommendation1. The UCITS Directive discusses procedures and internal control mechanisms at asset man-agement companies (article 5), and risk management in the context of derivatives (article 21). Hence current legis-lation focuses on the use of derivatives, and fails to look at all the risks embedded in the investment process and the portfolios.

With its consultation paper, CESR aims to introduce gen-eral principles for dealing with all risks that UCITS investors could be exposed to. These principles should in CESR’s view apply to both asset management companies and investment companies that have not designated a man-agement company (self-managed UCITS). The principles relate to four key areas:1. organising the risk management process2. identifying and measuring risks relevant to the UCITS3. managing these risks4. reporting and monitoring

All principles are to be integrated into the company’s risk management policy, supplemented at the company level by supervisory principles guiding the review of risk man-agement processes.

Supervision by the competent authoritiesCESR proposes that the adequacy and efficiency of the risk management process be assessed by the

On 19 August 2008, the Committee of European Securities Regulators (CESR) issued a consultation paper on risk management for ‘undertakings for collective investment in transferable securities’ (UCITS). Given the turmoil in financial markets, a formalised and coherent set of risk management principles for UCITS can only be welcomed. Investment funds and other types of investment products have seen their risk management processes put to test - and some of them failed.

UCITS risk management under construction

By Patricia Goddet

1 Commission Recommendation 2004/383/EC of 27 April 2004 on the use of financial derivative instruments for undertakings for collective investment in transferable securities (UCITS).

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About the authorPatricia Goddet is Manager at Deloitte Enterprise Risk Services, BelgiumFor more information: www.cesr-eu.org

One of the very challenging specifications that CESR includes in the consultation paper concerns the manage-ment of model risk. Companies are to deal appropriately with the possible vulnerability of their risk measurement framework and submit it to continuous assessment and revision. All techniques, tools and mechanisms are to be adequately documented and extensively tested prior to inception. This should include back-testing to demonstrate the quality of the model-based risk forecasts, but also stress-testing to capture the possibility of rare and severe losses, or to fully understand the underlying assumptions and so assess the validity range. The final level-3 text has watered down the back-testing requirement, only demanding back-testing where appropriate.CESR also explicitly refers to the link between risk meas-urement and asset valuation. As with every data tool, it goes without saying that the ’garbage in, garbage out‘ principle also applies here. Risk measurement can only be meaningful and useful if it is based on sound and reliable data. The risk management function should also provide support in the valuation of illiquid assets, structured secu-rities and complex derivatives.

Managing risks The risk management that CESR proposes focuses mainly on ensuring that each UCITS’ risk profile as defined by the Board of Directors corresponds with the actual level of risks incurred by that UCITS. To this end, each UCITS must have in place a risk limit system that is in line with the UCITS’ investment strategy and that includes measures to monitor and control the relevant risks. Indeed, CESR sug-gests that every transaction must immediately be taken into account in the calculation of the corresponding limits. The final level-3 text even adds that these risk limits should be linked with legal and contractual limits. Moreover, an audit trail is to be constituted in case limits are exceeded. For the risk management process to be effective, CESR insists that the risk limit system must be supplemented with a procedure for corrective action (triggered in the event of a breach, to be executed within a predefined timeframe) as well as a warning system that generates corrective actions to prevent breaches.

Reporting and monitoringCESR suggests introducing different risk reports for dif-

ferent levels within the organisation. Senior Management and the heads of the operational departments should receive regular internal risk reports. Written reports should be submitted to the Boards of Directors on the alignment between the realised risk profile and the target profile of the UCITS. The risk management process should be sub-ject to independent internal or external supervision.

CESR’s best practice is challenging from A to ZIn the light of the recent turmoil in financial markets, a formalised and coherent set of risk management principles for UCITS can only be welcomed. Investment funds and other types of investment products have seen their risk management processes be put to test - and some of them failed. The proposed framework comes close to what a good housekeeper’s risk management process would look like. It is not rocket science; the principles set forward are well tested in the banking industry.

The final level-3 text has added here and there the notions of proportionality and materiality. The former mainly at the level of the risk process and policy, the latter at the level of risk identification. One could still question, however, whether all the proposed measures are relevant to all UCITS, and whether they are always proportional to the size and complexity of the activities and organisation of the UCITS management company. On top of that, the more stringent requirements could fuel competition between UCITS and other investment products. Sometimes, similar or indeed the same invest-ment objectives can be achieved with (retail) investment products that are subject to totally different regulatory requirements.

Respondents to the consultation also see a significant additional burden in funding promoters and investment managers, without comparable investor benefits, which only results in longer timeframes and higher costs for investors. Moreover, the proposed measurement frame-work introduces challenges to the system, ranging from reconciliation matters where interfaces exist between accounting and front office systems, to transparency issues with vendors of off-the-shelf data tools. None of these issues have been addressed in the final level-3 text as published in February 2009.

The risk management function should also provide support in the valuation of illiquid assets, structured securities and complex derivatives

competent authorities as part of the licensing process for the UCITS/company, and subsequently monitored on an ongoing basis. Any changes to the risk management proc-ess should also be assessed. The text does not specify any transition regime. Obviously, already licensed companies should be brought under this new proposal’s regime in one way or another. The final level-3 text specifies that appraisals carried out at the time of licensing the company may be taken into account.

GovernanceAll the key principles are to be appropriately documented and formalised in the company’s risk management policy. The Board of Directors must approve and regularly review this policy and will be held accountable for the risk man-agement process in its entirety. The policy should specify principles and methods for identifying risks, as well as measurement techniques and tools deemed suitable for the UCITS. These measurement techniques should be both qualitative and quantitative, which might require IT systems to be integrated with front office or accounting applications.

Organising the risk management processIn CESR’s view, a sound risk management system places demands on a company’s organisational structure. Besides being adequate and proportionate, the risk management process must be driven by a clearly identified and inde-pendent risk management function. This risk management function must perform according to minimum compe-tence standards and be sufficiently separated from the company’s front office functions. It must report directly to the Board of Directors and Senior Management. In a difficult balancing act, the company must maintain the separation between the risk management function and the front office, and at the same time embed risk manage-ment in the investment process. The risk management function and the front office are to operate very much in parallel, enabling dynamic risk management rather than just checks at predefined intervals.

To meet these organisational requirements, companies will need people with the appropriate skills, knowledge and experience, and this will represent a big human resource challenge for the smaller players. But besides people, CESR

views processes and technology as equally important to the success of the risk management process. Companies may want to outsource some or all of their risk manage-ment activities for efficiency reasons, a move that would at the same time enhance the level of independence between the operating units. However, this should be pre-ceded by a thorough due diligence of the party delivering the risk management services. And, obviously, the Board of Directors still retains full responsibility. The final level-3 text puts even more emphasis on due diligence, and this prior to entering an agreement, as well as on the compa-ny’s responsibility to retain sufficient human and technical skills to ensure a proper and effective supervision on the way that the outsourced activities are carried out.

Identifying and measuring risks The risk management process should define for all UCITS the material risks arising from their investment objective and strategy, the trading style and the valuation process. CESR sees two main categories of relevant risks for UCITS: financials risks and operational risks. Within financial risks a distinction is made between market risk, liquidity risk, credit risk and counterparty risk. Of the operational risks, which are typically related to trading and settlement and to valuation processes, only those are relevant that also affect investors’ interests by their direct impact on the UCITS’ portfolio. A UCITS may equally be exposed to risks that emerge only at the aggregate level, such as concen-tration risk or some forms of liquidity risk.

The identified risks should subsequently be translated by the Board of Directors into a UCITS risk profile. This risk profile must be reviewed regularly to allow for possible changes to market conditions or the UCITS’ investment strategy. The risk measurement framework as defined in the policy must depend primarily on the characteristics of the UCITS. This means that UCITS with a higher risk pro-file may need more complex measures than plain vanilla, low-risk ones. The final level-3 text goes even further and specifies that investments in structured financial instru-ments are to be preceded by a due diligence concerning the characteristics and the overall risk profile of the under-lying assets.

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The forced nationalisation of once proud and all-powerful financial insti-tutions, historically low interest rates and government backing for hundreds of billions’ worth of bank loans mean we are currently witnessing attempts

on an unprecedented scale to rescue the world’s financial system and, with it, the global economy. Although these rescue plans are necessary and mainly robust, they do not address the real and fundamental problem facing the financial services industry. In other words, the total collapse of consumer confidence. Indeed the biggest chal-lenge in the wake of the credit crunch is how to rebuild the general public’s trust in our financial institutions.

Rebuilding strong and trusted brandsRestoring confidence means that only strong and trusted brands will survive. Although a brand is an asset that is hard to measure and truly intangible, corporate history and compelling academic evidence show that brands have a very real and positive impact on financial parameters such as companies’ profits, returns on investment, mar-ket shares and stock prices. On top of that, strong brand companies like Coca-Cola, IBM, General Electric, Procter and Gamble and Wells Fargo have proven they can out-perform their peers in their innovativeness, their risk protection capabilities and their ability to attract talent.

Rebuilding strong and trusted brands will also force finan-cial institutions to shift their focus from quarterly results and short-term profitability – the true evil at the root of the current financial and economic crisis – towards long-term, sustainable profitability. Strong and trusted brands can only be created by investing in customer loyalty (are your customers willing to forgive you?) and a strong corporate culture. And both of these take a long time to create, but can be destroyed overnight. Needless to say, customer loyalty and a strong corporate culture have a positive correlation with cross-selling ratios and custom-ers’ willingness to explore brand-stretching activities such as those of Tesco Finance.

Restoring the general public’s confidence and rebuild-ing strong and trusted brands are challenges not to be underestimated by any financial institution. Nowadays most stakeholders’ associations with the financial services industry are purely negative. To them, CEOs and CFOs have become the personification of unreliability, arro-gance, greed and a closed community. The captains of the banking industry are unfriendly, do not care and will not listen.

Integral corporate branding strategy The traditional and 'quick' method for turning these negative images around is to develop and execute an integral corporate branding strategy, where the goal is to affirm and strengthen stakeholder identification with strong and trusted brand drivers such as wise, in control, caring, straightforward, friendly, desirable, assertive, generous and innocent.

The first step in designing such a strategy is to perform a stakeholder analysis. What are the current views of various stakeholders, such as employees, customers (current, lost and future), financial analysts, politicians, trade unions and the general public, on these drivers? The aim of this analysis is to identify the aspects that will have most impact in changing perceptions in the desired direction.

An integral corporate branding strategy is then devel-oped on the basis of this analysis. What intertwined sets of internal and external branding and communications

are needed to create positive stakeholder identification with an affirmation of the trusted brand drivers?

Redesigning business modelsYet although an integral corporate branding strategy is certainly an essential part of regaining consumer confi-dence, it will not be sufficient in itself. The only way to achieve this goal is to redesign business models and cre-ate true customer centricity.

By implementing multi-channel strategies and creating a single customer view, the early adopters in the financial services industry have taken the first steps towards these new business models. The true challenge for them, and others, will be to create open structures, where outside-in thinking is the norm rather than the exception and customers are involved in the business operations them-selves. Co-innovation and co-creation will be facilitated by web2.0 technologies such as social networking, peer-2-peer banking, user communities and blogs.

You don’t own your brandThe defining feature of these technologies is that they create an open dialogue instead of facilitating top-down communications. Financial institutions will need, however, to open up if they are to benefit from these opportunities. A corporate culture of humility and vulnerability and a genuine ability to listen are necessary if equal interaction with the consumer is to be possible.

These financial institutions’ operations and activities will be driven by real, manifest and latent consumer needs and motives. In this way, brands will reclaim their role of creating sustainable satisfaction and wealth for custom-ers and other stakeholders, and thus for the society as a whole in which they exist.

Ironically, creating openness and adaptability as a means of rebuilding strong and trusted brands will require a will-ingness on the part of the brand owners to let go of their obsessive control of their brands. Co-innovation means ultimately also creating the brand in an open dialogue. Or, as Procter & Gamble’s CEO Lafley puts it, ‘We don’t own the brand, the brand is owned by the consumer.’

Regaining consumer confidence after the credit crunch

Only strong and trusted brands will survive

The real and fundamental challenge currently facing the financial services industry is how to restore consumer confidence. Yet a lot more than a traditional, integral branding strategy will be needed to create strong and trusted brands. Co-innovation means ultimately also creating brands in an open dialogue.

