FSI Magazine #5, April 2009

8/14/2019 FSI Magazine #5, April 2009

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‘Maintaining acompetitive internal

market is the onlyway forward’

FSI magazine | #5 April 2009

Balancing state aid and

competition

Interview with Irmfried

Schwimann, Director

Financial Services (DGC),

European Commission

Will bank branches

survive?

How to reconnect with

retail bank customers

High hopes, low

expectations

Foreign retail banking

opportunities in China

'Banking is the love of

my life'

Portrait of Józef Wancer,

CEO of Bank BPH

The cost

of cash

How the economic turmoil

impacts cash usage



FSI magazine | #5

Towards anew reality

An unprecedented global crisis

has now extended its reach to

all geographies and sectors o

the economy. The discussion

today ocuses on how long it

will take or the economy to

recover, and what can be done to move it back in

the right direction.

With regard to the nancial services industry, it is

still unclear to what extent the sector itsel 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 o the severe

slowdown in the real economy.

It is equally clear to all observers that the bank-

ing and insurance businesses will have to ace a

new reality in the months and years to come. The

industry is likely to be restructured around our 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 or the industry itsel.

Business and operating model: All the actors in

the nancial services industry will have to rethink

their ambitions in terms o both their geograph

spread and their range o activities (banking, in

asset management). They will all have to get an

ness o where the true synergies are, and be re

their promises to the markets.

Regulation: I all observers agree that regulatio

not helped to avert the current crisis, it is also c

regulation will be only a part o the solution. Th

bound to be major initiatives on the regulators’

obviously at both international and national lev

Clients: Clients must by all means regain their p

the centre o the debate. This calls or a thorou

sion o the value proposition oered to the ma

nancial services industry will be able to nd an

its new role in the global economy only by ocu

its clients.

All observers agree that the nancial services in

acing a new reality. Some even believe that weon the brink o a total transormation o our so

What is certain, at any rate, is that we are in o

exciting times.

Deloitte SE FSI Leader

PreaceIn thisissue

ews & Research

alancing state aid and competition

nterview with Irmfried Schwimann, Director Financial

ervices, DG Competition of the European Commission

Will bank branches survive?

ains of the credit crisis

olumn by Harry Smorenberg

CITS risk management under construction

Only strong and trusted brands will survive

oreign retail banking opportunities in China

olish banking leaders caught in the lens

Banking is the love of my life’

ortrait of Józef Wancer, CEO of Bank BPH

inancial crisis changes the regulatory and

upervisory landscape

he cost of cash

Managing reputational risk

olvency II: Dealing with operational risk

owards a more transparent tax position

nprecedented action by the IASB

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FSI magazine | #5

and a clear methodology or ass essing liquidity risk. It

now appears that valuation and measurement systems did

not ully capture risk at the product le vel, making it hard

to get a complete view o the nancial institution’s aggre-

gate exposure.

Recommendation: A rm should be able to measure the

risks associated with all transactions. To do this, it should

have a consistent set o models, data and related systems

or pricing and risk management that ully captures, to the

extent practicable, all relevant drivers o value and risk.

Moreover, it should have consistent approaches to data,

models, and processes. A nancial institution hoping to

compile an aggregated, enterprise-wide view o its risk

must make sure that its technology a nd data are consist-

ent across business units and across specic risk unctions.

Transparency and disclosure

Due to the limitations o the risk management inrastruc-

ture, plus the complexity o structured credit products

themselves, essential risk-related inormation oten 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 rms, it is not surprising that exter-

nal disclosure was incomplete.

Recommendation: The rm should demonstrate clear

intent to provide transparency and appropriate disclosure

at all levels, both internally and externally.

The 6th Annual Global SecuSurvey, which benchmarksIT security and privacy in thenancial services industry, wpublished in February 2009.

In 2008, nancial institutions saw a decline in th

o both external (47% vs. 65% in 2007) and inte

(27% vs. 30% in 2007) security breaches. The to

inormation security priorities o nancial institut

security regulatory compliance, ollowed by data

tion and inormation leakage, and access and id

management.

Some other ndings include:

• Peoplearebothanorganisation’sgreatest

and its weakest link. But security vigilance is

more important in hard economic times, wh

increased stress levels can lead people to be

atypical ways.

• Eventhoughbothinternalandexternalsec

breaches at nancial institutions worldwide

declined in number over the past twelve mo

employee misconduct is a growing concern.

• Thegrowingpopularityofsocialnetworks

proliferationofmobilemedia,suchasUSBk

playersandPDAs,allcauseanextraloado

and external security. These devices present

tunities or unauthorised download and stor

condential inormation in an unprotected m

This is one o the actors that has contribute

sudden rise o data protection and inormat

age as a top priority or nancial institutionssecond place with access and identity mana

• Theleadingdriversfornancialinstitutions

the privacy o their clients' inormation are p

regulatory requirements (79%) ollowed by

and brand concerns (70%).

Global Security Survey 2009

Protecting what matters

Shaping the new nancial services marketplace'Risk management in the age o structured prod-

ucts' is the rst o a series entitled 'Shaping the new

nancial services marketplace', in which the US-based

Deloitte Center or Banking Solutions will examine the

rules, regulations, and operating models that evolve

as the industry sails uncharted waters.

For a hard copy o the report, or or more inormation

about this topic, please contact Frank De Jonghe

([email protected]).

For the ull survey, please visit www.deloitte

(search or: Global Security Survey 2009).

News &Research

This is not the rst time individualrms or the nancial servicesindustry have experienced adownturn. But the magnitudeo the losses and the numbero rms involved make this

market collapse dierent. It ismore important than ever orthe nancial services industryto take stock o the lessonslearned. In its recently releasedreport, 'Risk Management intheAgeofStructuredProducts',the US-based Deloitte Centeror Banking Solutions explains,with the benet o hindsight,how rms can improve their riskmanagement so that they cancome to a better understandingo their aggregate risk exposures.

These lessons all generally into our areas:

1. Revamping governance, risk oversight and risk

management

2. Integrating both risk and return into decision-making

3. Building capacity to understand and manage risk

4. Revisiting the need or improved transparency and

disclosure

Governance, risk oversight and risk management

A key issue in the credit crisis relates to the role o

senior management and the board. In some cases, it

appears that senior management and the board were

not adequately inormed o the risks the ir rms aced in

structured products and o the aggregate risk contained

on their balance sheets. Risk management culture and

approaches were, in some cases, not suciently embed-

ded throughout the organisation. Because o that, risk

and reward perspectives were not brought together in

a way that would have allowed a more accurate, enter-

prise-wide understanding o the rm’s risks. This lack o

understanding across the organisation o the true magni-

tude o its risks laid the groundwork or ailure.

Recommendation: A rm should have, in writing, a

clear, detailed, board-approved risk management charter

or ramework that denes risk management roles and

responsibilities. This charter or ramework should be

clearly communicated throughout the organisation.

Building risk and return into the business practice

Focused as they were on generating revenues, a number

o nancial institutions did not ully understand the

structured products that generated the losses. It is time

to build risk and return more ee ctively into the businesspractice.

Recommendation: Senior management – with board

input and approval – should dene the institution’s risk

appetite as part o its written risk ramework.

Capability to identiy, measure, monitor and control

risks

It has been widely reported that management’s response

to the credit crunch was delayed largely be cause institu-

tions lacked suciently sophisticated analytical systems

isk management in the age o structured products:

Lessons learned or improving risk intelligence

News &Research



FSI magazine | #5

What were the greatest challenges and achievements

o the European Commission’s competition depart-

ment (nancial services) in 2008?

We’ve been working very hard in re cent months to help

EU member states restore condence in the market and

protect their nancial 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

ace in the rapidly changing circumstances o the crisis.

On 13 October 2008, the Commission adopted guidance

on the criteria to be used to assess national measures or

supporting nancial institutions. In early December we

also published a communication on the recapitalisation

o nancial institutions. This provided detailed inorma-

tion on how we would approach bank recapitalisation

measures.

Over the past our months, the Commission has adopted

nearly 40 decisions on state aid in the nancial services

sector. These provide clarity and legal certainty or 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 o measures,

including guarantees, asset purchases, pure recapitalisa-

tions and general schemes combining all o the above.

Our main aim has been to achieve the right balance

between allowing aid to the extent necessary in order to

maintain nancial stability and seeking to ensure a return

to normal market unctioning, while at the same time

making sure that state support does not unduly distort

competition between banks and worsen the nancial

crisis.

What lessons can be learnt rom the nancial crisis,

and what role can the Commission play in establish-

ing a more stable economic environment?

The crisis has demonstrated the importance o the EU

state aid rules. Without controls on state aid, govern-

ments would be tempted to support national banking

institutions to the detriment o their European competi-

tors; strong companies would be penalised and necessary

reorms might be postponed, all o which would delay

recovery.

Even though the support schemes or t he nanc

sector remain in the hands o the member state

the Commission provides a ramework, through

implementation o the EU state aid rules, that en

consistency in national responses throughout th

Our role in establishing a more stable economic

ment or the uture is, however, limited. What w

is to help member states by ensuring that the st

rules preserve a level playing eld, while at the s

giving them legal certainty and sucient fexibil

timely measures in support o their nancial inst

What developments can we expect in 2009 a

are your plans or dealing with them?

In 2009 the Commission is going to be working

tional nancial support measures proposed by m

states, and will also need to review existing mea

We may need to make adjustments in response

as they evolve, and make sure that aid continue

minimised. The Commission will also report to t

European Council on the nancial reorm packag

present the initiatives that the Commission is cur

working on.

The Commission also adopted a temporary ram

last year that provides member states with addit

ways o ensuring access to nance or both stron

vulnerable non-nancial enterprises in order to h

‘real’ economy cope with the recession. This ra

which will apply until the end o 2010, is design

ensure that member states can oer consistent

wide variety o businesses.

The Commission will also have to examine a s ec

o recapitalisations this year. It will have to consi

eective the present recapitalisation model has

decide how best to deal with banks that need u

recapitalising.

Finally, the treatment o toxic assets and their po

acquisition by member states will need to be ad

under the state aid rules. How such assets are tr

particularly complex issue, with direct implicatio

assessment o state aid.

State aid rulesare at the centreo the EuropeanCommission’sresponse to thenancial crisis,but as IrmriedSchwimann,Director o FinancialServices at theCommission’scompetition

department, tellsFSI Magazine,maintaining acompetitive internalmarket is the onlyway orward.

Balancingstate aidandcompetitionBy Jon Eldridge



FSI magazine | #5

How do increased state aid measures and widespread

nationalisation o banks impact on the level playing

eld, and what are the essential criteria or a well-

balanced European nancial services industry?

The nancial crisis has undoubtedly led to unprecedented

changes in the EU member states. The situation is evolv-

ing, and so are our rules or dealing with the changing

market circumstances.

The Commission does not question the need or national

support schemes in order, or instance, to avoid bank ail-

ures that could have ar worse consequences or the real

economy. However, by applying our state aid policy, we

have been able to maintain a level playing eld while deal-

ing with the crisis.

Our state aid policy is based on two undamental princi-

ples: any distortion o competition must be in proportion

to the objective o the aid, and any state aid measures

should be temporary. Beore 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 o competi-

tion are minimised. I this is not the case, member states

are asked to change their schemes beore they can be

approved. The conditions imposed, or example, on the

pricing o these schemes and the review mechanisms in

place to re-evaluate the need or such schemes six months

later ensure that the Commission can help tackle the

crisis, while also avoiding harmul economic imbalances

between banks and member states.

One o the main criteria or a well-balanced European

nancial services industry in the uture is that banks needto be adequately capitalised and to be well placed to

provide nance and play an intermediary role in the econ-

omy. In order to arrive at this po int, the level and orm

o state aid provided may need to vary rom one country

to another. We are currently striving to est ablish a solid

starting point. And the Commission's role is to ensure that

state aid gets us to that point.

How eective has the Commission’s state aid policy

been, and how can it be improved?