By Pieter Vijn

Rebuilding strong and trusted brands will force financial institutions to shift their focus from short-term profitability – the true evil at the root of the current financial and economic crisis – towards sustainable profitability

About the authorPieter Vijn advises companies on corporate brand-ing and innovation strategies. He is also part-time Professor of Branding & Integrated Marketing Communication at Nyenrode Business University in the Netherlands. Prof. Vijn can be reached at [email protected].

Customer loyalty and a strong corporate culture have a positive correla-tion with cross-selling ratios and customers’ willingness to explore brand-stretching activi-ties, such as those of Tesco Finance, UK’s larg-est supermarket bank.

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With its 1.3 billion inhabit-ants and strong economic growth prospects, China is currently a very interesting country for foreign finan-cial institutions. Following

the political reforms of 1978, the banking sector, which until then featured only one bank, became a dynamic market with hundreds of players. In retail banking, China now boasts four state-owned banks, joint stock banks, city commercial banks, small rural and urban credit unions - and foreign banks. The state-owned banks have long dominated the market, but are operationally weak, while the more advanced joint-stock and city commercial banks are strong, but only in their respective regions. Although given permission to offer renminbi products in 1996, foreign banks were at first only allowed to do business with foreign firms and foreign individuals. Gradually, they were allowed to offer a broader range of products and from 2006 onwards, they have also been allowed to offer renminbi products to Chinese consumers. Over the last two years, 30 foreign banks have set up shop in China, competing directly with Chinese banks in a number of services, including retail banking for the Chinese popu-lation. The standard products and services offered by banks in China are basically the same as in the rest of the world, but demand has to date been very much focused on deposits and cash withdrawals. Mortgages, con-sumer loans and credit cards are still in their infancy. For example, only three percent of banking customers have mortgages. Credit cards are swiftly gaining popularity, but customers use them only as a convenient way of paying and not as a form of credit.

Opportunities for foreign banksDespite the relaxation of restrictions for foreign banks in China’s retail banking market, they have as yet captured just a modest market share (2.4% in assets at year-end 2007). Their focus has been on high-end customers in the wealthiest cities, which makes sense, given their lack of a branch network. But their low market penetration is also partly due to rules introduced by the government to fight ‘uncontrolled competition’. These include capital and liquidity requirements, and make life very difficult for foreign banks.

Foreign retail banking opportunities in China:

High hopes, low expectations

What scope do foreign banks have to develop operations in China, and how fast can they do so? That is largely up to the Chinese government, a recent study reveals. Foreign players who already have or aspire to a role in the Chinese retail banking sector must be realistic about what they can achieve in the People’s Republic.

By Haico Ebbers and Harry Smorenberg

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This article is based on a study recently conducted by Nyenrode Business University’s Europe China Institute and Smorenberg Corporate Consultancy (see box). The study shows that the trends influencing and ultimately shaping the Chinese retail banking sector are: • theemergingmiddleclass• theincrementaluseoftechnology• deregulationandtheroleofthegovernment• intensifyingcompetition

In particular, the emergence of a Chinese middle class and technological progress could create opportunities for foreign banks. To overcome the immense network advantage of the state-owned banks in China, foreign banks need to find creative distribution channels to serve the mass market. This is where technology could help: you don’t need a branch network for internet and mobile banking. And as the middle class grows, demand increases for a wider range of more sophisticated services and products - which foreign banks are much better at delivering than state-owned banks. Another advantage is that China’s emerging middle class is relatively young. This growing body of young, demanding customers with a more open mind to new technology creates high hopes for foreign banks.

Key trends in the Chinese retail banking sectorBooming prosperity and the fast-growing number of

households ranking as middle class are trends that will change the face of retail banking in China. Figure 1 shows the rapid growth of spending power.

With the emergence of a middle class, retail banking is gaining importance in China. Apart from the fact that the middle class is getting bigger, trends within the middle class are highly relevant in this context. The distribution of wealth is higher over younger age groups in China than in developed countries. The country’s one-child policy, along with growing prosperity, has spawned a genera-tion more demanding when it comes to service and convenience. Chinese consumers, the study reveals, are in general rather disappointed in the service offered by Chinese banks. Moreover, there turn out to be consider-able differences within this middle class. All this implies an increasing need for customer segmentation.

Another key trend the study identifies is technology. In general, there is a close correlation between technology used in a sector and efficiency in that sector. State-owned banks are keen to implement the latest technology in order to improve their operational efficiency. Other play-ers in the market are focusing on technologies such as internet banking and mobile banking to enhance their accessibility for customers. Although the penetration of internet and mobile phones is rising swiftly (in 2008, China became the country with the world’s largest

number of internet and mobile phone users), the use of internet for banking services is not catching on. The study shows that this is due to a lack of trust in the safety of internet. Despite the government’s indication that it wants to make rural areas more accessible as a big poten-tial market through internet and mobile banking, this reluctance among the population to use the latest tech-nology for banking activities remains a hurdle for foreign banks. Furthermore, it should be borne in mind that some technologies that are common in the developed world have barely begun to conquer China. To some extent, this is culturally driven: of all payment transactions in China, 83 percent is done in cash.

A third key trend is intensifying competition. This is reflected in the increasing number of players active in the Chinese retail banking sector. In the battle for mar-ket share, technology is a double-edged sword: it can increase convenience for customers while at the same time reducing operating costs for the banks. Eventually, competition will lead to smaller margins for banks operat-ing in China.

Key findingsSo the emerging middle class and the incremental use and improvement of technology will shape the future of the sector, but to what extent will this create opportunities for foreign banks operating in China?

First, the trends in and features of the middle class make it necessary to segment the market, and to focus on bet-ter service and more efficient operations. State-owned banks, too, now realise that they cannot treat the mass market as one segment. For example, the Bank of China appointed a team to conduct a study into the demands, behaviour and preferences of different segments of the mass market. Eventually, the product range of these state-owned banks will cease to differ significantly from that of foreign banks. There is little that foreign banks can offer that Chinese banks cannot. Trust in the bank is essential, and therefore no mass shift of customers to other banks is foreseen. Meanwhile, regulatory restrictions make it dif-ficult for foreign banks to expand quickly. Consequently, foreign banks will remain focused on foreign customers and high net worth individuals. Some respondents to the researchers’ survey cite the banking sector in Japan and the telecom and computer equipment sector in China as cases in point: foreign players in these sectors invested huge amounts of money, brought in all kinds of technologies and all their experience with the purpose of capturing a sizeable chunk of the middle–class consumer market, but they all failed. After a struggle of decades, local companies now control over 95% of the market in those industries.

Second, although technology makes it possible to enter the mass market, and a branch network is not essential

With the emergence of a middle class, retail banking is gaining importance in China

Global affluent (>200,000 renminbi)

Mass affluent (100,001 - 200,000 renminbi)

Upper middle class (40,001 - 100,000 renminbi)

Lower middle class (25,001 - 40,000 renminbi)

Poor (≤25,000 renminbi)

1985 1995 2005 2015² 2025²

66 109 191 280 373

1985 1995 2005 2015² 2025²

509 1,625 5,132 12,544 26,059

Share of Chinese urban households,¹% Share of total urban disposable income,¹%

00

0.20.5

1.30.51.21.8

0.10.11.3

2.00.85.1

0.10.5 0.4 3.3

2.4

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100%, millions of urban households 100%, billion renminbi

¹Some figures do not sum to 100%, because of rounding; disposable income = after-tax income, including savings; real renminbi, base year = 2000; 1 renminbi = $0,12.²Base case forecast, Q1 2006 Source: National Bureau of Statistics of China; McKinsey Global Institute Analysis

Segments by annual income

99.392.9

77.3

23.2

49.7

21.212.6

9.4

59.4

78.4

13.624.2

6.919.4

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27.6

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19.8

7.7

9.7

5.7 5.6






1985 1995 2005 2015² 2025²

66 109 191 280 373

1985 1995 2005 2015² 2025²

509 1,625 5,132 12,544 26,059


00

0.20.5

1.30.51.21.8

0.10.11.3

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9.9

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1985 1995 2005 2015² 2025²

66 109 191 280 373

1985 1995 2005 2015² 2025²

509 1,625 5,132 12,544 26,059


00

0.20.5

1.30.51.21.8

0.10.11.3

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5.7 5.6

Figure 1: Chinese spending power is on the rise

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thanks to internet and mobile banking, in China face-to-face contact is of overriding importance. It relates to trust, which is everything to the Chinese. While some people are convinced that internet will be the main platform for tomorrow’s retail banks, this is not likely to happen in China in the medium term. Apart from the Chinese prefer-ence for doing business face to face, another major hurdle is the government’s firm grip on market forces. For exam-ple, the competitive advantage of direct banking is a low price, but because internet rates are fixed, it isn’t possible to compete on price in China. And this won’t change any time soon.

Third, Chinese banks are changing. While only five years ago, all the big banks offered about the same service, now there is more differentiation. The government is very much behind this. Its primary drive is to improve the operations of the Big Four. Competition is needed, the idea is, but only to a certain level. Meanwhile, branches in rural areas are being closed, signalling the beginning of consolidation. All in all, there is strong consensus among respondents to the survey that in the foreseeable future, state-owned banks will remain the only banks to cover the whole of China.

Government as restrictive factorThe above makes clear how important the government’s role is in the Chinese retail banking sector, and conse-quently its role in shaping the environment for foreign banks in China. Government actions are the main reason why the activities of foreign banks are still relatively mod-est and why further growth is difficult.

While governments around the world are currently look-

Government intervention is the main barrier to penetrating the Chinese retail banking market

ing for ways to regain control of the banking sector, China never lost control of its banks. The Chinese government has a controlling stake in the country’s four largest banks and is involved in many joint stock and city commercial banks. This is not surprising, since the banking sector is not yet ready for a market-based structure. The govern-ment uses the four state-owned banks to develop the country and distribute wealth. There is some movement towards relaxing regulations and reducing government interventions in the banking sector, but over the last dec-ade the pace of deregulation has been extremely slow. And expectations are that the current financial crisis will only make it slower.

Many reports on banking in China describe deregulation as a big opportunity for foreign financial institutions in the Chinese retail banking sector. The study presented here does not deny this, but it does show that the impor-tance - indeed decisiveness - of the Chinese government’s role tends to be underestimated. After all, the Chinese government not only manages the sector through regu-lations, but actually still has a majority stake in the four largest banks. Moreover, it conducts micro-economic policy by influencing banks’ management: almost all bank managers are party members and many top managers are also government officials. Respondents explained that in practice, it was common for the management of Chinese banks to give priority to party/government policy over pursuing a business strategy of its own. There was consensus among all respondents that government regu-lation is the main reason why foreign banks still have only relatively small operations in China. Figure 2 shows how different players in the Chinese retail banking sector are influenced by the Chinese government.

Analysis of China’s retail banking sectorNyenrode Business University’s Europe China Institute and Smorenberg Corporate Consultancy launched a joint research project to analyse China’s retail bank-ing sector and the opportunities there for foreign banks. Having identified the key trends in this sector, they asked 15 experts – employees of foreign banks in China and Chinese banks, as well as independent banking specialists from the academic world and the consultancy industry – how these trends would influ-ence the Chinese retail banking sector and its players. There was consensus about the key factors shaping the future of retail banking in China: the emergence of a demanding middle class, deregulation measures and the incremental use of technology will certainly affect the environment in which foreign banks will operate in China. But government intervention remains the main barrier to penetrating the Chinese retail banking market, and this will not change in the medium term.

The study was carried out by Gerard Baan and Wilbert van den Brink under the auspices of professor Haico Ebbers and FSI Strategist Harry Smorenberg. An executive summary is available on the website of the Europe China Institute: www.nyenrode.nl/ECI.