Since the very onset o the nancial crisis, the

Commission's role in the eld o competition policy has

been to underpin public authorities’ eorts to support

nancial stability and sustain lending to the real e conomy

by switly providing a legal ramework or applying state

aid rules, in exceptional crisis conditions, so as to ensure

co-ordinated and eective action by member states.

State aid rules are sophisticated enough to cope with the

dierences between member states, and strong enough

to cope with the diculties. We allow national govern-

ments reedom to tackle the root causes o the crisis, but

prevent them rom taking action at the expense o other

member states or taxpayers.

The crisis has been a valuable learning e xperience, both

or the Commission and the member states. I 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 or the approval o state

aid packages. What are the threats to this relation-

ship, and are you optimistic about the uture?

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 aced

by one member state does not have a negative impact

on neighbouring countries. We clearly need a coherent

response i we are to protect our economies and ensure

jobs, stable business conditions and value or money or

consumers.

I am condent that all member states acknowledge the

risk o a subsidy race and the nee d or a neutral arbitra-

tor to ensure that aid schemes do not unduly distort

competition.

What were the main aims o the communication on

recapitalising banks? Given the legal challenge to

the Belgian government’s role in the rescue o Fortis,

could the Commission have done more to ensure

greater regularity?

The main aim o the communication was to respond rap-

idly to the need or guidance on whet her specic orms

o recapitalisation complied with state aid rules. The com-

munication sought to provide a co-ordinated ramework,

legal certainty and a possibility or rapid implementation

o the required measures in order to refect the varying

scope and conditions o recapitalisation schemes.

The communication also recognises that undamen-

tally sound banks should be included in rec apitalisation

schemes so that they do not de-leverage their balance

sheets too much in a short period o time, but also main-

tains the need or caution, so as to ensure that schemes

are properly designed to achieve the objective o lend-

ing to the rest o the economy and avoid distorting

competition.

The communication also requires schemes to include

incentives or redeeming state capital once market condi-

tions return to normal. The Commission is o nly competent

to assess action taken under the state aid rules. This

means that its role in cases such as Fortis has ocused on

saeguarding the above objectives in a situation o great

complexity, involving three dierent member states, and

o extreme urgency or the Belgian government.

How great a threat is protectionism, and is the

Commission prepared to get tough with member

states that fout EU rules?Protectionismmaybeathreat,butweallsharearespon-

sibility to avoid alling into this trap, which would result

in a decline in world trade. Finding a s olution to the crisis

should, in my view, involve scaling up the regulatory proc-

ess in a way that preser ves the dynamism and innovation

that comes rom ree competition.

Our experience so ar shows that members states

acknowledge that a subsidy race is in noo ne's interest.

They clearly understand that the Commission is deter-

mined to apply the state a id rules. Until now, there has



0

FSI magazine | #5

been no need or the Commission to open the ormal

investigation procedure, but in many cases discussions

with member states have resulted in plans being amended

or in the member st ate providing the Commission with

a series o undertakings beore the scheme could be

approved.

What do you see as potential growth areas or the

nancial services industry? Does the recent nan-

cial crisis represent an opportunity or innovative

companies?

The nancial crisis might represent an opportunity or

banks that have managed their risks well and compa-

nies that have dealt with their problems promptly and

actually. Thanks to the substantial changes that the

Commission has made in the state aid rules over the past

ew years, and providing member states meet certain

criteria, states can now give aid designed to meet certain

objectives specically linked to improving the competi-

tiveness o Europe's economy, without having to notiy

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 rame-

work that opens up additional ways or member states

to provide access to nance or businesses in the real

economy and encourage them to continue investing in a

sustainable uture. This ramework allows member states

to increase the amount o risk capital that can be oered

to each SME to €2.5 million a year, and re duces the

percentage o this capital that must come rom private

sources rom 50 per cent to only 30 per cent.

Are we likely to see more mergers and greater market

consolidation?

The nancial turmoil may have an impact on the global

structure o the nancial services se ctor. In principle,

mergers and acquisitions can make a valuable contribu-

tion to the consolidation o the banking industry, with a

view to achieving the objectives o stabilising the nancial

markets and ensuring a steady fow o credit to the real

economy.

I a nancial institution alls victim to the crisis, t he solu-

tion is sometimes or it to be taken over by a more stable

nancial institution. Such a takeover will all under EU

merger control, and the normal merger review principles

will apply. But the Commission will also take account o

the changing market conditions and, where applicable, a

‘ailing rm’ deence.

Some member states may be uneasy about the restriction

on aggressive commercial behaviour o banks benetingrom state aid. This restriction is not designed to hamper

the consolidation o the banking sec tor, but rather to

ensure that recapitalisations at excessively avourable

conditions do not lead to takeovers to the detriment o

non-recapitalised competitors.

Is there a need or a new EU Financial Services Action

Plan when the old one expires in 2010 and, i so,

what should this new plan ocus on?

TheFinancialServicesActionPlanwasdesignedtocreate

a single market or nancial services in the EU. It consisted

o a set o measures intended to ll gaps and remove

remaining barriers so as to provide a legal and regulatory

environment supporting the integration o nancial mar-

kets. The Commission will have to assess the need or a

newActionPlannearertheexpirydateoftheoldone.

What is the outlook or the Single Market? Are

ree market principles under threat? What is the

Commission’s long-term strategy?

The current global crisis has orced us to go back to

basics. Few people would dispute that markets must play

a key role i we are to maintain and extend our prosper-

ity. But governments may need to intervene and provide

better regulation, while still maintaining ree competition.This is the only way orward, a nd it’s the basis o our

long-term strategy.

Given the current nancial markets, can EU countries

expect Competition Commissioner Neelie Kroes to be

more lenient?

The Commission accepts that the current crisis is e xcep-

tional and warrants an exceptional response. Clearly,

however, leniency on state aid rules would risk a disinte-

gration o the European Single Market or banking and

nancial services and simply store up problems or later.

As our commissioner has repeatedly explained, state aid

rules are part o the solution, not part o the problem.

I am condent that member st ates have by now realised

that a co-ordinated response to the crisis is the only way

orward.

Jean-Claude Trichet, Chairman o the European

Central Bank, recently said, 'We need a paradigm

change or the global nancial system.' Do you agree,

and what contribution can the Commission make?

Changes are obviously needed i we are to deal with

the root causes o the crisis and avoid acing the same

problems in the uture. The Commission is already t ak-

ing steps to bring about the res tructuring o the nancial

sector, which is essential to ensure its long-term viability.

The independent High Level Group on nancial supervi-

sion chaired by Jacques de Larosière will repor t 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 o the EU nancial sector

(responding to the recommendations o the de Larosière

Group), regulation and overview o EU nancial institu-

tions and markets, consumer and investor protection,

market transparency, the accountability and integrity o

market participants and international co-operation.

Irmried Schwimann

Dr. Irmried Schwimann is Director o the DG

Competition’s Financial Services unit, dealing with

antitrust matters and state aid. Mrs Schwimann

waspreviouslyHeadoftheFinancialServicesPolicy

unit o the DG Internal Market and Services. Beore

that, Mrs Schwimann worked in the unit dealingwithRetailIssuesandPaymentSystemswithinthe

DG Internal Market and Services. And subsequently

in Commissioner Bolkestein’s Cabinet, where she

was responsible or nancial services issues. Mrs

Schwimann studied law at the University o Linz

in Austria as well as political science at the Institut

d’EtudesPolitiquesinParis.Beforejoiningthe

Commission, Mrs Schwimann worked or the Austrian

Ministry o Foreign Aairs and an Austrian Insurance

group.

‘Restructuring thefnancial sector isessential to ensure itslong-term viability’



2

FSI magazine | #5

I

n uncertain times it is crucial or banks to main-

tain a competitive market position. This may

mean reocusing their customer and channel

strategies. The currently restricted availability

o capital means that both management and

stakeholders are demanding that strategic

decisions are underpinned by act-based evaluationso 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 o the customer experience, but they are not the

most important dierentiating actors or customers. The

Deloitte survey summarises customers’ experience and

levels o satisaction with retail bank branches, while also

analysing the Belgian and Dutch retail markets and draw-

ing conclusions or branch strategies.

Shiting paradigms

The retail distribution landscape is shiting rom a branch-

dominated paradigm to one o integration and balance

between multiple channels. Nevertheless, the branch

remains a key channel or Belgian and, to a lesser extent,

Dutch retail banking customers. The new paradigm

demands a undamental shit in the position and role othe branch.

Importance o ace-to-ace contact

Our customer survey conrms that the branch is still

highly valued by Belgian customers. Although Dutch

branch visits are declining in avour o the internet, most

Dutch customers would not apply or complex product s

entirely online.

The survey indicates that both Belgian and Dutch retail

customers demand ace-to-ace contact and will continue

ow to reconnect with retail bank customers

Willbankbranchessurvive?Every new technology prompts predictions o theend o retail bank branches. Emerging channelssuch as the internet, ATMs, sel-service banking, callcentres and mobile phones have always triggeredquestions about whether the 8,000 branchesn Belgium and the Netherlands can survive. ADeloitte survey clearly shows that branches are hereo stay, providing banks adapt their branch and

channel strategies and ocus on increasing customersatisaction.

By Patrick Callewaert,

Emeric van Waes and

Alexandre Gangji



4

FSI magazine | #5

to visit their branches. However, they are not very satised

with the services provided by the ir current branch and

bank.

Better customer service and access

The survey highlights that customers are not satised with

branch services and access. The results are surprisinglysimilar in Belgium and the Netherlands, although Dutch

customers are more negative about the current perorm-

ance o the branches.

• Adviceprovidedatthebranchfailstosatisfy1in

3 customers in Belgium and 2 in 3 customers in

the Netherlands

27% o personal and 30% o business customers in

Belgium and 62% o personal and 71% o business

customers in the Netherlands are not satised with

the quality and promptness o advice provided.

• Accesstothebranchistoolimited

Key ndings in Belgium Key ndings in the Netherlands

Branches are still visited.79% o personal and 89% o business customers visit theirbranch at least once every 6 months, compared to 59%and 84% using internet banking and 65% and 44% orsel-banking.

In contrast to Belgium, branch visits in theNetherlands are declining.41% o personal and 45% o business customers visittheir branch at least once every 6 months, compared to93% and 96% using internet banking

The internet is used or getting inormation on nan-cial products, while visiting branches is the preerred

channel or buying and getting ater-sales service.71% o personal and 79% o business customers see thebranch as their preerred sales channel.

The internet is the key channel or getting inorma-tion on nancial products and ater-sales.

92% o SME customers and 90% o perso nal customerssee bank websites as the key channel or inormation.Only 47% o personal and 30% o business customersconsider the branch to be their preerre d sales channel.

Most customers would not carry out complex transac-tions or apply or complex products entirely via directchannels.72% o personal and 65% o business customers wouldcertainly not apply or complex products entirely online.

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

Most customers would like their banks to review theirnancial positions and proactively propose relevantoers to them.80% o personal and 65% o business customers expectmore proactivity rom their banks.

Very similar to Belgium, most customers would liketheir banks to proactively propose relevant oers.75% o personal and business customers expect moreproactivity rom their banks.

Some customers are even willing to pay or ace-to-ace contact and proessional advice.23% o personal and 35% o business customers are willingto pay or proessional and personalised advice.

Similar to Belgium, some customers are willing topay or ace-to-ace contact.15% o personal and 23% o business customers arewilling to pay or proessional and personalised advice.


Belgium and 27% o personal and 41% o business

customers in the Netherlands consider the opportu-

nity or appointments outside oce hours to be the

main area in which branches can improve.

• Morethan1outofevery2customersbelievethat

banks act in their own interests 50% o personal and business customers in Belgium

and between 50% and 64% o personal and business

customers in the Netherlands think that banks act pri-

marily in their own interests.

• Bankdonotknowtheircustomerssufciently

well, especially in the Netherlands


Belgium and more than 80% o pers onal and business

customers in the Netherlands do not think that their

bank knows their history and current situation su-

ciently well.

Strategic Positioning Universal Bank Community Bank Discount Bank Direct Ba

Distribution Strategy Integrated Multi-channel Strategy Direct Channel Strategy

Branch role

The branch manages customer relationships, provides

advice, completes sales o complex products and proc-

esses quality leads stemming rom direct channels.

Branch role

The branch should be seen as a trust contribut

physical presence that reinorces the branding

Bank.

Integrated Channel

Branch is part o a multi-channel strategy

Not a Channel

Branch is a physical presence

Key succes actors

• Strongmulti-channelcapabilities

• Peoplewithrightskills(advisors,experts,...)

• Appropriatesellingapproach

• Easyaccessandconvenience

Key succes actors

• Keylocalisationofthebranch

• Easeandexibilitytomakeappointments

channels

• Closecollaborationwiththemobilesalesf

enhance reach

Branch Strategy

Figure 1: Branch and channel strategies

Banks will have to address these issues i they are to

reconnect with their customers and control the churn.

According to our survey, more than 10% o personal and

over 12% o business customers intend to change their

main banks in the next six months.

One model does not t allBanks need to adapt their branch and channel strategies

according to their strategic positioning. Our analysis has

identied two groups o banks:

1. Universal banks and community banks

Universal banks and community banks need to imple-

ment a multi-channel strategy that ully 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 demandace-to-ace contacand will continue visit their branchebut are not satisfewith the servicesprovided by theircurrent branch andbank



6

FSI magazine | #5

bout the research

his article is based on the results o a quantitative

urvey among 1,400 branch-banking customers in

elgium and the Netherlands in summer 2008. The

m o this research was to understand what cus-

omers expect rom their branches and how these

xpectations will evolve in the uture. It specically

ooked at primary customers’ likes and dislikes about

heir branches. The answers to these questions have

ar-reaching implications or retail banks in terms

how they can improve the customer experience

t branches. The research covered all retail nancial

stitutions operating in Belgium and the Netherlands

nd sampled personal and SME business customers.

he survey was conducted beore the start o the cur-

ent banking crisis. It would seem sae to assume thatecent events will have urther reinorced the threat s

entied, such as low customer loyalty and lack o

ondence in banks, and reduced levels o trust even

more.

bout the authors

atrickCallewaertisapartnerinDeloitteBelgium,

meric van Waes is a director o Deloitte Netherlands

nd Alexandre Gangji is a Senior Manager at Deloitte

elgium.

Day ater day, doom scenarios are

paraded past us by a host o lead-

ing economists, now amiliar TV

personalities. All repeat the same

message, and it isn’t a pleas-

ant one. Consumers “on s trike”,

mounting inventories, zero growth and even total e co-

nomic seizure are what they predict. The year 2009 looks

unpromising indeed. The eed-through o bankers’ woes

to the real economy was ast, ar aster than anybody

imagined. The sudden halt o economic activity has taken

us all by surprise and hit us hard.

Still, I’m not so pessimistic. In material terms, o 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 ew.

From G8 to G20

Justice has come at last or those other powerul econo-

mies around the world. And recognition o the act that a

country’s say in global aairs is determined not by politi-

cal tradition but by the economic acts on the ground. A

strong signal to the BRIC-countries, this also highlights the

reality that the world is One Open Economy!

New risk perspective

Risk management is no longer a national or regional mat-

ter, but will take place in an international playing eld,

where the rules must be strictly and uniormly imple-

mented and monitored. This will leave no room or local

politicking, and provide more protection and transparency

or proessional risk takers. Moreover, risk managementhas made its way into the top tiers o organisations with

the appearance o independent CROs in company boards.

Sustainability

The 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 or our approach to the climate. The wild

seesawing o oil prices – rom $ 120 to $ 42 – is just a

taste o what’s in store as the world’s resources dwindle.

A wake-up call, i ever there was one, that we need to

innovate and to nd new, global ways to deal with short-

ages based on air sharing o energy and ood.

Breakthrough projects

Given the gloomy economic outlook, economic stimu-

lus measures are high on the age nda o governments

worldwide. In China, hundreds o billions have already

been earmarked or public megaprojects in inrastructure.

PerhapsPresidentObamacangivetheUSautomotive

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 ve

nations in search o the same potentially limitless energy

resources.… Just think how much more they could

achieve working together!

More sel-refection

Executives in the nancial sector are very much in the

public eye, and the nger is easily pointed. O course,

things have gone badly wrong. There were rules, but

notenoughmonitoring.Peoplesawtherisks,butwere

also blinded by the potential prots. It ’s only right that

nancials and supervisory authorities should be called

to account. But the individual, the client, cannot be held

entirely blameless. All o us have contributed, direc tly and

indirectly, to the present stalemate. We’ve been living in

the era o “more and more” and need to begin an era o

“more together”. O sharing wealth and better balancing

risks and rewards. Not only at home, but also betweengroups, countries and continents. Over the years, the

imbalance between rich and poor has only grown. That,

too, is a kind o indebtedness that poses huge risks or the

uture.

The current crisis, however serious, may turn out to be a

painul lesson in building a global society on m ore posi-

tive oundations. A society with more balanced priorities

when it comes to people, planet, power and prot.

Gains o the credit crisis

harry@smorenb

channel: it is used as a window to deliver brand prom-

ises and supplement the customer experience or

highly protable customers.

ur research also shows that customer needs and hab-

s can vary dramatically rom one country to another,

ertainly between Belgium and the Netherlands. Belgian

ustomers value the relationships and advice they have

ace-to-ace branch contacts much more than the ir

utch neighbours. In the Netherlands, the internet is the

ey channel or getting inormation on nancial prod-

cts, with the branch channel playing a more supportive

ole in closing the sale. This dissimilarity means the roles

nd strategies or the branches in the Netherlands and

elgium are dierent.

Banks need to adapttheir branch andchannel strategies

Column



8

FSI magazine | #5

The consultation is an attempt to

address current limitations in European

legislation regarding collective porto-

lio risk management, and orms part

o the European Commission’s broader

eorts to revise the UCITS Directive,

adding level-3 measures. In the paper, CESR proposes a

risk management ramework and identies principles and

elements essential to the risk management process. The

consultation was closed on 17 October 2008. The nal

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 manageme nt.

Legislation

The current European legislation regarding risk manage-

ment or UCITS can be ound 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 o derivatives (article 21). Hence current legis-

lation ocuses on the use o derivatives, and ails to look at

all the risks embedded in the investment process and the

portolios.

With its consultation paper, CESR aims to introduce gen-

eral principles or 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 (sel-managed UCITS). The principles

relate to our key areas:

1. organising the risk management process

2. identiying and measuring risks relevant to the UCITS3. managing these risks

4. 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 o risk man-

agement processes.

Supervision by the competent authorities

CESR proposes that the adequacy and eciency o the risk

management process be assessed by the

On 19 August 2008,the Committee oEuropean SecuritiesRegulators (CESR) issueda consultation paperon risk managementor ‘undertakings orcollective investment intranserable securities’(UCITS). Given the turmoilin nancial markets, aormalised and coherentset o risk managementprinciples or UCITScan only be welcomed.Investment unds andother types o investmentproducts have seentheir risk managementprocesses put to test -

and some o them ailed.

UCITS risk managementunder construction

y Patricia Goddet

1Commission Recommendation 2004/383/EC o 27 April 2004 on theuse o nancial derivative instruments or undertakings or collectiveinvestment in transerable securities (UCITS).



0

FSI magazine | #5

About the a

PatriciaGodd

Manager at D

Enterprise Ris

Services, Belg

For more ino

www.cesr-eu

One o the very challenging specications that CESR

includes in the consultation paper concerns the manage-

ment o model risk. Companies are to deal appropriately

with the possible vulnerability o their risk measurement

ramework 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 o the model-based risk orecasts, but also

stress-testing to capture the possibility o rare and severe

losses, or to ully understand the underlying assumptions

and so assess the validity range. The nal level-3 text

has watered down the back-testing requirement, only

demanding back-testing where appropriate.

CESR also explicitly reers 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

meaningul and useul i it is based on sound and reliable

data. The risk management unction should also provide

support in the valuation o illiquid assets, structured secu-

rities and complex derivatives.

Managing risks

The risk management that CESR proposes ocuses mainly

on ensuring that each UCITS’ risk prole as dened by the

Board o Directors corresponds with the actual level o

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 t aken

into account in the calculation o the corresponding limits.

The nal level-3 text even adds that these risk limits shouldbe 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 eec tive, CESR

insists that the risk limit system must be supplemented

with a procedure or corrective action (triggered in the

event o a breach, to be executed within a predened

timerame) as well as a warning system that generates

corrective actions to prevent breaches.

Reporting and monitoring

CESR suggests introducing dierent risk reports or di-

erent levels within the organisation. Senior Management

and the heads o the operational departments should

receive regular internal risk reports. Written reports should

be submitted to the Boards o Directors o n the alignment

between the realised risk prole and the target prole o

the UCITS. The risk management process should be sub-

ject to independent internal or external supervision.

CESR’s best practice is challenging rom A to Z

In the light o the recent turmoil in nancial markets, a

ormalised and coherent set o risk management principles

or UCITS can only be welcomed. Investment unds and

other types o investment products have seen their risk

management processes be put to test - and some o them

ailed. The proposed ramework comes close to what a

good housekeeper’s risk management process would look

like. It is not rocket science; the principles set orward are

well tested in the banking industry.

The nal level-3 text has added here and there t he

notions o proportionality and materiality. The ormer

mainly at the level o the risk process and policy, the

latter at the level o risk identication. 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 o the activities

and organisation o the UCITS management company.

On top o that, the more stringent requirements could

uel 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 dierent regulatory

requirements.

Respondents to the consultation also see a signicant

additional burden in unding promoters and investment

managers, without comparable investor benets, which

only results in longer timerames and higher costs or

investors. Moreover, the proposed measurement rame-

work introduces challenges to the system, ranging rom

reconciliation matters where interaces exist between

accounting and ront oce systems, to transparency

issues with vendors o o-the-shel data tools. None o

these issues have been addressed in the nal level-3 text

as published in February 2009.

The risk managementunction should alsoprovide support in thevaluation o illiquid assets,tructured securities and

complex derivatives

ompetent authorities as part o the licensing process or

he UCITS/company, and subsequently monitored on an

ngoing basis. Any changes to the risk management proc-

ss should also be assessed. The text does not speciy any

ansition regime. Obviously, already licensed companies

hould be brought under this new proposal’s regime in

ne way or another. The nal level-3 text species that

ppraisals carried out at the time o licensing the company

may be taken into account.

overnance

ll the key principles are to be appropriately documented

nd ormalised in the company’s risk management policy.

he Board o Directors must approve and regularly review

his policy and will be held accountable or the risk man-

gement process in its entirety. The policy should speciy

rinciples and methods or identiying risks, as well as

measurement techniques and tools deemed suitable or

he UCITS. These measurement techniques should be

oth qualitative and quantitative, which might require IT

ystems to be integrated with ront oce or accounting

pplications.

rganising the risk management process

CESR’s view, a sound risk management system places

emands on a company’s organisational structure. Besides

eing adequate and proportionate, the risk management

rocess must be driven by a clearly identied and inde-

endent risk management unction. This risk management

unction must perorm according to minimum compe-

ence standards and be suciently separated rom the

ompany’s ront oce unctions. It must report directly

o the Board o Directors and Senior Management. In a

cult balancing act, the company must maintain theeparation between the risk management unction and

he ront oce, and at the same time embed risk manage-

ment in the investment process. The risk management

unction and the ront oce are to operate very much in

arallel, enabling dynamic risk management rather than

st checks at predened intervals.

o meet these organisational requirements, companies will

eed people with the appropriate skills, knowledge and

xperience, and this will represent a big human resource

hallenge or the smaller players. But besides people, CESR

views processes and technology as equally important to

the success o the risk management process. Companies

may want to outsource some or all o their risk manage-

ment activities or eciency reasons, a move that would

at the same time enhance the level o independence

between the operating units. However, this should be pre-

ceded by a thorough due diligence o the party delivering

the risk management services. And, obviously, the Board

o Directors still ret ains ull responsibility. The nal 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 sucient human and technical

skills to ensure a proper and eective supervision on the

way that the outsourced activities are carried out.