Negative Positive

External

Internal

Effect of the influence of the goverment

Influence of the goverment

non state owned banks

state owned banks

foreign banks

Figure 2: Influence of the Chinese government on banks and effect of this influence

ConclusionThe Chinese retail banking sector is set to grow in size and relevance, and will certainly offer opportunities for foreign banks. However, foreign banks should not underestimate the decisive influence that the Chinese government has on their freedom to operate and what they might achieve in the Chinese market. Foreign banks are allowed to operate in the market and are invited to help develop the Chinese retail banking sector. As long as they contribute to this government policy, they enjoy relative freedom. However, the Chinese government is not likely to allow a large share of such an important sector as banking to be managed by non-Chinese parties. Banking is regarded as the backbone of the Chinese economy, and a key instrument in achiev-ing economic goals.

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The project kicked off with a contest for young Polish photographers. The three winners were given the challeng-ing task of portraying 20 CEOs of the biggest financial institutions in Poland in two roles: professional and private.

The double portraits of the banking leaders were accom-panied by interviews, led by Deloitte FSI partners. The interviews reveal each CEO’s individual approach to both business and non-business related challenges.

Remarkable life storiesThe CEOs of the Polish financial sector accepted the invi-tation with great enthusiasm and some curiosity. They devoted their precious time to giving long, intimate inter-views, opening wide the doors to both their offices and their homes. They told remarkable stories from their pri-vate and professional experience: stories of their struggles to achieve success, learning from the market and surviving its ups and downs, but also stories of pure joie de vivre, and of private dreams and ambitions, fulfilled and yet to be fulfilled. And they participated with real commitment in the photo sessions, which resulted in original and sug-gestive portraits of great people seen through the lenses of young artists. Together, the amazing and unique life stories and the lively and passionate images constitute a wonderful album that captures the reality of 2008 bank-ing and its Polish icons.

Creativity versus the downturnJózef Wancer, CEO of Bank BPH, is one of the banking leaders portrayed. Why did he participate? ‘I was fasci-nated with the idea of fishing for photographic talent through a photo contest. Moreover, showing banking leaders from both a professional and a personal perspec-tive is a great concept. It has generated optimism and creativity. Something we need more than ever nowadays, as the financial sector faces a downturn and the media persist in painting black scenarios.’

Banking leaders caught in the lens

Mix the talent of young photographers and the charisma of CEOs of major Polish financial institutions, and what do you get? “Business in focus – 2008 banking leaders”, a creative initiative connecting two worlds: business and art.

By Sylwia Jackowska and Halina Frańczak

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Business in focus“Business in focus – 2008 banking leaders” is an initiative of Deloitte Poland, realised jointly with the Commitment to Europe Arts & Business Foundation and the Harvard Business Review Polska. The portraits of bank CEOs were exhibited during a vernissage on 25 November 2008 at the Zachęta National Gallery of Art in Warsaw. This event was attended by numerous chairmen and board members of Poland’s largest banks and representatives of the world of finance and culture, including the Polish Ministries of Finance and Culture. All the photographs and interviews have been published in an exclusive album. The proceeds will go towards scholarships awarded to young, gifted fine art photographers.

More information: www.bizneswobiektywie.pl, Sylwia Jackowska ([email protected]), PR/Marketing Manager Deloitte Poland, Halina Frańczak ([email protected]), Marketing Director Deloitte Poland or Matthew Howell ([email protected]), Marketing Director Deloitte Central Europe.

A creative initiative connecting two worlds: business and art

Photos by Małgorzata PytelFrom left to right:Mariusz Grendowicz, CEO Bre BankJerzyPruski,CEOPKOPBPiotrKamiński,CEOBankPocztowyWłodzimierzKiciński,CEONordeaBankSławomir Skrzypek, CEO National Bank of PolandSławomir Lachowski, former CEO Bre Bank

34 35


How did you get into banking?You could say I got into banking by coincidence because, as a little boy, I wanted to become a doctor. I moved to the United States in 1961, right after my final high-school exams. I had only five dollars in my pocket and started working in a factory. My superiors wanted me to become a mechanic, but instead I joined the army. After military service I returned to the factory, but I knew then that being a mechanic was certainly not for me. That’s why I started looking for a new job, preferably in an interna-tional organisation. I was hired by the Foreign Operations Department at Citibank. The department’s job was to analyse mistakes made by individual employees and com-plaints filed by clients in Asia and Europe. That job was a quick lesson in banking for me. Alongside my regular job, I took university evening classes. That was the most essen-tial period of my life. I was impressed by the individualism of Americans and by them being so driven by success.

Born in a Siberian labour camp in World War II. Moved to the United States in the early 1960s with only five dollars in his pocket. Now a citizen of the world and CEO of Bank BPH. A portrait of a Polish banking pioneer, Józef Wancer.

‘ Banking is the love of my life’

You’ve had wide-ranging banking experience in sev-eral countriesThe American management style taught me that added value should be the key objective. It’s certainly the key objective for clients, including those in the banking industry. Banks in the United States do not see large cor-porations as their key clients, but rather retail customers and small businesses. A typical John Doe has the greatest influence on the domestic economy and life as a whole. We need to listen to people and understand their needs.

That must have been quite a surprise for you, com-pared to what you had experienced in Poland?Huge queues to the cash register are what I remember from the 50s and the 60s in Poland. Customers had no rights, they were just petitioners. I remembered all of this in the 90s when I returned to Poland. No-one talked about customers, but everyone knew the word.

36 37


That reminded me of the 60s in the United States. Each generation in America has its traditions; changes have to be implemented step by step. However, the changes that took place in Poland after 1989 were more radical and rapid. Some of them happened from one day to the next.

Multinationality has become part of your life. What is your personal identity?I regard myself as a citizen of the world. I’ve lived in so many places that moving to another country is not a problem for me. I easily assimilate and get used to places, but I’ve also faced situations that were completely unac-ceptable to me. As an American soldier based in Germany I came across extreme racism among soldiers who were membersoftheKuKluxKlan.MovingtotheUnitedStates and then returning to Poland was the best thing that ever happened to me.

What are your plans for the future?I’ve decided to have three more years running the bank, and then I’m going to slow down. I’m going to remain active, but I’ll no longer be working ten to twelve hours a day – that’s something I’ve promised my wife and children.

What are you going to do then?I collect documents from the Second World War and have a small but interesting collection of papers about the lives of Polish and other European Jews during the holocaust. I’d like to trace the families of some of these people and see if anyone is still alive. I would also like to spend time renovating Asian furniture, for example, particularly Japanese. My wife says I’m no good with my hands, but she forgets that I worked in a factory for two years. The third thing I plan to do is to continue in business as a consultant or as a member of a supervisory body. I could do that from time to time, on a project basis. My true

hobby is travelling, though. I’m leaving for China soon, but I’d also like to go to Tanzania, New Zealand and South America.

Are you able to maintain the right work-life balance?Maintaining the right work-life balance is not easy for me because I’m a workaholic – just like my father was. However, I’m not really addicted to work. I’ve managed to combine my work and personal life, mainly because my family is very understanding. I do my best to spend all my free time with them. Once I leave the office I just need a couple of minutes to forget about my professional prob-lems. To relax, I go for walks on weekdays and ride a bike during weekends, particularly in the summer. In winter I go skiing. I exercise every day, as my doctors recommend. I also enjoy painting, particularly Polish painting from the 1920s and 30s. Going to auctions is something that gives me a great deal of pleasure. And lastly I enjoy music, especially classical music.

‘ My true hobby is travelling’

What is your recipe for success in banking and your personal life?The recipe is like a doctor’s prescription. It depends on the doctor and the patient. First of all, you need to have a vision and a goal in life. You need to choose your path and know what you want to achieve. Secondly, you have to be optimistic in both business and your personal life. I was born in a labour camp in Siberia during the Second World War. My family survived five years of traumatic experiences. Despite that, my parents were still extremely enthusiastic about life and still believed it was beautiful. Another thing you need is trust in other people.

Do you regret not becoming a doctor?I have a lot of respect for doctors. I admire their knowl-edge and huge responsibility for human health and life. But nevertheless, I have no regrets that my career turned out differently. Banking is the love of my life.

38 39


Increasingly stringent rules are already in the process of being implemented. On 1 October 2008, for instance, the European Commission proposed introducing more demanding capital requirements for banks. And more is likely to follow. So, after the dust has settled, what will

the new regulatory landscape look like? We will endeav-our to shed some light on that question by looking at the most important recent contributions to the debate about the future of financial regulation and supervision.

Risk, liquidity and capital managementAn early assessment of the ‘lessons learned’ in the wake of the credit crisis was published in March 2008 by the Senior Supervisors Group (SSG), a consortium of regula-torsfromFrance,Germany,Switzerland,theUKandtheUS. The Group’s recommendations, based on a survey of 11 global banking organisations and securities firms, mainly focuses on the improvement of risk measurement and management and of liquidity and capital manage-ment. The report makes a strong case for the need to enhance risk management in general and liquidity risk management in particular.

The SSG has identified four risk management practices that made the difference between firms heavily affected by the crisis and those able to weather the storm with lesser damage:• Effectivefirm-wideriskidentificationandanalysis• Consistentapplicationofindependentandrigorous

valuation practices across the firm• Effectivemanagementoffundingliquidity,capitaland

the balance sheet• Informativeandresponsiveriskmeasurementand

management reporting and practices

Starting from these best practices, the SSG also makes a number of suggestions for the revision of Basel 2, the framework regulating banks’ risk and capital manage-ment. Proposed reforms include increasing capital charges for securitised assets and strengthening liquidity risk man-agement, but also encouraging firms to simply develop better, firm-wide risk management. Thus, the SSG report notes: ’In firms that experienced greater difficulties, busi-ness line and senior managers did not discuss promptly

among themselves and with senior executives the firm’s risks in light of evolving conditions in the marketplace. This left business areas to make some decisions in isola-tion regarding business growth and hedging, and some of those decisions increased, rather than mitigated, the exposure to risks.’

Since the publication of the SSG report, a number of the recommended reforms have already been put into practice. On 1 October 2008, the European Commission (EC) announced its proposals for changing the Capital Requirements Directive (the EU version of Basel 2), to include more stringent liquidity requirements for banks operating across the EU and improved risk management for securitised products. Further revisions of Basel 2 are likely to follow, both on the EU and on the international level.

Nevertheless, it is at present far from clear whether the regulatory response in the domain of risk and capital man-agement will be limited to fine-tuning or re-calibrating the existing framework, or whether a more substantial over-haul of the approach is in the cards.

Senior Supervisors’ Group: ‘In firms that experienced greater difficulties, business line and senior managers did not discuss promptly among themselves and with senior executives the firm’s risks in light of evolving conditions in the marketplace.’

Accounting rulesAccounting rules have been hotly debated since the beginning of the financial turmoil. Bankers have come to argue that a new bookkeeping rule requiring them to value their assets at market prices – also known as fair value accounting – has had a devastating effect on their balance sheets, and has therefore helped intensify the financial crisis. Other stakeholders argue that a loophole in the accounting rules, allowing banks to move large amounts of assets off their balance sheets, was partly responsible for the escalation of the crisis.

An industry that already faces intense regulatory scrutiny is likely to face more

Financial crisis changes the regulatory and supervisory landscape

When will the financial crisis end? What will be its final impact? As the crisis continues to escalate, these questions are becoming harder to answer. However, there is little doubt that the present turmoil will radically change the regulatory and supervisory landscape. An industry that already faces intense regulatory scrutiny is likely to face more.

By Gert-Jan Ros, Frank De Jonghe and Caroline Veris

40 41


In response to the worsening of the crisis in the early fall, the US Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB) gave US financial institutions the green light on 1 October of last year to disregard the prices paid for assets in a forced liquidation in computing the ‘fair value’ of their own assets. This clarification of fair value accounting has since been accepted by the IASB and the EC. On 13 October, moreover, the IASB announced a change in its accounting rules which allows IFRS-compliant financial institutions to reclassify certain financial instruments in the case of a ‘rare event’. This change – prepared in record time by the IASB and adopted by the EC two days later – was meant to create a level playing field for European financial insti-tutions vis-à-vis their American counterparts, who enjoy a similar ‘rare event’ exception under US GAAP.

But more changes in accounting standards are under way. In March 2008, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) released a joint discussion paper, “Reducing Complexity in Reporting Financial Instruments”, which proposes far-reaching changes to IAS39, the account-ing rule setting out the requirements for recognising and measuring financial assets and liabilities. This paper will be used as a starting point for the reforms to be proposed by both the IASB and the FASB in the months to come.