Identiying and measuring risks

The risk management process should dene or all UCITS

the material risks arising rom their investment objective

and strategy, the trading style and the valuation process.

CESR sees two main categories o relevant risks or UCITS:

nancials risks and operational risks. Within nancial risks

a distinction is made between market risk, liquidity risk,

credit risk and counterparty risk. O the ope rational risks,

which are typically related to trading and settlement and

to valuation processes, only those are relevant that also

aect investors’ interests by their direct impact on the

UCITS’ portolio. A UCITS may equally be exposed to risks

that emerge only at the aggregate level, such as concen-

tration risk or some orms o liquidity risk.

The identied risks should subsequently be translated by

the Board o Directors into a UCITS risk prole. T his risk

prole must be reviewed regularly to allow or possible

changes to market conditions or the UCITS’ investmentstrategy. The risk measurement ramework as dened in

the policy must depend primarily on the characteristics o

the UCITS. This means that UCITS with a higher risk pro-

le may need more complex measures than plain vanilla,

low-risk ones. The nal level-3 text goes even ur ther and

species that investments in structured nancial instru-

ments are to be preceded by a due diligence concerning

the characteristics and the overall risk prole o the under-

lying assets.



2

FSI magazine | #5

The orced nationalisation o once

proud and all-powerul nancial insti-

tutions, historically low interest rates

and government backing or hundreds

o billions’ worth o bank loans mean

we are currently witnessing attempts

on an unprecedented scale to rescue the world’s nancial

system and, with it, the global economy. Although these

rescue plans are necessary and mainly robust, they do

not address the real and undamental problem acing

the nancial services industry. In other words, the total

collapse o consumer condence. Indeed the biggest chal-

lenge in the wake o the credit crunch is how to rebuild

the general public’s trust in our nancial institutions.

Rebuilding strong and trusted brandsRestoring condence means that only strong and t rusted

brands will survive. Although a brand is an asse t that is

hard to measure and truly intangible, corporate histor y

and compelling academic evidence show that brands have

a very real and positive impact on nancial parameters

such as companies’ prots, returns on investment, mar-

ket shares and stock prices. On top o that, strong brand

companieslikeCoca-Cola,IBM,GeneralElectric,Procter

and Gamble and Wells Fargo have proven they can out-

perorm their peers in their innovativeness, their risk

protection capabilities and their ability to attract talent.

Rebuilding strong and trusted brands will also orce nan-

cial institutions to shit their ocus rom quarterly results

and short-term protability – the true evil at the root o

the current nancial and economic crisis – towards long-

term, sustainable protability. Strong and trusted brands

can only be created by investing in customer loyalt y (are

your customers willing to orgive you?) and a strong

corporate culture. And both o 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 o Tesco Finance.

Restoring the general public’s condence and rebuild-

ing strong and trusted brands are challenges not to be

underestimated by any nancial institution. Nowadays

most stakeholders’ associations with the nancial services

industry are purely negative. To them, CEOs and CFOs

have become the personication o unreliability, arro-

gance, greed and a closed community. The captains o

the banking industry are unriendly, do not care and will

not listen.

Integral corporate branding strategy

The traditional and 'quick' method or turning these

negative images around is to develop and execute an

integral corporate branding strategy, where the goal is

to arm and strengthen stakeholder identication with

strong and trusted brand drivers such as wise, in control,

caring, straightorward, riendly, desirable, assertive,

generous and innocent.

The rst step in designing such a strategy is to perorma stakeholder analysis. What are the current views o

various stakeholders, such as employees, customers

(current, lost and uture), nancial analysts, politicians,

trade unions and the general public, on these drivers?

The aim o this analysis is to identiy 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 o this analysis. What intertwined sets

o internal and external branding and communications

are needed to create positive stakeholder identication

with an armation o the trusted brand drivers?

Redesigning business models

Yet although an integral corporate branding strategy is

certainly an essential part o regaining consumer con-

dence, it will not be sucient in its el. The only way to

achieve this goal is to redesign business models a nd cre-

ate true customer centricity.

By implementing multi-channel strategies and creating a

single customer view, the early adopters in the nancial

services industry have taken the rst steps towards these

new business models. The true challenge or them, and

others, will be to create open structures, where outside-

in thinking is the norm rather than t he exception and

customers are involved in the business operations them -

selves. Co-innovation and co-creation will be acilitated by

web2.0 technologies such as social networking, pee r-2-

peer banking, user communities and blogs.

You don’t own your brand

The dening eature o these technologies is that they

create an open dialogue instead o acilitating top-down

communications. Financial institutions will need, however,

to open up i they are to benet rom these opportunities.

A corporate culture o humility and vulnerability and a

genuine ability to listen are necessary i equal interaction

with the consumer is to be possible.

These nancial institutions’ operations and activities will

be driven by real, maniest and latent consumer needs

and motives. In this way, brands will reclaim their role o

creating sustainable satisaction and wealth or custom-ers and other stakeholders, and thus or the society as a

whole in which they exist.

Ironically, creating openness and adaptability as a means

o rebuilding strong and trusted brands will require a will-

ingness on the part o the brand owners to let go o their

obsessive control o their brands. Co-innovation means

ultimately also creating the brand in an open dialogue.

Or,asProcter&Gamble’sCEOLaeyputsit,‘Wedon’t

own the brand, the brand is ow ned by the consumer.’

egaining consumer confdence ater the credit crunch

Only strong and trustedbrands will survive

The real and undamental challengecurrently acing the nancial servicesndustry is how to restore consumercondence. Yet a lot more than araditional, integral branding strategy

will be needed to create strong andrusted brands. Co-innovation means

ultimately also creating brands in anopen dialogue.

y Pieter Vijn

Rebuilding strong andtrusted brands will orfnancial institutions toshit their ocus romshort-term proftabilitythe true evil at the roothe current fnancial aneconomic crisis – towasustainable proftability

About the author

PieterVijnadvisescompaniesoncorporate

ing and innovation strategies. He is also par

ProfessorofBranding&IntegratedMarketi

Communication at Nyenrode Business Unive

theNetherlands.Prof.Vijncanbereached

[email protected].

Customer loyalty and astrong corporate culturehave a positive correla-tion with cross-sellingratios and customers’willingness to explorebrand-stretching activi-ties, such as those oTesco Finance, UK’s larg-est supermarket bank.



4

FSI magazine | #5

With its 1.3 billion i

ants and strong

growth prospect

currently a very i

country or oreig

cial institutions. F

the political reorms o 1978, the banking sector

until then eatured only one bank, became a dy

market with hundreds o players. In retail ba nkin

now boasts our state-owned banks, joint stock

city commercial banks, small rural and urban cre

- and oreign banks. The state-owned banks hav

dominated the market, but are operationally we

the more advanced joint-stock and city commer

are strong, but only in their respective regions. A

given permission to oer renminbi products in 1

oreign banks were at rst only allowed to do bu

with oreign rms and oreign individuals. Gradu

were allowed to oer a broader range o produ

rom 2006 onwards, they have also bee n allowe

renminbi products to Chinese consumers. Over t

two years, 30 oreign banks have set up shop in

competing directly with Chinese banks in a num

services, including retail banking or the Chinese

lation. The standard products and services oer

banks in China are basically the same as in the r

world, but demand has to date be en very much

on deposits and cash withdrawals. Mortgages, c

sumer loans and credit cards are s till in their ina

example, only three percent o banking custome

mortgages. Credit cards are switly gaining pop

customers use them only as a convenient way o

and not as a orm o credit.

Opportunities or oreign banks

Despite the relaxation o restrictions or oreign

China’s retail banking market, they have as yet c

just a modest market share (2.4% in assets at ye

2007). Their ocus has been on high-end custom

the wealthiest cities, which makes sense, given

o a branch network. But their low market pene

is also partly due to rules introduced by the gove

to ght ‘uncontrolled competition’. These includ

and liquidity requirements, and make lie very d

oreign banks.

Foreign retail banking opportunities in China:

High hopes,low expectations

What scope dooreign bankshave to developoperations inChina, and howast can they doso? That is largelyup to the Chinesegovernment, arecent study reveals.Foreign playerswho already haveor aspire to a rolein the Chinese retailbanking sectormust be realistic

about what theycan achieve in thePeople’sRepublic.

By Haico Ebbers and

Harry Smorenberg



6

FSI magazine | #5

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 infuencing and ultimately shaping

the Chinese retail banking sector are:

• theemergingmiddleclass

• theincrementaluseoftechnology

• deregulationandtheroleofthegovernment

• intensifyingcompetition

In particular, the emergence o a Chinese middle class

and technological progress could create opportunities

or oreign banks. To overcome the immense network

advantage o the state-owned banks in China, oreign

banks need to nd creative distribution channels to

serve the mass market. This is where technology could

help: you don’t need a branch network or internet andmobile banking. And as the middle class grows, demand

increases or a wider range o more sophisticated services

and products - which oreign 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 o young, demanding customers with

a more open mind to new technology creates high hopes

or oreign banks.

Key trends in the Chinese retail banking sector

Booming prosperity and the ast-growing number o

households ranking as middle class are trends that will

change the ace o retail banking in China. Figure 1 shows

the rapid growth o spending power.

With the emergence o a middle class, retail banking is

gaining importance in China. Apart rom the act that the

middle class is getting bigger, trends within the middle

class are highly relevant in this context. The distr ibution o

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 oered by

Chinese banks. Moreover, there turn o ut to be consider-

able dierences within this middle class. All this implies an

increasing need or customer segmentation.

Another key trend the study identies is technology. In

general, there is a close correlation between technology

used in a sector and eciency in that sector. State-owned

banks are keen to implement the latest technology in

order to improve their operational eciency. Other play-

ers in the market are ocusing on technologies such as

internet banking and mobile banking to enhance their

accessibility or customers. Although the penetration

o internet and mobile phones is rising switly (in 2008,

China became the country with the world’s largest

number o internet and mobile phone users), the use

o internet or banking services is not catching on. The

study shows that this is due to a lack o trust in the saet y

o 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 or banking activities remains a hurdle or oreign

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 ex tent, this

is culturally driven: o all payment transactions in China,

83 percent is done in cash.

A third key trend is intensiying competition. This is

refected in the increasing number o players active in

the Chinese retail banking sector. In the battle or mar-ket share, technology is a double-edged sword: it can

increase convenience or customers while at the same

time reducing operating costs or the banks. Eventually,

competition will lead to smaller margins or bank s operat-

ing in China.

Key ndings

So the emerging middle class and the incremental use and

improvement o technology will shape the uture o the

sector, but to what extent will this create opportunities

or oreign banks operating in China?

First, the trends in and eatures o the middle class make

it necessary to segment the market, and to ocus on bet-

ter service and more ecient operations. State-owned

banks, too, now realise that they cannot treat the mass

market as one segment. For example, the Bank o China

appointed a team to conduct a study into the demands,

behaviour and preerences o dierent segments o the

mass market. Eventually, the product range o these state-

owned banks will cease to dier signicantly rom that o

oreign banks. There is little that oreign banks can oer

that Chinese banks cannot. Trust in the bank is essential,

and thereore no mass shit o customers to other banks

is oreseen. Meanwhile, regulatory restrictions make it di-

cult or oreign banks to expand quickly. Consequently,

oreign banks will remain ocused on oreign customer s

and high net worth individuals. Some respondents to

the researchers’ survey cite the banking sector in Japanand the telecom and computer equipment sector in

China as cases in point: oreign players in these sectors

invested huge amounts o money, brought in all kinds o

technologies and all their experience with the purpose o

capturing a sizeable chunk o the middle– class consumer

market, but they all ailed. Ater a struggle o decades,

local companies now control over 95% o the mar ket in

those industries.

Second, although technology makes it possible to enter

the mass market, and a branch network is not essential

With the emergeno a middle class,retail banking is

gaining importancin China

gure 1: Chinese spending power is on the rise



8

FSI magazine | #5

thanks to internet and mobile b anking, in China ace-to-

ace contact is o overriding importance. It relates to trust,

which is everything to the Chinese. While some people

are convinced that internet will be the main plat orm or

tomorrow’s retail banks, this is not likely to happen in

China in the medium term. Apart rom the Chinese preer-

ence or doing business ace to ace, another major hurdle

is the government’s rm grip on market orces. For exam-

ple, the competitive advantage o direct banking is a low

price, but because internet rates are xed, 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 ve years

ago, all the big banks oered about the same service,

now there is more dierentiation. The government is

very much behind this. Its primary drive is to improve the

operations o 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 o

consolidation. All in all, there is strong consensus among

respondents to the survey that in the oreseeable uture,

state-owned banks will remain the only banks to coverthe whole o China.

Government as restrictive actor

The above makes clear how important the government’s

role is in the Chinese retail bank ing sector, and conse-

quently its role in shaping the environment or oreign

banks in China. Government actions are the main reason

why the activities o oreign banks are still relatively mod-

est and why urther growth is dicult.

While governments around the world are currently loo k-

Governmentintervention isthe main barrier

to penetratingthe Chinese retailbanking market

ing or ways to regain control o the banking sector, China

never lost control o its banks. The Chinese government

has a controlling stake in the country’s our largest banks

and is involved in many joint stock and city commercial

banks. This is not surprising, since the bank ing sector is

not yet ready or a market-based structure. The govern-

ment uses the our 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 t he last dec-

ade the pace o deregulation has been extremely slow.

And expectations are that t he current nancial crisis will

only make it slower.

Many reports on banking in China describe deregulation

as a big opportunity or oreign nancial 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 - o the Chinese government’s

role tends to be underestimated. Ater all, the Chinese

government not only manages the sector through regu-

lations, but actually still has a majority stake in the our

largest banks. Moreover, it conducts micro-economicpolicy by infuencing banks’ management: almost a ll bank

managers are party members and many top managers

are also government ocials. Respondents explained

that in practice, it was common or the management o

Chinese banks to give priority to party/government policy

over pursuing a business strategy o its own. There was

consensus among all respondents that government regu-

lation is the main reason why oreign banks still have only

relatively small operations in China. Figure 2 shows how

dierent players in the Chinese retail banking sector are

infuenced by the Chinese government.

Analysis o China’s retail banking sector

Nyenrode Business University’s Europe China

and Smorenberg Corporate Consultancy lau

joint research project to analyse China’s reta

ing sector and the opportunities there or o

banks. Having identied the key trends in th

they asked 15 experts – employees o oreig

in China and Chinese banks, as well as indep

banking specialists rom the academic world

consultancy industry – how these trends wo

ence the Chinese retail banking sector and i

There was consensus about the key actors

the uture o retail banking in China: the em

o a demanding middle class, deregulation m

and the incremental use o technology will c

aect the environment in which oreign banoperate in China. But government interventi

remains the main barrier to penetrating the

retail banking market, and this will not chan

medium term.

The study was carried out by Gerard Baan a

Wilbert van den Brink under t he auspices o

Haico Ebbers and FSI Strategist Harry Smore

executive summary is available on the websi

Europe China Institute: www.nyenrode.nl/EC

Negative Positive

External

Internal

Eect o the infuence o the goverment

Infuence o the

goverment

non state owned banks

state owned banks

oreign banks

Figure 2: Infuence o the Chinese government on banks and eect o this infuence

Conclusion

The Chinese retail banking sector is set to grow

relevance, and will certainly oer opportunities

banks. However, oreign banks should not unde

the decisive infuence that the Chinese governm

their reedom to operate and what they might

the Chinese market. Foreign banks are allowed t

in the market and are invited to help develop th

retail banking sector. As long as they contribute

government policy, they enjoy relative reedom.

the Chinese government is not likely to allow a l

o such an important sector as banking to be m

non-Chinese parties. Banking is regarded as the

o the Chinese economy, and a key instrument i

ing economic goals.



0

FSI magazine | #5

The project kicked o with a contest

foryoungPolishphotographers.The

three winners were given the challeng-

ing task o portraying 20 CEOs o the

biggestnancialinstitutionsinPoland

in two roles: proessional and private.

The double portraits o 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 lie stories

TheCEOsofthePolishnancialsectoracceptedtheinvi-

tation with great enthusiasm and some curiosity. The y

devoted their precious time to giving long, intimate inter-

views, opening wide the doors to both their oces and

their homes. They told remarkable stories rom their pri-

vate and proessional experience: stories o their struggles

to achieve success, learning rom the market and surviving

its ups and downs, but also s tories o pure joie de vivre,

and o private dreams and ambitions, ullled and yet to

be ullled. And they participated with real commitment

in the photo sessions, which resulted in original and sug-

gestive portraits o great people seen through the lenses

o young artists. Together, the amazing and unique lie

stories and the lively and passionate images constitute a

wonderul album that captures the reality o 2008 bank-

inganditsPolishicons.

Creativity versus the downturn

JózefWancer,CEOofBankBPH,isoneofthebanking

leaders portrayed. Why did he participate? ‘I was asci-

nated with the idea o shing or photographic talent

through a photo contest. Moreover, showing banking

leaders rom both a proessional and a personal perspec-

tive is a great concept. It has generated optimism and

creativity. Something we need more than ever nowadays,

as the nancial sector aces a downturn and the media

persist in painting black scenarios.’

Bankingleaders

caught inthe lens

Mix the talent o youngphotographers and thecharisma o CEOs omajorPolishnancialinstitutions, and whatdo you get? “Business inocus – 2008 bankingleaders”, a creativeinitiative connecting twoworlds: business and art.

By Sylwia Jackowska and

Halina Frańczak



2

FSI magazine | #5

Business in ocus

“Business in ocus – 2008 banking leaders”

ofDeloittePoland,realisedjointlywiththe

toEuropeArts&BusinessFoundationand

BusinessReviewPolska.Theportraitsofba

exhibited during a vernissage on 25 Novemb

at the Zachęta National Gallery o Art in Wa

event was attended by numerous chairmen

membersofPoland’slargestbanksandrep

oftheworldofnanceandculture,includin

Ministries o Finance and Culture. All the phand interviews have been published in an ex

album. The proceeds will go towards schola

awarded to young, gited ne art photogra

More inormation: www.bizneswobiektywie

Jackowska([email protected]),

ManagerDeloittePoland,HalinaFrańczak(

deloitteCE.com),MarketingDirectorDeloitt

or Matthew Howell (mathowell@deloitteCE

Marketing Director Deloitte Central Europe.

A creative initiativeconnecting two worbusiness and art

Photos by Małgorzata Pytel

From let to right:

Mariusz Grendowicz, CEO Bre Bank

JerzyPruski,CEOPKOPB

PiotrKamiński,CEOBankPocztowy

WłodzimierzKiciński,CEONordeaBank

SławomirSkrzypek,CEONationalBankofPolan

Sławomir Lachowski, ormer CEO Bre Bank



4

FSI magazine | #5

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 ater my nal high-school

exams. I had only ve dollars in my pocket and started

working in a actory. My superiors wanted me to become

a mechanic, but instead I joined the army. Ater militaryservice I returned to the actory, but I knew then that

being a mechanic was certainly not or me. That’s why

I started looking or a new job, preerably 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 led by clients in Asia and Europe. That job was a

quick lesson in banking or me. Alongside my regular job,

I took university evening classes. That was the most essen-

tial period o my lie. I was impressed by the individualism

o 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 theearly 1960s with only ve dollars in hispocket. Now a citizen o the world and CEOofBankBPH.AportraitofaPolishbankingpioneer, Józe Wancer.

‘Banking isthe love o my lie’

You’ve had wide-ranging banking experience

eral countries

The American management style taught me tha

value should be the key objective. It’s certainly t

objective or clients, including those in the bank

industry. Banks in the United States do not see l

porations as their key clients, but rather retail cuand small businesses. A typical John Doe has the

infuence on the domestic economy and lie as a

We need to listen to people and understand the

That must have been quite a surprise or you

pared to what you had experienced in Polan

Huge queues to the cash register are what I rem

fromthe50sandthe60sinPoland.Customers

rights, they were just petitioners. I remembered

thisinthe90swhenIreturnedtoPoland.No-o

about customers, but everyone knew the word.



6

FSI magazine | #5

That reminded me o 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

tookplaceinPolandafter1989weremoreradicaland

rapid. Some o them happened rom one day to the next.

Multinationality has become part o your lie. What is

your personal identity?I regard mysel as a citizen o the world. I’ve lived in so

many places that moving to another country is not a

problem or me. I easily assimilate and get used to places,

but I’ve also aced 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.MovingtotheUnited

StatesandthenreturningtoPolandwasthebestthing

that ever happened to me.

What are your plans or the uture?

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 wie and

children.

What are you going to do then?I collect documents rom the Se cond World War and have

a small but interesting collection o papers about the lives

ofPolishandotherEuropeanJewsduringtheholocaust.

I’d like to trace the amilies o some o these people

and see i anyone is still alive. I would also like to spend

time renovating Asian urniture, or example, part icularly

Japanese. My wie says I’m no good with my hands, but

she orgets that I worked in a actory or two years. The

third thing I plan to do is to continue in business as a

consultant or as a member o a supervisory body. I could

do that rom time to time, on a project basis. My true

hobby is travelling, though. I’m leaving or China soon,

but I’d also like to go to Tanzania, New Zealand and South

America.

Are you able to maintain the right work-lie balance?

Maintaining the right work-lie balance is not easy or

me because I’m a workaholic – just like my ather was.

However, I’m not really addicted to work. I’ve managedto combine my work and personal lie, mainly because my

amily is very understanding. I do my be st to spend all my

ree time with them. Once I leave the oce I just need a

couple o minutes to orget about my proessional prob-

lems. To relax, I go or 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.

Ialsoenjoypainting,particularlyPolishpaintingfrom

the 1920s and 30s. Going to auctions is something that

gives me a great deal o pleasure. And lastly I enjoy music,

especially classical music.

‘My truhobbytravell

What is your recipe or success in banking and your

personal lie?

The recipe is like a doctor’s prescription. It depends on

the doctor and the patient. First o all, you need to have

a vision and a goal in lie. 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 lie. I

was born in a labour camp in Siberia during the SecondWorld War. My amily survived ve years o traumatic

experiences. Despite that, my parents were still extremely

enthusiastic about lie and still believed it was beautiul.

Another thing you need is trust in other people.

Do you regret not becoming a doctor?

I have a lot o respect or doctors. I admire their knowl-

edge and huge responsibility or human health and lie.

But nevertheless, I have no regrets that my career turned

out dierently. Banking is the love o my lie.



8

FSI magazine | #5

Increasingly stringent rules are already in the

process o being implemented. On 1 October

2008, or instance, the European Commission

proposed introducing more demanding capital

requirements or banks. And more is likely to

ollow. So, ater 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 uture o nancial regulation and supervision.

Risk, liquidity and capital management

An early assessment o the ‘lessons learned’ in the wake

o the credit crisis was published in March 2008 by t he

Senior Supervisors Group (SSG), a consortium o regula-

torsfromFrance,Germany,Switzerland,theUKandthe

US. The Group’s recommendations, based on a survey

o 11 global banking organisations and securities rms,

mainly ocuses on the improvement o risk measurement

and management and o liquidity and capital manage -

ment. The report makes a strong case or the need to

enhance risk management in general and liquidity risk

management in particular.

The SSG has identied our risk management practices

that made the dierence between rms heavily aected

by the crisis and those able to weather the storm with

lesser damage:

• Effectiverm-wideriskidenticationandanalysis

• Consistentapplicationofindependentandrigorous

valuation practices across the rm

• Effectivemanagementoffundingliquidity,capitaland

the balance sheet

• Informativeandresponsiveriskmeasurementandmanagement reporting and practices

Starting rom these best practices, the SSG also makes

a number o suggestions or the revision o Basel 2, the

ramework regulating banks’ risk and capital manage-

ment.Proposedreformsincludeincreasingcapitalcharges

or securitised assets and stre ngthening liquidity risk man-

agement, but also encouraging rms to simply develop

better, rm-wide risk management. Thus, the SSG report

notes: ’In rms that experienced greater diculties, busi-

ness line and senior managers did not discuss promptly

among themselves and with senior executives the rm’s

risks in light o evolving conditions in the marketplace.