Supervisory structureIn view of the unprecedented severity of the financial cri-sis, the debate has not stopped at rules and regulations as such. The structure of financial supervision itself is coming under discussion. A recent report by the G30 Regulatory Systems working group, a think tank, frames the upcom-ing debate over reform of the world’s financial services regulatory systems in the context of existing structures, their various strengths and their implicit weaknesses. In the report, Paul Volcker, Chairman of the G30’s Board of Trustees notes: ‘It is evident that a number of countries need to revise and reform financial regulatory structures.’

Paul Volcker, Chairman of the G30’s Board of Trustees: ‘It is evident that a number of countries need to revise and reform financial regulatory structures.’

The report assesses the four approaches to financial supervision currently employed across the globe. It describes the key design issues of each supervisory model, illustrates how each has been implemented in practice, and assesses the strengths and weaknesses of each approach.

Institutional: A firm’s legal status (for example, a bank, broker-dealer or insurance company) determines which regulator is tasked with overseeing its activity from both a safety and soundness and a business-conduct perspec-tive. The jurisdictions reviewed that use the institutional approachareChina,HongKongandMexico.

Functional: Supervisory oversight is determined by the business that is being transacted by the entity, without regard to its legal status. Each type of business may have its own functional regulator. The countries reviewed that use the functional approach are Brazil, France, Italy and Spain.

Integrated: A single universal regulator conducts both safety and soundness oversight as well as conduct-of-business regulation for all the sectors of financial services industry. The countries reviewed that use this approach are: Canada, Germany, Japan, Qatar, Singapore, SwitzerlandandtheUnitedKingdom.

Twin peaks: A form of regulation by objective, in which there is a separation of regulatory functions between two regulators: one that performs the safety and sound-ness supervision function and the other that focuses on conduct-of-business regulation. The two countries that use the twin peaks approach are Australia and the Netherlands.

The US fits into none of these categories. Its structure is functional with institutional aspects, with the added com-plexity of a number of state level agencies and actors.

The study claims that no simple correlation exists between the supervisory approach adopted in a jurisdic-tion and effective supervision during a financial crisis like the present one. Nor does one model appear to be clearly superior to the others in responding to crises. Yet the integrated and twin peaks approaches reflect more rationally the many changes that have taken place in the financial services business in recent years and might thus be more efficient and cost effective in the future. For this reason, they are functioning as a model for reforming jurisdictions, such as the United States. As the G30 report points out, the US Treasury Secretary’s Blueprint for a

UCITS 3

UCITS 4?

E-Privacy Directive

SOX MarketAbuse

Directive

3rd AMLDirective

MiFID ReinsuranceDirective

Revision ofIAS 39?

EU Committeeof Supervisors?

Financial Conglomerates

Directive

IFRS

CDR Directive

Revision of CDR Directive?

Transparency Directive

Solvency II

Payment Services Directive

Directive on Credit

Agreements

2002 2005 2007 2010

•Theaboveillustrationoffersanoverview,albeitnotacomprehensiveone,ofrecentEUregulationsinfluencingtheEuropeanfinancialservicesindustry.

•Thetimelineindicateswhenaregulationwasorisduetobeapproved;inblueareregulationsnowbeingdiscussedbytheEU.

Group of ThirtyThe Washington, D.C.-based G30, founded in 1978, is an international body of former central bank gover-nors, leading economists and private financial sector specialists. In the fall of 2007, the Group of Thirty established a Financial Regulatory Systems working group to address the large changes in the world of financial reviews.

The Deloitte Center for Banking Solutions and Deloitte’s Regulatory & Capitals Markets Consulting supported the G30 study on the structure of financial supervision. Deloitte representatives participated in the G30’s Regulatory Systems working group and an international team of Deloitte’s global regulatory spe-cialists assisted in the research and profiling of the 17 national supervisory systems.

For a copy of the report please contact Gert-Jan Ros, [email protected] or Frank De Jonghe, [email protected].

Figure 1: Overview of recent EU regulations

42 43


Modernized Financial Regulatory Structure will bring the US supervisory system a lot closer to both the Integrated and Twin Peaks models than it is today. Other jurisdictions might well follow suit.

International cooperationIf the cross-functional nature of modern financial insti-tutions necessitates a more integrated approach to supervisory oversight, international expansion has similarly created a need for closer supervisory cooperation across borders. According to the G30 report, representatives of many jurisdictions favour more formal mechanisms for cooperation and information sharing. In particular, those interviewed were supportive of the use of ’colleges of supervisors’ on the international level, focused on large, systemically important financial institutions. Again, these proposals are rapidly turning from fiction into fact. EU Commissioner Charlie McCreevy announced a revision of the Capital Requirements Directive on 1 October, entail-ing the establishment of Committees of Supervisors in the EU. These Committees will have various tasks to enhance cross-border oversight in the EU, including mediation and drafting of recommendations and guidelines. They will be given an explicit role in strengthening the analysis of and responsiveness to risks that threaten the stability of the EU financial system.

ConclusionThe financial sector is at the eve of what might well become the most dramatic overhaul within living memory of the way in which it is regulated and supervised. Under these circumstances, it pays to keep abreast on the debate about financial supervision. Blueprints now being developed by think tanks, supervisors and other experts give a preview of the regulatory reforms we might expect in the coming months and years. Now is the time to speak out, and be part of the debate.

About the authorsGert-Jan Ros is Partner at Deloitte ERS in the Netherlands, Frank De Jonghe is Partner and Caroline Veris is Director at Deloitte ERS in Belgium.

The past year, and the past few months in particular, have been tough for the financial sector. Though its origins are in the US, the subprime crisis has had never dreamt-of consequences not only for US Banks, but for European banks as well. The financial and economic situation also affects the amount of cash in circulation in the eurozone - and the related costs for banks.

By Ortwin De Vliegher

How the economic turmoil impacts cash usage

The cost of cash

José Manuel Barroso, President of the European Commission, received Jacques de Larosière, Chairman of the High Level Group on Cross-border Financial Supervision.

Recent reports by supervisors, think tanks and other experts• SSG,“ObservationsonRiskManagement

Practices”, March 2008.• IASB,“ReducingComplexityinFinancial

Instruments”, March 2008.• USTreasury,“BlueprintforaModernized

Regulatory Structure”, March 2008. • FSF,“ReportoftheFinancialStabilityForumon

Enhancing Market and Institutional Resilience”, April 2008

• IIF,“FinalReportoftheCommitteeonMarketBest Practices”, July 2008

• “Volcker-FergusonReportonFinancialRegulatorySystems” from the G30 Working Group, October 2008.

44 45


Recent events have clearly struck a blow to the collective psyche and weakened people’s belief in the stability and future of the banking system in general and some banks in particular. The drastic interventions

by central banks and governments, which even went as far as nationalising some institutions to rebuild trust, do not seem to have removed all doubts in customers’ minds. This public uncertainty has led to massive withdrawals of deposits from certain banks, with many customers demanding physical cash. A recent survey analyses the influence of the crisis on the cost of cash and provides recommendations how banks can minimise these costs.

Part 1: Analysis of the influence of the economic and financial crisis on the amount of cash in circulation

The annual growth rate of the amount of euro notes in circulation has steadily slowed since the euro’s intro-duction in 2002 till the end of 2007. If we compare the amount of euro notes in circulation at the end of the month of December in each year, we see a rise of 22% in 2003 gradually falling to less than 8% in 2007. Traditionally, the bulk of annual growth takes place in the month of December, and relates to holiday shopping. Growth in December 2003, 2004 and 2005 represented 35% of full-year growth. By December 2007, this percent-age had risen to 60%.

In the light of the historical growth trend of the amount of euro banknotes in circulation, with most growth tradi-tionally occurring in December, the latest figures, running till the end of December 20081, present several surprises. First of all, during the first nine months of 2008, the amount of euro notes in circulation rose by only 1%, the smallest increase for that period ever.

In October 2008, however, the amount of euro notes in circulation jumped by 6,4%, the biggest monthly increase since December 2003 and the biggest October increase ever. The main factor behind this jump was withdrawal of notes for hoarding purposes: the total value of the 500, 200 and 100 euro notes in circulation grew month-on-month by a remarkable 8,5% or approximately EUR 25 billion in October 20082, making it the sole reason for the increase in the annual cash growth rate in 2008.

Finally, the extra amount of cash withdrawn for hoard-ing in October did not re-enter the banking system in November or December but continued to be hoarded. The good news, though, is that November did not see a new massive withdrawal of cash.

Part 2: The influence of the 2008 economic crisis on the cost of cash

Existing estimations of the cost of cashIn recent years, two profound analyses gave a good view on what the cost of cash could be for European banks. In 2003, the European Payments Council Cash Working Group estimated the cost of cash for the European Market as a whole at around EUR 50 billion a year, of which EUR 32 billion is borne by the banking sector. In September 2005,aMcKinseystudyconcluded(onthebasisofanevaluation for nine European countries) that cash costs banks EUR 21 billion a year, making it the single most important cost item in their whole payment cycle.

Estimated influence of 2008 economic events on the cost of cashThe cost of cash for banks is influenced by numerous, very diverse cost drivers. Many of these are fixed or semi-fixed and therefore not immediately impacted by economic events or an increase in the amount of cash. Other cash-related costs are variable and could be affected by the 2008 economic events and the significantly higher amount of cash in circulation. Variable cost drivers that are most likely to be influenced are the interest rate received on deposits (at the central bank) and the cost of Cash in Transit (CIT). Missed interest revenues linked to cash usageTo simplify the analysis, we initially assume that all banks withdrawing cash at their national central banks are using their sufficiently high deposits held on an NCB account. If cash is withdrawn, banks lose interest revenue on the ECB-held deposits. This revenue depends on the ECB deposit rate.

Taking into account all changes in the ECB deposit rate, we may conclude that the interest rate linked potential revenue loss has been pretty stable at 2.75% to 3% for the last 18 months. Only between 9 July and 12 November 2008 did it rise to 3.25%. After 10 December, the rate dropped to 2%, to be lowered further to 1% on 21 January.

Annual Y2Y growth of the amount of euro notes in circulation

0

5

10

15

20

25

Growth %

Dec 08Dec 07Dec 06Dec 05Dec 04Dec 03

Total amount of € notes in circulation

580

600

620

640

660

680

700

720

740

760

780

Total

dec/08nov/08okt/08sep/08aug/08jul/08jun/08may/08apr/08mar/08feb/08jan/08dec/07

Amount of 500 € notes in circulation in b€

150

170

190

210

230

250

270

Data 1

dec 08nov 08okt 08sep 08dec 07dec 06

1Source: European Central Bank monthly statistics.2 It is likely that the rise is also partly due to the currency crisis seen in countries like Iceland and Hungary, leading to an increased use of the euro for domestic purposes and hoarding.

46 47


It is important to bear in mind that the opportunity cost of missed interest revenues on ECB deposits was only 1% at year-end 2003, when the EPC study was performed. Taking also into account that this study estimated the inventory cost of cash carried by the banking sector at EUR 6.9 billion a year, that only recently the ECB rate dropped to historical lows and that, of the EUR 760 bil-lion in banknotes currently in circulation, approximately 75 to 85% is in the hands of the public3, we could esti-mate the increase in the cost of cash for banks linked to missed interest revenues at up to EUR 1.5 billion a year. Obviously, however, the opportunity cost for all banks will be based on higher interest rates than the base rates offered by the National Bank. While the 12-month euri-bor rate was 3% early 2009, some banks still pay higher rates on the interbank market. Thus we think it is safe to assume that missed interest revenues could raise the cost of cash for banks by EUR 3 billion a year.

The cost of Cash in Transit (CIT)The cost of Cash in Transit operations for a bank depends on two things: the price per drop and the number of drops performed.

Price per dropIn most cases, CIT operations are performed by special-ised external firms working under long-term contracts at a fixed price, which is only periodically reviewed. This means that any change in the cost base of the CIT opera-

tors would not immediately affect prices paid by banks and retailers. In a few countries, however, an automatic (wage-linked) indexation of CIT prices is imposed by law. Still, this does not mean that the underlying cost base and the commercial need for price increases were generally perceived as a necessity in these countries. Indeed, our interviews with many CIT operators and banks still per-forming their own CIT operations led us to the opposite conclusion. The general rise of inflation and specifically fuel prices during the first half of 2008 not only stopped but reversed during the second half of the year. Therefore, it had no significant, lasting effect on the total cost base of CIT operations.