This let business areas to make some decisions in isola-

tion regarding business growth and hedging, and so me

o those decisions increased, rather than mitigated, the

exposure to risks.’

Since the publication o the SSG report, a number o

the recommended reorms have already been put into

practice. On 1 October 2008, the European Commission

(EC) announced its proposals or changing the Capital

Requirements Directive (the EU version o Basel 2), to

include more stringent liquidity requirements or banks

operating across the EU and improved risk management

or securitised products. Further revisions o Basel 2 are

likely to ollow, both on the EU and on the international

level.

Nevertheless, it is at present ar rom clear whether the

regulatory response in the domain o risk and capital man-

agement will be limited to ne-tuning or re -calibrating the

existing ramework, or whether a more substantial over-

haul o the approach is in the cards.

Senior Supervisors’ Group:

‘In rms that experienced greater diculties, business

line and senior managers did not discuss promptly amo ng

themselves and with senior executives the rm’s risks in

light o evolving conditions in the marketplace.’

Accounting rules

Accounting rules have been hotly debated since thebeginning o the nancial turmoil. Bankers have come

to argue that a new bookkeeping rule requiring them to

value their assets at market prices – also known as air

value accounting – has had a devastating eec t on their

balance sheets, and has thereore helped intensiy the

nancial crisis. Other stakeholders argue that a loophole

in the accounting rules, allowing banks to move large

amounts o assets o their balance sheets, was partly

responsible or the escalation o the crisis.

n industry that already aces intense regulatory scrutiny is likely to ace more

Financial crisis changes theregulatory and supervisorylandscape

When will the nancial crisis end? What will be its nal impact?As the crisis continues to escalate, these questions are becomingharder to answer. However, there is little doubt that the presenturmoil will radically change the regulatory and supervisoryandscape. An industry that already aces intense regulatoryscrutiny is likely to ace more.

y Gert-Jan Ros,

rank De Jonghe and

aroline Veris



0

FSI magazine | #5

In response to the worsening o the crisis in the early all,

the US Securities and Exchange Commission (SEC) and

the Financial Accounting Standards Board (FASB) gave

US nancial institutions the green light on 1 Oc tober o

last year to disregard the prices p aid or assets in a orced

liquidation in computing the ‘air value’ o their own

assets. This clarication o air value accounting has since

been accepted by the IASB and the EC. On 13 October,

moreover, the IASB announced a change in it s accounting

rules which allows IFRS-compliant nancial institutions

to reclassiy certain nancial instruments in the case o a

‘rare event’. This change – prepared in record time by the

IASB and adopted by the EC t wo days later – was meant

to create a level playing eld or European nancial insti-

tutions vis-à-vis their American counterparts, who enjoy a

similar‘rareevent’exceptionunderUSGAAP.

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 ar-reaching changes to IAS39, the account-

ing rule setting out the re quirements or recognising and

measuring nancial assets and liabilities. This paper will be

used as a starting point or the reorms to be proposed by

both the IASB and the FASB in the months to come.

Supervisory structure

In view o the unprecedented severity o the nancial cri-

sis, the debate has not stopped at rules and regulations as

such. The structure o nancial supervision itsel is coming

under discussion. A recent report by the G30 Regulatory

Systems working group, a think tank, rames the upcom-

ing debate over reorm o the world’s nancial ser vices

regulatory systems in the context o existing structures,

their various strengths and their implicit weaknesses. In

thereport,PaulVolcker,ChairmanoftheG30’sBoardof

Trustees notes: ‘It is evident that a number o countries

need to revise and reorm nancial regulatory structures.’

Paul Volcker, Chairman o the G30’s Board o

Trustees:

‘It is evident that a number o countries need to reviseand reorm nancial regulatory structures.’

The report assesses the our approaches to nancial

supervision currently employed across the globe. It

describes the key design issues o each supervisory model,

illustrates how each has been implemented in prac tice,

and assesses the strengths and weaknesses o each

approach.

Institutional: A rm’s legal status (or example, a bank,

broker-dealer or insurance company) determines which

regulator is tasked with overseeing its activity rom both

a saety 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 o business may have

its own unctional regulator. The countries reviewed that

use the unctional approach are Brazil, France, Italy and

Spain.

Integrated: A single universal regulator conducts both

saety and soundness oversight as well as conduct-

o-business regulation or all the sectors o nancial

services industry. The countries reviewed that use this

approach are: Canada, Germany, Japan, Qatar, Singapore,

SwitzerlandandtheUnitedKingdom.

Twin peaks: A orm o regulation by objective, in which

there is a separation o regulatory unctions between

two regulators: one that perorms the saety and sound-

ness supervision unction and the other that ocuses

on conduct-o-business regulation. The two countries

that use the twin peaks approach are Australia and the

Netherlands.

The US ts into none o these categories. Its structure is

unctional with institutional aspects, with the added com-

plexity o a number o state level agencies and actors.

The study claims that no simple correlation e xistsbetween the supervisory approach adopted in a jurisdic-

tion and eective supervision during a nancial 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 refect more

rationally the many changes that have taken place in the

nancial services business in recent years and might thus

be more ecient and cost eective in the uture. For this

reason, they are unctioning as a model or reorming

jurisdictions, such as the United States. As the G30 report

points out, the US Treasury Secretary’s Blueprint or a

UCITS 3

UCITS 4?

E-PrivacyDirective

SOX MarketAbuse

Directive

3rd AMLDirective

MiFID ReinsuranceDirective

Revision oIAS 39?

EU Committeeo Supervisors?

FinancialConglomerates

Directive

IFRS

CDRDirective

Revision oCDR Directive?

TransparencyDirective

Solvency II

PaymentServicesDirective

Directiveon Credit

Agreements

2002 2005 2007 2010

Theaboveillustrationoffersanoverview,albeitnotacomprehensiveone,ofrecentEUregulationsinuencingtheEuropeannancialservices

industry.

Thetimelineindicateswhenaregulationwasorisduetobeapproved;inblueareregulationsnowbeingdiscussedbytheEU.

Group o Thirty

The Washington, D.C.-based G30, ounded

is an international body o ormer central ba

nors, leading economists and private nanc

specialists. In the all o 2007, the Group o

established a Financial Regulatory Systems w

group to address the large changes in the w

nancial reviews.

The Deloitte Center or Banking Solutions a

Deloitte’sRegulatory&CapitalsMarketsCosupported the G30 study on the structure o

supervision. Deloitte representatives particip

the G30’s Regulatory Systems working grou

international team o Deloitte’s global regul

cialists assisted in the research and proling

national supervisory systems.

For a copy o the report please contact Gert

[email protected] or Frank De Jonghe,

[email protected].

gure 1: Overview o recent EU regulations



2

FSI magazine | #5

Modernized Financial Regulatory Structure will bring the

S supervisory system a lot closer to both the Integrated

ndTwinPeaksmodelsthanitistoday.Otherjurisdictions

might well ollow suit.

nternational cooperation

the cross-unctional nature o modern nancial insti-

utions necessitates a more integrated approach to

upervisory oversight, international expansion has similarly

reated a need or closer supervisory cooperation across

orders. According to the G30 report, representatives o

many jurisdictions avour more ormal mechanisms or

ooperation and inormation sharing. In particular, those

terviewed were supportive o the use o ’colleges o

upervisors’ on the international level, ocused on large,

ystemically important nancial institutions. Again, these

roposals are rapidly turning rom ction into act. EU

ommissioner Charlie McCreevy announced a revision o

he Capital Requirements Directive on 1 October, entail-

g the establishment o Committees o Supervisors in the

U. These Committees will have various tasks to enhance

ross-border oversight in the EU, including mediation and

rating o recommendations and guidelines. They will be

ven an explicit role in strengthening the analysis o a nd

esponsiveness to risks that threaten the stability o the EU

nancial system.

onclusion

he nancial sector is at the eve o what might well

ecome the most dramatic overhaul within living memory

the way in which it is regulated and super vised. Under

hese circumstances, it pays to keep abreast on the

ebate about nancial supervision. Blueprints now being

eveloped by think tanks, supervisors and other experts

ve a preview o the regulatory reorms we might expect

the coming months and years. Now is the time to speak

ut, and be part o the debate.

About the authors

Gert-JanRosisPartneratDeloitteERSinthe

Netherlands,FrankDeJongheisPartnerandCaroline

Veris is Director at Deloitte ERS in Belgium.

The past year, and thepast ew months inparticular, have beentough or the nancialsector. Though itsorigins are in the US,the subprime crisis hashad never dreamt-oconsequences not onlyor US Banks, but orEuropean banks aswell. The nancial andeconomic situation alsoaects the amount ocash in circulation inthe eurozone - and therelated costs or banks.

By Ortwin De Vliegher

How the economic turmoil impacts cash usage

The costo cash

José Manuel Barroso,

President o the

European Commission,

received Jacques de

Larosière, Chairman o

the High Level Group on

Cross-border Financial

Supervision.

Recent reports by supervisors, think tanks and

other experts

• SSG,“ObservationsonRiskManagement

Practices”,March2008.

• IASB,“ReducingComplexityinFinancial

Instruments”, March 2008.

• USTreasury,“BlueprintforaModernized

Regulatory Structure”, March 2008.

• FSF,“ReportoftheFinancialStabilityForumon

Enhancing Market and Institutional Resilience”,

April 2008

• IIF,“FinalReportoftheCommitteeonMarket

BestPractices”,July2008

• “Volcker-FergusonReportonFinancialRegulatorySystems” rom the G30 Working Group, October

2008.



4

FSI magazine | #5

Recent events have clearly struck a

blow to the collective psyche and

weakened people’s belie in the

stability and uture o the banking

system in general and some banks in

particular. The drastic interventions

by central banks and governments, which even went as

ar 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

o deposits rom certain banks, with many customers

demanding physical cash. A recent survey analyses the

infuence o the crisis on the cost o c ash and provides

recommendations how banks can minimise these costs.

Part 1: Analysis o the infuence o the economic

and nancial crisis on the amount o cash in

circulation

The annual growth rate o the amo unt o euro notes

in circulation has steadily slowed since the euro’s intro-

duction in 2002 till the end o 2007. I we compare

the amount o euro notes in circulation at the end o

the month o December in each year, we see a rise o

22% in 2003 gradually alling to less than 8% in 2007.

Traditionally, the bulk o annual growth takes place in

the month o December, and relates to holiday shopping.

Growth in December 2003, 2004 and 2005 represented

35% o ull-year growth. By December 2007, this percent-

age had risen to 60%.

In the light o the historical growth trend o the amount

o euro banknotes in circulation, with most growth tradi-

tionally occurring in December, the latest gures, running

till the end o December 20081, present several surprises.

First o all, during the rst nine m onths o 2008, the

amount o euro notes in circulation rose by only 1%, the

smallest increase or that period ever.

In October 2008, however, the amount o euro notes in

circulation jumped by 6,4%, the biggest monthly increase

since December 2003 and the biggest October increase

ever. The main actor behind this jump was withdrawal o

notes or hoarding purposes: the total value o 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 or the

increase in the annual cash growth rate in 2008.

Finally, the extra amount o cash withdrawn or 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 o cash.

Part 2: The infuence o the 2008 economic

the cost o cash

Existing estimations o the cost o cash

In recent years, two proound analyses gave a g

on what the cost o cash could be or European

In2003,theEuropeanPaymentsCouncilCash

Group estimated the cost o cash or the Europe

as a whole at around EUR 50 billion a year, o w

32 billion is borne by the banking sec tor. In Sept

2005,aMcKinseystudyconcluded(onthebas

evaluation or nine European countries) that cas

banks EUR 21 billion a year, making it t he single

important cost item in their whole payment cyc

Estimated infuence o 2008 economic event

cost o cash

The cost o cash or banks is infuenced by num

diverse cost drivers. Many o these are xed or s

and thereore not immediately impacted by eco

events or an increase in the amount o cash. Oth

cash-related costs are variable and could be ae

the 2008 economic events and the signicantly

amount o cash in circulation. Variable cost drive

are most likely to be infuenced are the interest

received on deposits (at the central bank) and th

Cash in Transit (CIT).

Missed interest revenues linked to cash usag

To simpliy the analysis, we initially assume that

withdrawing cash at their national central banks

their suciently high deposits held on an NCB a

I cash is withdrawn, banks lose interest revenue

ECB-held deposits. This revenue depends on thedeposit rate.

Taking into account all changes in the ECB depo

we may conclude that the interest rate linked po

revenue loss has been pret ty stable at 2.75% to

or the last 18 months. Only bet ween 9 July and

November 2008 did it rise to 3.25%. Ater 10 D

the rate dropped to 2%, to be lowered urther t

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



6

FSI magazine | #5

is important to bear in mind that the opportunity cost

missed interest revenues on ECB deposits was only 1%

tyear-end2003,whentheEPCstudywasperformed.

aking also into account that this study estimated the

ventory cost o cash carried by the banking sector at

UR 6.9 billion a year, that only recently the ECB rate

ropped to historical lows and that, o the EUR 760 bil-

on in banknotes currently in circulation, approximately

5 to 85% is in the hands o the public 3, we could esti-

mate the increase in the cost o cash or banks linked to

missed interest revenues at up to EUR 1.5 billion a year.

bviously, however, the opportunity cost or all banks

will be based on higher interest rates than the base rates

ered by the National Bank. While the 12-month euri-

or rate was 3% early 2009, some banks still pay higher

ates on the interbank market. Thus we think it is sae to

ssume that missed interest revenues could raise t he cost

cash or banks by EUR 3 billion a year.

he cost o Cash in Transit (CIT)

he cost o Cash in Transit operations or a bank depends

n two things: the price per drop and the number o

rops perormed.

rice per drop

most cases, CIT operations are perormed by special-

ed external rms working under long-term contracts

t a xed price, which is only perio dically reviewed. This

means that any change in the cost bas e o the CIT opera-

tors would not immediately aect prices paid by banks

and retailers. In a ew countries, however, an automatic

(wage-linked) indexation o CIT prices is imposed by law.

Still, this does not mean that the underlying cost base and

the commercial need or price increases were generally

perceived as a necessity in these countries. Indeed, our

interviews with many CIT operators and banks still per-

orming their own CIT operations led us to the opposite

conclusion. The general rise o infation and specically

uel prices during the rst hal o 200 8 not only stopped

but reversed during the second hal o the year. Thereore,

it had no signicant, lasting eect on the total cost base

o CIT operations.

Number o perormed drops

Most banks and CIT operators conrmed that the ongo-

ing trend o decreasing the number o drops per branch

slowed, but nevertheless continued during 2008. Therewas an uptick in October when many banks ordered extra

CIT drops, but the rise did not continue during the rest o

2008 and did not ultimately impact the overall decline.

Looking at the very limited increase o the cost per CIT

drop on one hand and a steadily decreasing number o

drops on the other hand, we may conclude that the cost

o CIT or banks did not change dramatically during 2008

and shows no signicant departure rom the ndings in

previously perormed studies on the cost o cash.

Part 3: Recommendations or the uture to minimise

the cost o cash

Cost-o-cash optimisation key in banks’ 2009 cost

eciency strategies

Our interviews conrmed that most European banks do

not need to be convinced o the importance and impact

o the cost o cash. However, they clearly underestimate

thepotentialsavings,highNetPresentValueandvery

short pay-back period o most cost-o-cash optimisation

projects. We are convinced that, given recent economic

events and the current general strategic ocus o banks on

cost eciency, cost-o-cash optimisation programmes are

not only more benecial 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 requencies o r the

amount o 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-

ormed partial cost-o-cash programmes will benet rom

a new, integrated analysis o the cash chain.

Campaigns to bring increased amounts o hoarded

money back to banks

The sharp increase in the amount o euro notes in circu-

lation in October 2008 was mainly concentrated in thebiggest notes used or hoarding. Our second recommen-

dation toward banks is to tr y to bring this money back

into the banking system. There are several reasons to do

so:

• Theextraamountofhoardedmoneyhasasignicant

infuence on costs borne by banks

• Attractingnewdepositsisoneofthemostinteresting

ways or banks to overcome liquidity shortages and

improve their Tier 1.

Conclusion

The ECB statistics make it clear that 2008 has be

remarkable year with regard to physical cash. Th

the amount o euro notes in circulation was hist

low till September 2008. In October 2008, how

nancial crisis led to an unprecedented 6,4% mo

month rise in the amount o euro notes in circul

increase was most marked or 100, 200 and 500

notes, suggesting that the amount o hoarded m

rose by approximately EUR 25 billion during the

The statistics or November show that this mone

immediately fow back into the banking system.

We have demonstrated that the estimated total

cash probably grew by EUR 1.5 to 3 billion a yea

taking into account the eect o r ising missed in

revenue. Considering also the great benets o c

misation programmes, we are convinced that ru

such programmes should be a key priorit y or al

2009, and a key eature in the cost optimisation

gies they are currently busy with. Furthermore, w

convinced that specic actions are needed to br

increased amount o hoarded money back into t

ing system. Successully running a campaign to a

deposits will boost the liquidity position and eve

the competitive position o some banks in the d

area.

About the author

Ortwin De Vliegher is Senior Manager at De

Consulting Belgium and co-ounder o the ‘F

Cash’ networking and knowledge-sharing p

or all those involved in the cash c ycle

(see www.utureocash.org).

3The ‘Future o Cash’ report

2006, Agis Consulting: average

o approximately EUR 1200

held per inhabitant o euro-

zone in 1999.

Missed interest revenuescould raise the cost o cashor banks by EUR 3 billiona year



8

FSI magazine | #5

Managing reputational risk

Reputational risks one o thoserisks that are

hard to measure,even thought should beaddressed in theCAAPprocess.Nevertheless,t deserves acomprehensiverisk managementramework.

y Mathias Christiaens

nd Frank De Jonghe

Several surveys conrm that reputational

risk has emerged as a major concern or

many executives and risk managers in the

FSI industry. The increase in reputational

risk is or the most part attributable to the

increasing dominance o intangible assets.

In today’s economy, intangible assets such as brand, intel-

lectual capital, strategic relationships and the ‘licence to

operate’ account or 70% to 80% o a company’s market

value1. This is certainly the case in the nancial services

industry, where the ability to underwrite new business is

heavily reliant on the standing o the rm, a act that was

dramatically underscored in last year’s takeover o Bear

Stearns. Despite the increased awareness o reputational

risk, most (i not all) organisations will admit that they

struggle to manage this risk.

Dening reputational risk

An important obstacle in the management o reputa-

tional risk lies in the absence o a commonly accepted

denition. The Basel II Accord recognises the existence

o reputational risk but does not dene it. It simply states

that it is excluded rom the denition o operational risk,

but includes it in the scope o risk s to be considered under

PillarII.

The Committee o European Insurance and Occupational

PensionSupervisors(CEIOPS)hasdenedreputationalrisk

as ollows2: 'The risk o potential damage to an undertak-

ing through deterioration o its reputation or standing

due to a negative perception o the undertaking’s image

among customers, counterparties, shareholders and/or

regulatory authorities.'

'It takes 20 years to build a reputation and ve minutes to

ruin it. I you think about that, you’ll do things dierently.'

Warren Buet

CEIOPSgoesontosaythatreputationalriskshouldbe

regarded as less o a separate risk, than one consequent

on the overall conduct o an undert aking. Similarly, The

Economist Intelligence Unit reerred to reputational

risk as 'the risk o risks'3. Indeed, each credit, market or

operational loss event has the potential to harm your

organisation’s reputation as a second order impa

What’s worse, the damage inficted to a rm’s re

could well prove to be more signicant than the

impact, the underlying loss itsel.

A striking example is Northern Rock. The origin

bank’s problems presumably lay in its inadequat

ity risk management. It ailed to address its depe

on money market unding, which dried up in the

o the global credit crunch. This problem, howev

addressed when the Bank o England provided a

support acility, helping the bank to und its ope

during the period o turbulence in nancial mark

the bank could take the required actions to reso

structural problems. At the end o the day, how

bank was not aected as much by its liquidity p

it was by the erosion o consumer condence (re

the headline pictures o people lining up on the

waiting to withdraw their unds). The bank run i

a vicious circle o ever-increasing liquidity proble

the end, the reputational damage was to blame

downall o the bank.

Notwithstanding the act that the majority o re

damage can be described as a second order imp

number o reputational risks can nevertheless be

sied as ‘independent risks’, meaning that reput

damage could be considered a rst order impac

independent risks can oten be associated with

Organisations that do not abide by high ethical s

and that ignore principles o market conduct are

able to losing their customers’ trust and conde

short, each organisation has a social responsibil

it cannot ignore and that it must a ddress in its cgovernance.

Link between capital adequacy and reputatio

A ercely debated topic is whether a nancial in

must consider making provisions or reputationa

Naturally, setting aside capital to absorb unexpe

losses attributable to reputational damage requ

quantitative risk assessment. For reputational ris

quantication will prove to be dicult due to a

generally accepted measurement method. In ant

o a market consensus about this, many rms ar



0

FSI magazine | #5

currently arguing that the assessment o reputational

risk is above all a qualitative assessment based on expert

judgment.

This point o view seems to be supported by the

Committee o 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 o risk s, it may not always be

the sole or best solution to mitigating risk. For less quan-

tiable risks (such as reputational risk), the ocus o the

ICAAPcouldindeedbemoreonaqualitativeassessment,

risk management and mitigation.

Whether nancial services rms have quantied their

reputational risk or not, it seems air to conclude that

supervisors will expect all nancial rms to be able to

demonstrate that they have implemented a compre-

hensive set o procedures and internal controls aimed at

reducing reputational risk to a minimum.

Does this mean that quantiying reputational risk is a use-

less eort? No! On the contrary, the ability to quantiy

reputational risk is helpul in prioritising and presenting

the sources o reputational risks to senior management.

A rm that is able to combine the best o both worlds,

i.e. is able to understand its exposure to reputational risk

through quantication and is capable o dealing with the

risk through reputational risk management, has a clear

competitive advantage.

Prevention is the best remedy

Eectively managing reputational risk can be achievedby applying the well-known ramework o ide ntication,

assessment and management.

Identication

To identiy potential events that may negatively aect its

reputation, a rm must rst acknowledge that its reputa-

tion is owned by the stakeholders. Every organisation

has a multitude o stakeholders: investors, customers,

employees, management, board o directors, regulators,

suppliers, the community in which the rm o perates, etc.

These stakeholders have an array o expectations covering

dierent aspects o corporate perormance. A rm’s repu-

tation is determined by how the stakeholders perceive its

perormance in each o these aspects. The reputation is

at risk as soon as expectations o the rm’s perormance

exceed underlying reality. In order to avoid damage to its

reputation, the rm should try and close the gap by either

improving perormance 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

perorm in accordance with the stakeholders’ expecta-

tions will be revealed. Not only will the organisation then

ace severe reputational damage, it could also nd itsel at

the other end o the pendulum, with its reputation allingshort o its actual perormance. Hence our earlier asser-

tion that reputational risk is a second-order risk.

Closing the expectations gap, however, could in itsel

expose the organisation to reputational risks. I, or

example, the perormance o a rm ails to meet investor

expectations, management could be tempted to ocus

too exclusively on boosting its nancial ratios (e.g. marke t

share, earnings growth, ROI, etc), at the expense o 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 dierent stakeholder expectations is one o

the main challenges o reputational risk management.