Number of performed dropsMost banks and CIT operators confirmed that the ongo-ing trend of decreasing the number of drops per branch slowed, but nevertheless continued during 2008. There was an uptick in October when many banks ordered extra CIT drops, but the rise did not continue during the rest of 2008 and did not ultimately impact the overall decline. Looking at the very limited increase of the cost per CIT drop on one hand and a steadily decreasing number of drops on the other hand, we may conclude that the cost of CIT for banks did not change dramatically during 2008 and shows no significant departure from the findings in previously performed studies on the cost of cash.

Part 3: Recommendations for the future to minimise the cost of cash

Cost-of-cash optimisation key in banks’ 2009 cost efficiency strategiesOur interviews confirmed that most European banks do not need to be convinced of the importance and impact of the cost of cash. However, they clearly underestimate the potential savings, high Net Present Value and very short pay-back period of most cost-of-cash optimisation projects. We are convinced that, given recent economic events and the current general strategic focus of banks on cost efficiency, cost-of-cash optimisation programmes are not only more beneficial than ever, but even among the most manageable and strategically relevant programmes to run in 2009.

To make these programmes a success, banks should not only strive to minimise CIT drop frequencies or the amount of cash in branches and ATMs, but should also work to optimise• existingcashprocessesandprocedures• internallyandexternallyperformedoperationalcash

services• branchconcepts

We are convinced that even banks that have already per-formed partial cost-of-cash programmes will benefit from a new, integrated analysis of the cash chain.

Campaigns to bring increased amounts of hoarded money back to banksThe sharp increase in the amount of euro notes in circu-lation in October 2008 was mainly concentrated in the biggest notes used for hoarding. Our second recommen-dation toward banks is to try to bring this money back into the banking system. There are several reasons to do so:• Theextraamountofhoardedmoneyhasasignificant

influence on costs borne by banks• Attractingnewdepositsisoneofthemostinteresting

ways for banks to overcome liquidity shortages and improve their Tier 1.

ConclusionThe ECB statistics make it clear that 2008 has been a remarkable year with regard to physical cash. The rise in the amount of euro notes in circulation was historically low till September 2008. In October 2008, however, the financial crisis led to an unprecedented 6,4% month-on-month rise in the amount of euro notes in circulation. The increase was most marked for 100, 200 and 500 euro notes, suggesting that the amount of hoarded money rose by approximately EUR 25 billion during the crisis. The statistics for November show that this money did not immediately flow back into the banking system.

We have demonstrated that the estimated total cost of cash probably grew by EUR 1.5 to 3 billion a year, only taking into account the effect of rising missed interest revenue. Considering also the great benefits of cash opti-misation programmes, we are convinced that running such programmes should be a key priority for all banks in 2009, and a key feature in the cost optimisation strate-gies they are currently busy with. Furthermore, we are convinced that specific actions are needed to bring the increased amount of hoarded money back into the bank-ing system. Successfully running a campaign to attract deposits will boost the liquidity position and even improve the competitive position of some banks in the deposit area.

ECB Deposit Rate

0,0

0,5

1,0

1,5

2,0

2,5

3,0

3,5

10-12-200810-12-200710-12-200610-12-200510-12-200410-12-200310-12-200210-12-2001

About the authorOrtwin De Vliegher is Senior Manager at Deloitte Consulting Belgium and co-founder of the ‘Future of Cash’ networking and knowledge-sharing platform for all those involved in the cash cycle (see www.futureofcash.org).

3 The ‘Future of Cash’ report

2006, Agis Consulting: average

of approximately EUR 1200

held per inhabitant of euro-

zone in 1999.

Missed interest revenues could raise the cost of cash for banks by EUR 3 billion a year

48 49


Managing reputational risk

Reputational risk is one of those risks that are hard to measure, even though it should be addressed in the ICAAP process. Nevertheless, it deserves a comprehensive risk management framework.By Mathias Christiaensand Frank De Jonghe

Several surveys confirm that reputational risk has emerged as a major concern for many executives and risk managers in the FSI industry. The increase in reputational risk is for the most part attributable to the increasing dominance of intangible assets.

In today’s economy, intangible assets such as brand, intel-lectual capital, strategic relationships and the ‘licence to operate’ account for 70% to 80% of a company’s market value1. This is certainly the case in the financial services industry, where the ability to underwrite new business is heavily reliant on the standing of the firm, a fact that was dramatically underscored in last year’s takeover of Bear Stearns. Despite the increased awareness of reputational risk, most (if not all) organisations will admit that they struggle to manage this risk.

Defining reputational riskAn important obstacle in the management of reputa-tional risk lies in the absence of a commonly accepted definition. The Basel II Accord recognises the existence of reputational risk but does not define it. It simply states that it is excluded from the definition of operational risk, but includes it in the scope of risks to be considered under Pillar II. The Committee of European Insurance and Occupational Pension Supervisors (CEIOPS) has defined reputational risk as follows2: 'The risk of potential damage to an undertak-ing through deterioration of its reputation or standing due to a negative perception of the undertaking’s image among customers, counterparties, shareholders and/or regulatory authorities.'

'It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.' Warren Buffet

CEIOPS goes on to say that reputational risk should be regarded as less of a separate risk, than one consequent on the overall conduct of an undertaking. Similarly, The Economist Intelligence Unit referred to reputational risk as 'the risk of risks'3. Indeed, each credit, market or operational loss event has the potential to harm your

organisation’s reputation as a second order impact. What’s worse, the damage inflicted to a firm’s reputation could well prove to be more significant than the first order impact, the underlying loss itself.

A striking example is Northern Rock. The origin of the bank’s problems presumably lay in its inadequate liquid-ity risk management. It failed to address its dependence on money market funding, which dried up in the context of the global credit crunch. This problem, however, was addressed when the Bank of England provided a liquidity support facility, helping the bank to fund its operations during the period of turbulence in financial markets whilst the bank could take the required actions to resolve its structural problems. At the end of the day, however, the bank was not affected as much by its liquidity problems as it was by the erosion of consumer confidence (remember the headline pictures of people lining up on the streets waiting to withdraw their funds). The bank run initiated a vicious circle of ever-increasing liquidity problems. In the end, the reputational damage was to blame for the downfall of the bank.

Notwithstanding the fact that the majority of reputational damage can be described as a second order impact, a number of reputational risks can nevertheless be clas-sified as ‘independent risks’, meaning that reputational damage could be considered a first order impact. These independent risks can often be associated with ethics. Organisations that do not abide by high ethical standards and that ignore principles of market conduct are vulner-able to losing their customers’ trust and confidence. In short, each organisation has a social responsibility that it cannot ignore and that it must address in its corporate governance.

Link between capital adequacy and reputational riskA fiercely debated topic is whether a financial institution must consider making provisions for reputational risk. Naturally, setting aside capital to absorb unexpected losses attributable to reputational damage requires a quantitative risk assessment. For reputational risk, such quantification will prove to be difficult due to a lack of a generally accepted measurement method. In anticipation of a market consensus about this, many firms are

50 51


currently arguing that the assessment of reputational risk is above all a qualitative assessment based on expert judgment.

This point of view seems to be supported by the Committee of European Banking Supervisors, which has stated that setting a capital requirement is only one tool made available by the Capital Requirements Directive4. Supervisors recognise that while capital has an important role to play in the mitigation of risks, it may not always be the sole or best solution to mitigating risk. For less quan-tifiable risks (such as reputational risk), the focus of the ICAAP could indeed be more on a qualitative assessment, risk management and mitigation.

Whether financial services firms have quantified their reputational risk or not, it seems fair to conclude that supervisors will expect all financial firms to be able to demonstrate that they have implemented a compre-hensive set of procedures and internal controls aimed at reducing reputational risk to a minimum.

Does this mean that quantifying reputational risk is a use-less effort? No! On the contrary, the ability to quantify reputational risk is helpful in prioritising and presenting the sources of reputational risks to senior management. A firm that is able to combine the best of both worlds, i.e. is able to understand its exposure to reputational risk through quantification and is capable of dealing with the risk through reputational risk management, has a clear competitive advantage.

Prevention is the best remedyEffectively managing reputational risk can be achieved by applying the well-known framework of identification, assessment and management.

IdentificationTo identify potential events that may negatively affect its reputation, a firm must first acknowledge that its reputa-tion is owned by the stakeholders. Every organisation has a multitude of stakeholders: investors, customers, employees, management, board of directors, regulators, suppliers, the community in which the firm operates, etc. These stakeholders have an array of expectations covering

different aspects of corporate performance. A firm’s repu-tation is determined by how the stakeholders perceive its performance in each of these aspects. The reputation is at risk as soon as expectations of the firm’s performance exceed underlying reality. In order to avoid damage to its reputation, the firm should try and close the gap by either improving performance or by managing the expectations down to more realistic levels.

Customers Suppliers

•Productquality,value•Service•Trust,respect

•Volumeofbusiness•Soundmanagement&

operations•Financialstability

Employees Regulator

•Pleasantworkplaceenvironment

•Faircompensation,knowl-edge building

•Equalopportunities

•Timelyreporting•Soundcorporate

governance•Transparent

communication

Investors Community / Society

•Returnoninvestment•Earningsgrowth•Regulatorycompliance

•Communityinvolvement

•Fairtreatmentofpeople

•Respectforenvironment

Failure to take actions aimed at closing the expectations gap will be detrimental. Sooner or later, the inability to perform in accordance with the stakeholders’ expecta-tions will be revealed. Not only will the organisation then face severe reputational damage, it could also find itself at the other end of the pendulum, with its reputation falling short of its actual performance. Hence our earlier asser-tion that reputational risk is a second-order risk.

Closing the expectations gap, however, could in itself expose the organisation to reputational risks. If, for example, the performance of a firm fails to meet investor expectations, management could be tempted to focus too exclusively on boosting its financial ratios (e.g. market share, earnings growth, ROI, etc), at the expense of its ethical standards. Actions such as aggressive selling could perhaps decrease the gap with investor expectations, but

are likely to increase the expectations gap with customers, causing them to lose their trust and respect. Balancing between the different stakeholder expectations is one of the main challenges of reputational risk management.

Once the stakeholder expectations have been identified, the organisation should make an effort to identify the incidents that, should they occur, would cause it to fall short of these expectations, and therefore damage the firm’s reputation. The following techniques can be used to identify both stakeholder expectations and potential reputational events:• Mediaanalysis(television,newspapers,magazines,

blogs, message boards, etc)• Interviewswithfront-lineemployees(i.e.those

employees that are frequently in contact with sup-pliers, customers, investors, bankers, etc and are therefore well aware of the issues raised by these stakeholders)

• Brainstormingwithmanagement• Industryresearch

Due to the dynamic nature of stakeholder expectations, this step must not be viewed as a one-off effort. Every organisation must continuously monitor changes in stake-holder expectations.

AssessmentHaving identified the events that could damage the firm’s reputation, each event needs to be assessed in terms of the likelihood that it will occur and the severity of the reputational damage which may result if it occurs. Risk rating scales can be used both for the assessment of likeli-hood and severity. The table provided here is a simplified approach.

When combining the likelihood and the severity, a risk score is obtained. This score can help to prioritise the risks and to aid in decision making (see adjoining table).

In addition to a qualitative assessment, firms could also opt to perform a quantitative assessment of their reputa-tional risk. The objective of such quantitative assessment is to measure the impact of reputational damage in terms of reduced operating revenues due to loss of clients,

Likelihood Severity

High Likely to occur at least once per year

High Regulator, clients, public opinion impacted, loss of clients

Medium Likely to occur once every few years

Medium Regulator or client impacted, few cli-ents lost

Low Very remote proba-bility of occurrence

Low Regulator or client impacted, no cli-ents lost

Likelihood

High Medium High High

Medium Low Medium High

Low Low Low Medium

Low Medium High

Severity

The reputation is at risk as soon as expectations of the firm’s performance exceed underlying reality

52 53


increased compliance and other costs to restore confi-dence, and perhaps the increase in the cost of capital as a result of the reputational event. An array of techniques exists, such as:• Examiningafirm’sstockpricereactiontothe

announcement of a major operational loss event. If the firm’s market value declines by more than the announced loss amount, this is interpreted as a repu-tational loss5

• Theactuarialapproach,whichfocusesonthelossdistribution. Frequency and loss severity are modelled separately and then aggregated using either Monte Carlo or numerical techniques

Whilst quantification is arguably as much an art as it is a science, we believe quantification is useful even where there are large uncertainties. It contributes to intelligent decision making and makes the risks even more tangible. Naturally, decision makers should continue to give due consideration to factors that defy quantification and that are thought to be important.

ManagementThe ERM Integrated Framework proposed by COSO defines four risk responses: avoiding, accepting, reducing and sharing.

Avoiding risks that can cause reputational damage is far from obvious, since these risks are often embedded in the core of the business. A classic example, however, of a risk that can be avoided is the reputation risk linked to mergers and acquisitions. When making strategic investment decisions, management should look into the litigation, regulatory and compliance history of its target. Targets that engage in wrongful conduct are often better avoided to prevent reputational damage to the acquirer. Another example is the risk of mis-selling, a risk that can be avoided by being less aggressive on sales targets.

Accepting certain reputational risks is a strategy that must be implemented with great care, as expectations can, and do, change over time. Take the example of oil companies in the previous century. During many years, little attention was paid to environmental issues. Whilst behaviour such as oil spills was criticised in the media,

it was not sanctioned. Consequently, companies in the oil industry accepted the risk of a spill. Then, suddenly, a large oil spill in 1969 ignited an environmental move-ment and stakeholders raised the bar, expecting all organisations to strengthen their environmental efforts. Companies that failed to do so and continued to neglect environmental concerns suffered important reputational damage.

Reducing reputational risks through preventive and detective control activities is the most likely and often the most appropriate response. Control activities should be designed to minimise the first-order risks (e.g. operational risks). In the context of reducing reputational risks, the importance of corporate governance deserves to be high-lighted. Firms should articulate, disseminate and enforce an ethical code throughout the business. Employees at all levels of the organisation should be well aware of the risks and events that could affect the firm’s reputation. The objective should be to develop and reinforce a true risk management culture in which compliance is put at the top of the agenda.

Sharing risks in the context of reputational risk man-agement is rare, and not recommendable. By nature, reputational risk is not something that can be legally transferred. Therefore, firms must be aware that they can even suffer reputational damage as a result of actions taken by others. A good illustration of this is the effect of the market distress that began in the second half of 2007. Banking organisations under no contractual obligations provided voluntary support to ABCP conduits and other off-balance sheet financing vehicles, including structured investment vehicles (SIVs), because of concerns about the potential damage to their reputation and to their future ability to sell investments in such vehicles if they failed to provide support during the period of market distress6.

The overall aim of managing reputational risk should be to close the gap between the stakeholders’ expectations and the true performance of the organisation. Indeed, reputation is at risk as soon as expectations exceed reality. Should an organisation identify an expectations gap, it needs to either lower expectations (through communica-tion) or increase performance (through operations).

Preparing for the worst: developing a crisis response strategyEvidently, no matter how well-developed the risk mitiga-tion tools in place (crisis prevention), no firm can fully avoid being exposed to reputational risk events. This leads us to the importance of crisis management, aimed at minimising the damage caused by such events. Being able to respond effectively to crisis events is likely to prove to be a much more efficient means of mitigating reputa-tional damage than (just) setting aside capital. Therefore, it is best practice for firms to develop a crisis response strategy. Such a strategy would typically include at least the following elements:• Identifyacrisisresponseteamwitheveryone'sroles

and responsibilities clearly defined• Preparedraftversionsofinternalandexternalcom-

munications with all key stakeholders• Ensurefastaccesstorelevantdatathatthecrisis

response team will need to make its decisions• Simulatecrisesinordertotestthecrisismanagement

plans

This last point is often overlooked. Having a crisis man-agement plan is a good first step, but it will only become useful once it is tested through simulation exercises. Simulating a crisis enables errors to be identified and addressed and lessons to be learned. Unfortunately, crises will rarely happen as envisioned during the simulations. Therefore, the crisis management plan should be flexible, and the people in charge of executing the plan must have the ability to adapt accordingly.

ConclusionWhilst many organisations are aware of the importance of reputational risk management, only few have imple-mented a true reputational risk management framework. The main challenge is recognising the need for a focused approach, and giving one person the responsibility to execute this. If done properly, the benefits will far out-weigh the costs and the organisation will be assured that its most important intangible asset is well protected.

1 “Reputation and its Risks”, by Robert G. Eccles, Scott C. Newquist, and Roland Schatz, Harvard Business Review, February 2007

2 “Risk Management and Other Corporate Issues”, Issues Paper, CEIOPS, 17 July 2007

3 “Reputation: Risk of Risks”, The Economist Intelligence Unit, December 2005

4 Guidelines on the Application of the Supervisory Review Process under Pillar 2 (CP03 Revised), Committee of European Banking Supervisors , 25 January 2006

5 “Measuring Reputational Risk: The Market Reaction to Operational Loss Announcements”, Jason Perry and Patrick De Fontnouvelle, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=861364&rec=1&srcabs=967313

6 “Observations on Risk Management Practices During the Recent Market Turbulence”, Senior Supervisors Group, March 6, 2008, available at http://www.newyorkfed.org/newsevents/news/bank-ing/2008/ssg_risk_mgt_doc_final.pdf

About the authorsDr. Frank De Jonghe is Partner at Deloitte ERS, Belgium. Mathias Christiaens is Manager at Deloitte ERS, Belgium.

54 55


Solvency II: Dealing with operational riskHistorically, insurers have focused on understanding and managing investment and underwriting risk. However, recent developments in operational risk management, guidelines by the rating agencies and the forthcoming Solvency II regime increase insurers’ focus on operational risk. Insurers consequently have to decide on their approach to managing operational risk.

By Jürgen van Grinsven and Remco Bloemkolk

Underwriting Risk

Investment Risk

Credit Risk

Liquidity Risk

Operational Risk Implementation Contol Disclosure

Pillar 1Minimum Standards

(Quantitative requirements)

Pillar 2Supervisor Review

(Quantitative requirements)

Pillar 3Market Discipline

(Disclosure & Transparency requirements)

Solvency IIFigure 1: Solvency II framework

The Solvency II framework consists of three pillars, each covering a different aspect of the economic risks facing insurers (see figure 1). This three-pillar approach aims to align risk measure-ment and risk management. The first

pillar relates to the quantitative requirement for insur-ers to understand the nature of their risk exposure. As such, insurers need to hold sufficient regulatory capital to ensure that (with a 99.5% probability over a one-year period) they are protected against adverse events. The second pillar deals with the qualitative aspects and sets out requirements for the governance and risk manage-ment of insurers. The third pillar focuses on disclosure and transparency requirements by seeking to harmonise reporting and provide insight into insurers’ risk and return profiles.

Solvency II (SII) is the updated set of regulatory require-ments for insurance companies operating in the European Union. It revises the existing capital adequacy regime and is expected to come into force in 2012. It has a number of expected benefits, both for insurers and consumers. Although the most obvious benefit seems to be prevent-ing catastrophic losses, other less obvious benefits which are considered to be important are summarised in table 1. Table 1: Solvency II expected benefits

Insurer Consumer

Reduced losses suffered by policyholders

Reduced risk of failure or default by an insurer

Enables internal risk and capital assessment models

Reduced costs of insur-ance and investment contracts

Reduced costs and increased flexibility

Broader range of products

Increased confidence in the financial stability of the insurer

Better match between products and individual requirements

Provides supervisors with early warning so that they can intervene promptly if capital falls below the required level

These expected benefits make SII an increasingly impor-tant issue for insurers. Not surprisingly, solvency has evolved into an academic discipline of its own and much of its literature is aimed at the quantitative requirements. Yet, despite the progress made in SII, the next section indicates that insurers will also encounter a number of dif-ficulties and challenges in operational risk before they can utilise these expected benefits.

The importance of operational risk in Solvency IIOver the past few decades many insurers have capitalised on the market and have developed new business services for their clients. On the other hand, the operational risk that these insurers face have become more complex, more potentially devastating and more difficult to antici-pate. Although operational risk is possibly the largest threat to the solvency of insurers, it is a relatively new risk category for them. It has been identified as a separate risk category in Solvency II. Operational risk is defined as the capital charge for ‘the risk of loss arising from inadequate or failed internal processes, people, systems or external events’. This definition is based on the underlying causes of such risks and seeks to identify why an operational risk loss happened, see figure 2. It also indicates that operational risk losses result from complex and non-linear interactions between risk and business processes.

Figure 2: Dimensions of operational risk

Several studies in different countries have attributed insur-ance company failure to under-reserving, under-pricing, under-supervised delegating of underwriting authority, rapid expansion into unfamiliar markets, reckless

Processes

People

Event Loss

Systems

External events

56 57


management, abuse of reinsurance, shortcomings in inter-nal controls and a lack of segregation of duties. See the examples below. Unbundling operational risk from other risk types in risk management and risk measurement can help prevent future failures. This holds true for smaller and larger losses. Often, larger losses are the cumulative effect of a number of smaller losses. In other words, the result of the bad practices that flourish in excellent economic circumstances, when the main focus is on managing the business rather than operational risks.

Examples of insurance company failureInsurance company failures in which operational risk played a significant role include:• Thenear-collapseofEquitableLifeInsuranceSociety

intheUK,whichresultedfromofacultureofmanipu-lation and concealment, where the insurer failed to communicate details of its finances to policyholders or regulators.

• ThefailureofHIHInsurance,whichresultedfromthe dissemination of false information, money being obtained by false or misleading statements and inten-tional dishonesty.

• AmericanInternationalGroup(AIG)andMarsh,where the CEOs were forced from office following allegations of bid rigging. Bid rigging, which involves two or more competitors arranging non-competitive bids, is illegal in most countries.

• DeltaLloyd,FortisASRandNationaleNederlanden(the Netherlands) agreed to compensate holders of unit-linked insurance policies for the lack of transpar-ency in the product cost structures.

The above examples illustrate that such losses are not iso-lated incidents in the insurance industry, but instead occur with some regularity. The large loss events mentioned above can be drilled down into operational risk catego-ries. Table 2 presents several examples of operational risk categories and insurer exposure.

Given the high-profile events, insurers need to be increas-ingly aware of the commercial significance of operational risk. The forthcoming Solvency II regime will present a number of difficulties and challenges for the operational risk management activities of insurers.

Difficulties and challenges in insurers’ operational risk management Insurers have not historically gathered operational risk data across their range of activities. As a result, the major difficulties and challenges that insurers face are closely related to the identification and estimation of the level of exposure to operational risk. A distinction can be made between internal and external loss data, risk self-assess-ment, supporting techniques, tools and governance. See table 3 for an overview.

Loss data form the basis for measuring operational risk. Although internal loss data are considered the most important source of information, they are generally insuf-ficient because of a lack and the often poor quality of such data. Insurers can overcome these problems by sup-plementing their internal loss data with external loss data from consortia such as ORX and ORIC. However, using external loss data raises a number of methodological issues, including the problems of reliability, consistency and aggregation. Insurers consequently need to develop documentation and improve the quality of their data and data-gathering techniques.

Table 2: Operational risk categories and insurer exposure

Operational risk category Example of insurer exposure

Internal fraud Employee theft, claim fabrication

External fraud Claim fraud, falsifying application information

Employment practices and workplace safety

Repetitive stress, discrimination

Clients, products and busi-ness practices

Client privacy, bad faith, redlining

Damage to physical assets Physical damage to own office, own automobile fleets

Business disruption and sys-tem failures

Processing centre downtime, system interruptions

Table 3: Difficulties and challenges concerning operational risk at insurers

Loss data Risk self-assessment Techniques, tools, governance

Lack of internal loss data Risk self-assessment process is labour-intensive

Biases of interviewees are not understood

Quality of internal loss data Static view of risk self-assessments

Chasing changing loss data

Applicability of internal loss data

Inconsistent use of risk self-assessments

Techniques and tools are not shared in the insurance firm

Aggregation of internal loss data

Quality of results Techniques have a bad fit with tools

Reliability of external loss data

Subjectivity of results Coordination of large data volumes

Consistency of external loss data

Assessments are only refreshed annually

Linkage between quali-tative approaches and scenario analysis used

Applicability of external loss data

Approaches tend to focus on expected losses

Governance of risk department versus actu-arial department

Aggregation of external loss data

Low-frequency, high-impact assessments can be arbitrary, resulting in significant over or understatement of sol-vency and economic capital requirements.

Keyriskindicatorsdonot link back to causal factors identified

Risk self-assessment (scenario analysis) can be an extremely useful way to overcome the problems of inter-nal and external loss data. It can be used in situations in which it is impossible to construct a probability distribu-tion, whether for reasons of cost or because of technical difficulties, internal and external data issues, regulatory requirements or the uniqueness of a situation. It also enables insurers to capture risks that relate, for example, to new technology and products, as these risks are not likely to be captured by historical loss data. However, cur-rent scenario analysis methods are often too complex, not used consistently throughout a group and do not take adequate account of the insurer’s strategic direction, busi-ness environment and appetite for risk.

The techniques and tools that insurers use to support risk self-assessments are often ineffective, inefficient and not successfully implemented. Research indicates that 19.5% of current practices are often not shared within the group, while 22% of respondents are dissatisfied and 11% very dissatisfied with the quality of their information technol-ogy support services. Another question that can be raised is the governance of risk management. How, for example, are the risk and actuarial departments aligned?

ConclusionsIn this article we discussed operational risk in the context of Solvency II. Operational risk is possibly the largest threat to insurers. This is because operational risk losses result from complex and non-linear interactions between risk and business processes. Unbundling operational risk from the other types of risk in risk management and risk measurement can help prevent future failures for insurers. SII is on track to put greater emphasis on the link between risk management and risk measurement of operational risk. We have addressed the most important difficulties and challenges in operational risk management: loss data, risk management, tools, techniques and governance. Those insurers able to ensure an effective response to these major difficulties and challenges are expected to achieve a significant competitive advantage.

About the authorsDr. ing. Jürgen H.M. van Grinsven is director at Deloitte Enterprise Risk Services and author of the books Improving Operational Risk Management and Risk Management in Financial Institutions.Drs. Remco Bloemkolk works at ING corporate risk management. Prior to joining ING he worked at Swiss Re and Ernst & Young. Remco Bloemkolk has written this article in a personal capacity.

Operational risk may represent the greatest threat to insurers

58 59


Driven by stakeholder demands for transparent risk management, financial institutions are increasingly having to work with a balanced Tax Control Framework. The benefits of such a framework are obvious: risks are identified promptly and opportunities are made use of more rapidly, while the tax function also becomes more effectively rooted in the organisation.

Financial institutions seeking greater efficiency and insight in tax function

Towards a more transparent tax positionBy Caroline Zegers and Robbert Hoyng

Over the past few years, financial institutions across the world have become increasingly interested in the issues of correct reporting and proper risk management. The attention devoted to corporate

governance, which has been prompted by developments such as the Sarbanes-Oxley Act and the introduction of IFRS, has resulted in European company directors wanting and having to establish a more in-depth understanding of the money flowing through their organisations. And this also means ensuring a proper understanding of tax pay-ments, both in terms of the risks and the opportunities they create.

Horizontal monitoring This trend of gaining a greater understanding of cash flows is reflected in the changing attitudes of stakeholders such as shareholders, tax authorities and CFOs. They, too, are increasingly focusing on financial institutions’ internal risk management and control processes. A good example of what this can result in is the Dutch Tax and Customs Administration’s decision a few years ago to introduce 'horizontal monitoring'. The traditional approach, where inspectors focused primarily on tax information in the returns, is now firmly in the past, with the tax authorities switching from control based on an absence of trust to monitoring through trust. The term “horizontalisation” illustrates that the government, and therefore also the Tax and Customs Administration, is no longer seeking to position itself above citizens and businesses, but instead alongside them. And this trust demands a proper Tax Control Framework (TCF) so that businesses can demon-strate that they are 'in control' of their tax affairs.

In other European countries, too, we have seen tax authorities moving in this direction. The Netherlands and UnitedKingdomareleadingthewayinintroducingtheTCF, while other European tax authorities are currently working on such frameworks or similar ones. The various countries’ tax authorities get together every two years to discuss tax risk management in the OECD Forum on Tax Administration. The most recent meeting, held in January 2008 in Cape Town, culminated in the forty participants issuing a communiqué emphasising the crucial importance

of risk management processes, of senior and executive management taking a greater interest in their companies’ tax strategies and of the need to extend regulations link-ing tax strategy and good corporate governance.

Risks create opportunitiesHowever, it is not only external stakeholders who are pushing for more transparent risk management. Indeed, we have seen a gradual change in attitudes to tax risk management within the financial institutions themselves since around the turn of the century. Previously, financial institutions thought of tax risks in terms of the risk of paying too much tax, or the risk of fines as a result of non-compliance. Now, however, they are increasingly aware that tax risk management actually means using, optimising and planning tax-related opportunities. The issue of social responsibility is also important. In the UnitedKingdom,forexample,itisnowperfectlynormalto publish information on which sectors pay most tax (three-quartersoftotalUKcorporatetaxrevenuesareattributable to financial institutions and the oil industry).

Given the importance of proper management of tax risks and the extensive range of risks (see box 1) to which financial institutions may be exposed, it is recommended classifying these risks in a risk portfolio. One way of doing this is to use a transparent tool such as the tax decision web (see figure 1), which helps financial institutions to visualise their risks and the extent to which they are and wish to be exposed.

Each TCF is tailor-madeWhat do these developments mean for financial institu-tions’ management? Managers need to monitor risks continually and to confirm in an 'in control statement' that they are managing the processes within their organisations properly, including those relating to tax. Implementing an Internal Control Framework (ICF) to describe how all the business processes are managed is very important in this respect. And one vital element of this is the Tax Control Framework, which focuses on inter-nal control of tax processes. The form of such a TCF will depend on the financial institution’s size and complexity. Each TCF is tailor-made and based on the need to provide organisations and, therefore, their stakeholders with an

The Netherlands and the United Kingdom are leading the way in introducing the Tax Control Framework

60 61


ongoing and up-to-date view of the tax position. The Dutch Tax and Customs Administration does not stipulate any specific model for the TCF, but does provide guide-lines. These are designed to ensure proper insight into the structure chosen for the TCF so that the Tax and Customs Administration can determine whether the framework is equal to the task of providing the required degree of reli-able information. This results in greater efficiency as the Tax and Customs Administration no longer has to check all the information provided. All it has to do is analyse and evaluate the TCF. This means the financial institution’s tax position can be established quickly and accurately, which in turn avoids unpleasant surprises for other stakeholders.

TCF building blocksThese developments mean that major changes in financial institutions’ tax function are inevitable. Institutions will, for example, be under increasing pressure to establish a TCF. And this framework will have to meet certain general requirements. The first building block involves establishing the tax strategy, which will be based on the business strategy. In other words, what the organisation is seeking to achieve. This in turn should result in a series of objectives being set for the chosen tax strategy. These objectives will vary from business to business. They do not only involve hard parameters such as cash flows or profits, but also issues such as integrity and the degree of socially responsible entrepreneurship as, since the start of the credit crisis, the corporate reputations of financial institu-tions have become more crucial than ever.

A second building block in each TCF is 'Tax Operations & Risk'. In other words, understanding all the business processes that interface with the tax function and then defining the roles, authorisations and responsibilities within these processes. This also involves analysing all the organisation’s possible tax risks and opportunities. The methods that Deloitte uses in this respect include scenario planning and a tool that supports decision-making proc-esses, while also providing insight into risks and making them quantifiable.

The third TCF element is 'Tax Accounting & Reporting'. In other words, recording the tax position in the organisa-tion’s administration and correctly accounting for it in quarterly and annual reports. The fourth and final building block is 'Tax Compliance', which involves detailing how and where the financial institution obtains its tax information. Financial institu-tions can support these compliance activities via an electronic platform that transfers information from their annual financial statements to their tax returns. This in turn significantly reduces their margin of error.

Internal integration of tax functionIn view of these developments, tax risk management should be high on financial institutions’ management priorities. A comprehensive understanding of risks and opportunities is essential if institutions are to avoid unpleasant surprises and be 'in control'. And until now that has at best been only in part. Although there is certainly a growing awareness of the importance of man-aging tax risks, many financial institutions’ energies are still being consumed by day-to-day concerns. They either fail to involve their tax directors or involve them too lit-tle in relevant business processes. All too often, the tax department is still seen as a separate department focusing primarily on completing tax returns and reducing the tax burden. Stakeholders, however, want financial institutions also to be 'in control' of their tax position and expect tax departments to be involved in relevant business proc-esses. And indeed this is also the basis of good tax risk management: making sure that tax management is inte-grated, wherever possible, into the other functions and processes within the organisation. Just as tax departments

0

1

2

3

4

5

6

7

8

9

10

Ability to executeand manage

Regulation, legal andaccounting impact

Balance sheetexposure

Risk headroom

Downsideexposure

Cost ofimplementation

Commercialpurpose

Technicalstrength

Reputationalimpact

Proposal 1Policy Proposal 2

Figure 1: The tax risk decision web

these days also have to be closely involved in developing and launching new financial products, given the possible tax consequences that these products may have.

Create involvement and insightProper tax risk management generally demands a far more pro-active approach from financial institutions’ CFOs and tax directors, and that is obviously not always easy to achieve. Where do you start? The first step is to get together around a table to create greater involvement and understanding of the tax function. All parties involved need to analyse the business processes and activities (such as investments and projects) in which tax aspects play a role. These activities may range, for example, from imple-menting an SAP system to HR’s reimbursing of expenses. There are often far more aspects involved than might be expected, certainly in financial institutions. Just think of the major write-downs that are being seen on so many financial instruments. Once the processes have been ana-lysed, it is time to prepare an action plan outlining how to improve the way the tax function is integrated into the business and business processes.

These are the first steps in the process of establishing an informative and customised TCF constituting part of a solid tax risk management system. The benefits are obvious: satisfied stakeholders (tax authorities, sharehold-ers, CFOs) and greater efficiency in and understanding of the tax function. And then there is the issue of cost. Establishing a TCF will certainly take a considerable amount of time. The question that each financial institu-tion has to answer for itself is whether and, if so, to what extent tax expertise should be brought in from outside. The long-term benefits of a TCF are evident: risks are iden-tified promptly and opportunities are made use of more rapidly, while the tax function also becomes more effec-tively rooted in the organisation.

Box 1: Risks for financial institutions

Key risk areas• Operationaltaxplanning,strategictaxplanning• Compliance:processandpositions• Legislation:governanceandbudgets• Deals:corporateeventsandmajortransactions• Corporatestructure:internationaltaxpresence• Operations:day-to-dayprocessesandmanage-

ment decisions

Specific risks include:• Upside/downsideofexternalfinancingarrange-

ments or use of financing instruments impacting on tax or interfering with group tax planning

• Taxexposureandmissedopportunitiesresult-ing from insufficient interdepartmental communication

• Incorrectlyimplementedtaxplanning• Unexpectedtaxcostsormissedopportunities

resulting from inconsistencies between commer-cial divisions’ and tax department’s goals

• Environmentalchangesthreateningtaxratesustainability

• Taxinefficienciesresultingfromlowappetiteforrisk or inadequate resources

• Lackofinvolvementorlateinvolvementoftaxinproduct development

• Localtaxissuesoverseas• WHTerrorsordeemedroyaltiesarisingfromintel-

lectual property rights in contracts • Complexityofgroupstructurehavingadverse

impact on tax management • InadvertentcreationofCFCsorsubpartforeign

income; failure to meet CFC exemptions • Uncertaintyandresourceimplicationsarising

from accounting and regulatory changes • Incorrecttaxcalculationsattributabletospread-

sheet errors • Failuretoperformcomplianceprocessontime

(reflected, for example, in late returns) • Taxlawandenvironmentalchangesimpactingon

group tax profile

Major changes in financial institutions’ tax function are inevitable

About the authorsCaroline Zegers is Lead Partner FSI Tax and Robbert Hoyng is an expert on tax strategy and Tax Control Framework for Deloitte Netherlands.

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Never before has the IASB moved so swiftly to issue an amendment to a standard as it did last October. However, although the amendments announced will certainly have a material impact on financial statements, the debate on presenting financial instruments is still far from over.

Amendments to IAS 39 and IFRS 7 – Reclassification of financial assets

Unprecedented action by IASBBy Carl Verhofstede

On 13 October 2008, the International Accounting Standards Board (IASB) published amend-ments to ‘IAS 39 Financial Instruments: Recognition and Measurement’ and ‘IFRS 7 Financial

Instruments: Disclosures’. These were followed on 24 October by some clarifying guidance on the effective date of the amendments and transitional provisions. This guidance was subsequently incorporated in an additional amendment dated 27 November 2008.

These amendments were a response to calls from constit-uents, particularly within the European Union, to create a level playing field with US GAAP regarding the ability to reclassify financial assets, primarily out of categories where fair value is applicable. In the general context of the current financial crisis, the IASB acted with unprec-edented swiftness, and for the first time an amendment to a standard was issued without due process (but with the consent of the IASCF trustees).

The changes to IAS 39 allow an entity to reclassify non-derivative financial assets out of the fair value through profit or loss (FVTPL) and available for sale (AFS) catego-ries in certain limited circumstances. Such reclassifications require extensive additional disclosures under IFRS 7 to permit users to understand the financial statements had the entity not reclassified.

As the amendments are effective as of 1 July 2008, sev-eral financial institutions in Europe started applying them from the third quarter of 2008.

Impact of classification on measurementFor a better understanding of the significance of these amendments, it has to be appreciated how important the classification of a financial asset (investments in loans, bank deposits, bonds, equity shares and the like) is for its measurement in the financial statements (balance sheet and income statement). Financial assets can be classified in four basic categories:• Atfairvaluethroughprofitorloss(FVTPL)• LoansandReceivables(L&R)• HeldtoMaturity(HTM)• AvailableforSale(AFS).

Commerzbank reclassi-fied €44 billion of bonds from AFS to L&R, while Deutsche Bank trans-ferred €12.8 billion of trading assets and €12.1 billion of AFS assets to L&R

The rules for attributing a financial asset to any of these categories at initial recognition are quite complex, being partially based on:• intent(forexample,assetsusedintradingactivi-

ties are Held for Trading (HFT) and fall under FVTPL classification);

• specificcharacteristicsoftheassets(equityshares,forexample, can never be classified as L&R or HTM);

• adeliberateclassificationchoicemadebytheentitywhen the asset is first recognised in the balance sheet (examples include the Fair Value Option, where voluntary classification as FVTPL is possible if certain conditions are met, or classification as AFS, which is available for every type of non-derivative financial asset that is not held for trading purposes, even if classification in another category would be allowed).

Loans and Receivables (L&R) are financial assets with fixed (for example, fixed interest) or determinable (for example, floating rate interest) payments that are not quoted in an active market, do not qualify as “trading” assets and have not been designated as FVTPL or AFS. Typical examples would be a term deposit with a bank, a trade receivable or an investment in a non-quoted corporate bond.

Held to Maturity (HTM) investments are financial assets with fixed or determinable payments and fixed maturities, other than L&R, for which there is a positive intention and ability to hold to maturity and which have not been designated as FVTPL or AFS. An investment in a quoted bond would typically be barred from classification as L&R, but could be classified as HTM if the entity demonstrates a positive intent and ability to hold the investment until it matures.

Before the amendment, a financial asset classified as FVTPL at first recognition in the balance sheet could never be reclassified out of that category. This applied even if there was no longer an active market for the asset, and so trading the asset had de facto become impossible.

Similarly, initial classification in the AFS category could not be changed at a later date, with only a very specific and limited exception for certain assets that are held to maturity (HTM).

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Transfers out of FVTPL and AFS categories allowed by IAS 39 amendmentsAs stated above, transfers out of the FVTPL category were prohibited before these amendments, while transfers out of the AFS category were allowed only in certain specific circumstances and for certain assets, providing the very strict conditions for classifying them into the HTM cat-egory were met. No other transfers were permitted.

Transfers out of the FVTPL category are still not allowed for derivatives (such as forward contracts, swaps and options) and financial assets that were voluntarily clas-sified as FVTPL when first recognised (applying the 'Fair Value Option'). This leaves only non-derivative financial assets Held for Trading (HFT) as potential candidates for transfer out of the FVTPL category.

Financial assets can only be reclassified out of FVTPL or AFS if they meet specific criteria. These criteria vary depending on whether the asset would have met the definition of L&R had it not been classified as FVTPL or AFS at initial recognition.

A debt instrument classified as HFT at initial recogni-tion may be reclassified out of FVTPL if the asset is not intended to be sold in the near term, providing it meets the definition of L&R and the entity has the intention and ability to hold the asset for the foreseeable future or until maturity.

A debt instrument designated as AFS at initial recognition may be reclassified to L&R if it meets the definition of L&R and the entity has the intention and ability to hold the financial asset for the foreseeable future or until maturity.

Any other debt instrument, or any equity instrument, may be reclassified from FVTPL to AFS or, in the case of debt instruments, from FVTPL to HTM if the financial asset is no longer held for the purposes of sale in the near term, but only in “rare” circumstances. In its press release accompanying the amendments the IASB acknowledged that market conditions in the third quarter of 2008 were a possible example of a 'rare' circumstance.

Sir David Tweedie, chair-man of the International Accounting Standards Board (IASB).

The measurement of a financial asset depends on its classification:• FinancialassetsatFairValueThroughProfitorLoss

(FVTPL) are measured, as the designation implies, at their fair value on each closing date, and all changes in fair value are immediately recognised in profit or loss.

• LoansandReceivables(L&R)andHeldtoMaturity(HTM) investments are measured at amortised cost (that is, basically at cost, but recognising interest income on the basis of the effective interest method, which can lead to the difference between the ini-tial cost and maturity amount being amortised by a regular adjustment to the carrying value of the asset). Any impairment loss (discussed below) is recognised immediately in profit or loss.

• AvailableforSale(AFS)financialassetsaremeasuredat fair value in the balance sheet at each clos-ing date (as for FVTPL assets), but changes in fair value are temporarily recognised in equity (Other Comprehensive Income – OCI) and recycled to profit or loss only when the asset is realised (i.e. sold or repaid). Nevertheless, effective interest income is always recognised directly in profit or loss on interest-bearing debt instruments. Any impairment loss (discussed below) on debt or equity instruments is also recognised immediately in profit or loss.

All financial assets have to be assessed for impairment. Under IFRS, this is a two-step process. The first step consists of establishing whether an impairment loss has occurred: the entity has to assess whether there is any objective evidence that the financial asset is impaired. This requires identification of any 'loss event' that will have an impact on the estimated future cash flows of the asset that can be reliably measured (indicating that the original investment will not be fully recovered). If such a loss event is identified, the second step is to determine the precise amount of the impairment loss.

The calculation of an impairment loss varies, depending on the categories of financial assets:• FVTPLassetsdonotrequireseparaterecognitionof

an impairment loss as this loss will already be included in the fair value. But fair value also includes other ele-

ments, such as the impact of any intervening changes in interest rates and changes in market expectations of future losses (reflected in market credit spreads and liquidity premiums).

• ForL&RandHTMinvestments(carriedatamortisedcost), the impairment loss will be based on a calcula-tion of the present value of the estimated future cash flows – excluding future credit losses that have not been incurred – discounted at the asset’s original effective interest rate. This means that the calculation is not impacted by changes in market interest rates, including credit spreads and other market factors, occurring since the asset was first acquired.

• ForAFSassets(carriedatfairvalueinthebalancesheet), the full amount of unrealised losses based on the current fair value should be recognised in profit or loss immediately. That is, all amounts previously recognised in OCI should be transferred to profit or loss. All subsequent decreases in fair value are consid-ered to be impairments and will impact on profit or loss (and not equity only) for the full amount. Under certain conditions, impairments on AFS debt instru-ments, such as bonds, can be reversed through the income statement, while impairments on AFS equity instruments (investments in shares) cannot.

The application of different impairment models means that, for AFS debt instruments, income is recognised in profit or loss on the basis of (historical) amortised cost, in line with L&R and HTM assets. Once, however, the value of the asset becomes impaired, impairment losses are rec-ognised using a method that reflects not only the impact of the cash flows estimated to be lost – as in the case of L&R and HTM assets – but also the effect of changed market factors on the present value of the cash flows still expected to be received – as in the case of FVTPL assets.

In other words, reclassifications out of the FVTPL and AFS categories, as the modified text allows, will have an impact on day-to-day income recognition of non-prob-lematic financial assets (for all transfers out of FVTPL), as well as on the precise amount of loss taken at the report-ing date for financial assets where an entity does not expect to fully recover its original investment (for transfers out of FVTPL or AFS into L&R or HTM).

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FSI magazine is a Deloitte publication for the Financial Services Industry. FSI maga-zine is published three times a year and distributed in controlled circulation in the Netherlands, Belgium, Luxemburg, Denmark, Germany and Central Europe.

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All reclassifications must be made at the fair value of the financial asset at the date of reclassification. Previously recognised gains or losses cannot be reversed. The fair value at the date of reclassification becomes the new cost or amortised cost of the financial asset, as applicable.

The existing requirements in IAS 39 for measuring financial assets at cost or amortised cost apply from the reclassification date.

For reclassifications out of AFS, IAS 39 requires the amounts previously recognised in other comprehensive income (OCI) to be reclassified to profit or loss either through the effective interest rate (if the instrument has a maturity date) or on disposal (if the instrument has no maturity date, i.e. it is perpetual). Amounts deferred in OCI may also need to be reclassified to profit or loss in the event of impairment.

When do reclassifications take effect?Reclassifications made before 1 November 2008 could take effect at any time between 1 July 2008 and 31 October 2008, providing documentation was in place by that date. An entity with a 31 October year-end could, for example, have chosen 1 August as the reclassification date in order to align with its quarterly reporting. Equally, an entity’s intent to hold assets for trading purposes may have changed part-way through a period for different loans, say 5 September and 25 September, as a result of specific events on those dates. An entity could reclassify at various dates, providing the criteria are met and evi-dence is available regarding the change of intent. Reclassifications made on or after 1 November 2008, however, are effective from the date of reclassification. In other words, on a real-time basis, with no backdating allowed.

What happens in practice?What does this mean for those trying to understand the financial statements of an entity applying the amend-ments? Several financial institutions in Europe applied the IAS 39 amendment in the third quarter of 2008. Commerzbank, for example, reclassified €44 billion of bonds from AFS to L&R, while Deutsche Bank transferred €12.8 billion of trading assets and €12.1 billion of AFS

assets to L&R. More reclassifications will follow in the fourth quarter of 2008, and probably additional transfers later still. Deutsche Bank disclosed that, ‘If the reclassifi-cation had not been made, the Group’s income statement for the third quarter of 2008 would have included unre-alised fair value losses on the reclassified trading assets of €726 million and additional impairment of €119 million on the reclassified financial assets available for sale which were impaired. For the third quarter of 2008 sharehold-ers’ equity (position net gains (losses) not recognised in the income statement) would have included €649 million of unrealised fair value losses on the reclassified financial assets available for sale which were not impaired.’

These amendments will clearly have a material impact on reported realised losses and on the equity of some enti-ties. Nevertheless, readers of financial statements should be able, on the basis of the disclosures, to adjust the statements to what they would have been if the assets had not been reclassified. Time will tell whether this is good or bad.

In the meantime, the European Commission has asked the IASB to consider allowing the reclassification of financial assets classified as FVTPL under the Fair Value Option on the same conditions as HFT assets, and also to consider adjustments to the impairment rules for AFS assets. In other words, to allow reversals of impairments on AFS equity instruments through profit or loss, as in the case of debt instruments, and to limit the impairment in the income statement to credit losses only (as for L&R assets), while keeping the remaining changes in fair value in equity. So the debate will continue for some time to come, and we can consider whether even a radical revi-sion of the standards will in the near future be able to resolve the question of what is the proper way to present financial instruments in the balance sheet, income state-ment and notes to the financial statements.

About the authorCarl Verhofstede is a Director of Deloitte Enterprise Risk Services, Belgium

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