Once the stakeholder expectations have been identied,

the organisation should make an eort to identiy the

incidents that, should they occur, would cause it to all

short o these expectations, and thereore damage the

rm’s reputation. The ollowing techniques can be used

to identiy both stakeholder expectations and potential

reputational events:

• Mediaanalysis(television,newspapers,magazines,

blogs, message boards, etc)

• Interviewswithfront-lineemployees(i.e.those

employees that are requently in contact with sup-

pliers, customers, investors, bankers, etc and are

thereore well aware o the issues raised by these

stakeholders)

• Brainstormingwithmanagement

• Industryresearch

Due to the dynamic nature o stakeholder expectations,

this step must not be viewed as a one-o eort. Every

organisation must continuously monitor changes in stake-

holder expectations.

Assessment

Having identied the events that could damage the rm’s

reputation, each event needs to be assessed in terms o

the likelihood that it will occur and the se verity o the

reputational damage which may result i it occurs. Risk

rating scales can be used both or the assessment o likeli-

hood and severity. The table provided here is a simpliedapproach.

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, rms could also

opt to perorm a quantitative assessment o their reputa-

tional risk. The objective o such quantitative assessment

is to measure the impact o reputational damage in terms

o reduced operating revenues due to loss o clients,

Likelihood Severity

High Likely to occur atleast once per year

High Regulator,public opinimpacted, clients

Medium Likely to occur onceevery ew years

Medium Regulator impacted, ents lost

Low Very remote proba-bility o occurrence

Low Regulatorimpacted, ents lost

Likelihood

High Medium High High

Medium Low Medium High

Low Low Low Med

Low Medium High

Severity

The reputation isat risk as soon asexpectations o thefrm’s perormanceexceed underlyingreality



2

FSI magazine | #5

increased compliance and other costs to re store con-

dence, and perhaps the increase in the cost o capital as

a result o the reputational event. An array o techniques

exists, such as:

• Examiningarm’sstockpricereactiontothe

announcement o a major operational loss e vent. I

the rm’s market value declines by more than the

announced loss amount, this is interpreted as a repu-

tational loss5

• Theactuarialapproach,whichfocusesontheloss

distribution. Frequency and loss severity are modelled

separately and then aggregated using either Monte

Carlo or numerical techniques

Whilst quantication is arguably as much an art as it is a

science, we believe quantication is useul 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 actors that dey quantication a nd that

are thought to be important.

Management

The ERM Integrated Framework proposed by COSO

denes our risk responses: avoiding, accepting, reducing

and sharing.

Avoiding risks that can cause reputational damage is

ar rom obvious, since these risks are oten embedded

in the core o the business. A classic example, however,

o 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 o its target.Targets that engage in wrongul conduct are oten better

avoided to prevent reputational damage to the acquirer.

Another example is the risk o 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 o 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 me dia,

it was not sanctioned. Consequently, companies in the

oil industry accepted the risk o 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 eorts.

Companies that ailed to do so and continued to neglect

environmental concerns suered important reputational

damage.

Reducing reputational risks through preventive and

detective control activities is the most likely and oten the

most appropriate response. Control activities should be

designed to minimise the rst-order risks (e.g. operational

risks). In the context o reducing reputational risks, the

importance o corporate governance deserves to be high-

lighted. Firms should articulate, disseminate and enorce

an ethical code throughout the business. Employees at

all levels o the organisation should be well aware o the

risks and events that could aect the rm’s reputation.

The objective should be to develop and reinorce a true

risk management culture in which compliance is put at the

top o the agenda.

Sharing risks in the context o reputational risk man-

agement is rare, and not recommendable. By nature,

reputational risk is not something that can be legally

transerred. Thereore, rms must be aware that they can

even suer reputational damage as a result o actions

taken by others. A good illustration o this is the eect o

the market distress that began in the second hal o 2007.

Banking organisations under no contractual obligations

providedvoluntarysupporttoABCPconduitsandother

o-balance sheet nancing vehicles, including structured

investment vehicles (SIVs), because o concerns about thepotential damage to their reputation and to their uture

ability to sell investments in such vehicles i they ailed to

provide support during the period o market distress6.

The overall aim o managing reputational risk should be

to close the gap between the stakeholders’ expectations

and the true perormance o the organisation. Indeed,

reputation is at risk as soon as expectations exceed reality.

Should an organisation identiy an expectations gap, it

needs to either lower expectations (through communica-

tion) or increase perormance (through operat ions).

Preparing or the worst: developing a crisis response

strategy

Evidently, no matter how well-developed the risk mitiga-

tion tools in place (crisis prevention), no rm can ully

avoid being exposed to reputational risk events. This

leads us to the importance o crisis management, aimed

at minimising the damage caused by such events. Being

able to respond eectively to crisis events is likely to prove

to be a much more ecient means o mitigating reputa-

tional damage than (just) setting aside capital. Thereore,

it is best practice or rms to develop a crisis response

strategy. Such a strategy would typically include at leas t

the ollowing elements:

• Identifyacrisisresponseteamwitheveryone'sroles

and responsibilities clearly dened

• Preparedraftversionsofinternalandexternalcom-

munications with all key stakeholders

• Ensurefastaccesstorelevantdatathatthecrisis

response team will need to make its decisions

• Simulatecrisesinordertotestthecrisismanagement

plans

This last point is oten overlooked. Having a crisis man-

agement plan is a good rst step, but it will only become

useul once it is tested through simulation exercises.

Simulating a crisis enables errors to be identied and

addressed and lessons to be learned. Unortunately, crises

will rarely happen as envisioned during the simulations.

Thereore, the crisis management plan should be fexible,

and the people in charge o e xecuting the plan must have

the ability to adapt accordingly.

Conclusion

Whilst many organisations are aware o the import anceo reputational risk management, only ew have imple-

mented a true reputational risk management ramework.

The main challenge is recognising the need or a ocused

approach, and giving one person the responsibility to

execute this. I done properly, the bene ts will ar 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“RiskManagementandOtherCorporateIssues”,IssuesPaper,CEIOPS,17July2007

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

4GuidelinesontheApplicationoftheSupervisoryReviewProcessunderPillar2(CP03Revised),CommitteeofEuropeanBankingSupervisors , 25 January 2006

5 “Measuring Reputational Risk: The Market Reaction toOperationalLossAnnouncements”,JasonPerryandPatrickDe

Fontnouvelle, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=861364&rec=1&srcabs=967313

6“ObservationsonRiskManagementPracticesDuringtheRecentMarket Turbulence”, Senior Supervisors Group, March 6, 2008,available at http://www.newyorked.org/newsevents/news/bank-ing/2008/ssg_risk_mgt_doc_nal.pd

About the authors

Dr.FrankDeJongheisPartneratDeloitteE

Belgium. Mathias Christiaens is Manager at

ERS, Belgium.



4

FSI magazine | #5

Solvency II:

Dealing with operational riskHistorically, insurers have ocused on understanding and managingnvestment and underwriting risk. However, recent developmentsn operational risk management, guidelines by the rating agenciesand the orthcoming Solvency II regime increase insurers’ ocuson operational risk. Insurers consequently have to decide on theirapproach to managing operational risk.

y Jürgen van Grinsvennd Remco Bloemkolk

Underwriting Risk

Investment Risk

Credit Risk

Liquidity Risk

Operational Risk Implementation Contol Disclosure

Pillar 1

Minimum Standards

(Quantitative

requirements)

Pillar 2

Supervisor Review

(Quantitative

requirements)

Pillar 3

Market Discipline

(Disclosure &

Transparency

requirements)

Solvency II

gure 1: Solvency II ramework

The Solvency II ramework consists o

three pillars, each covering a dierent

aspect o the economic risks acing

insurers (see gure 1). This three-pillar

approach aims to align risk measure-

ment and risk management. The rst

pillar relates to the quantitative requirement or insur-

ers to understand the nature o their risk exposure. As

such, insurers need to hold sucient 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 or the governance and risk manage-

ment o insurers. The third pillar ocuses on disclosure

and transparency requirements by seeking to harmonise

reporting and provide insight into insurers’ risk and return

proles.

Solvency II (SII) is the updated set o regulatory require-

ments or insurance companies operating in the European

Union. It revises the existing capital adequacy regime and

is expected to come into orce in 2012. It has a number

o expected benets, both or insurers and consumers.

Although the most obvious benet seems to be prevent-

ing catastrophic losses, other less obvious benets which

are considered to be important are summarised in table 1.

Table 1: Solvency II expected benets

Insurer Consumer

Reduced losses suered bypolicyholders

Reduced risk o ailure ordeault by an insurer

Enables internal risk and

capital assessment models

Reduced costs o insur-

ance and investmentcontracts

Reduced costs andincreased fexibility

Broader range oproducts

Increased condence inthe nancial stability o theinsurer

Better match betweenproducts and individualrequirements

Providessupervisorswithearly warning so that theycan intervene promptlyi capital alls below therequired level

These expected benets make SII an increasingly impor-

tant issue or insurers. Not surprisingly, solvency has

evolved into an academic discipline o its own and much

o 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 o di-

culties and challenges in operational risk beore they can

utilise these expected benets.

The importance o operational risk in Solvency II

Over the past ew decades many insurers have capitalised

on the market and have developed new business services

or their clients. On the other hand, the operational risk

that these insurers ace have become more complex,

more potentially devastating and more dicult to antici-

pate. Although operational risk is possibly the largest

threat to the solvency o insurers, it is a relatively new risk

category or them. It has been identied as a separate risk

category in Solvency II. Operational risk is dened as the

capital charge or ‘the risk o loss arising rom inadequate

or ailed internal processes, people, systems or external

events’. This denition is based on the underlying causes

o such risks and seeks to identiy why an operational

risk loss happened, see gure 2. It also indicates that

operational risk losses result rom complex and non-linear

interactions between risk and business processes.

Figure 2: Dimensions o operational risk

Several studies in dierent countries have attributed insur-

ance company ailure to under-reserving, under-pricing,

under-supervised delegating o underwriting authority,

rapid expansion into unamiliar markets, reckless

Processes

People

Event Loss

Systems

External events



6

FSI magazine | #5

management, abuse o reinsurance, shortcomings in inter-

nal controls and a lack o segregation o duties. See the

examples below. Unbundling operational risk rom other

risk types in risk management and risk measurement can

help prevent uture ailures. This holds true or smaller and

larger losses. Oten, larger losses are the cumulative eect

o a number o smaller losses. In other words, the result

o the bad practices that fo urish in excellent economic

circumstances, when the main ocus is on managing the

business rather than operational risks.

Examples o insurance company ailure

Insurance company ailures in which operational risk

played a signicant role include:

• Thenear-collapseofEquitableLifeInsuranceSociety

intheUK,whichresultedfromofacultureofmanipu-

lation and concealment, where the insurer ailed to

communicate details o its nances to policyholders or

regulators.

• ThefailureofHIHInsurance,whichresultedfrom

the dissemination o alse inormation, money being

obtained by alse or misleading statement s and inten-

tional dishonesty.

• AmericanInternationalGroup(AIG)andMarsh,

where the CEOs were orced rom oce ollowing

allegations o 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 o

unit-linked insurance policies or the lack o 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 o operational risk

categories and insurer exposure.

Given the high-prole events, insurers need to be increas-

ingly aware o the commercial signicance o operational

risk. The orthcoming Solvency II regime will present a

number o diculties and challenges or the o perational

risk management activities o insurers.

Diculties and challenges in insurers’ operational risk

management

Insurers have not historically gathered operational risk

data across their range o activities. As a result, the major

diculties and challenges that insurers ace are closely

related to the identication and estimation o the level o

exposure to operational risk. A distinction can be made

between internal and external loss data, risk sel-assess-

ment, supporting techniques, tools and governance. See

table 3 or an overview.

Loss data orm the basis or me asuring operational risk.

Although internal loss data are considered the mos timportant source o inormation, they are ge nerally insu-

cient because o a lack and the oten poor quality o

such data. Insurers can overcome these problems by sup-

plementing their internal loss data with external loss data

rom consortia such as ORX and ORIC. However, using

external loss data raises a number o methodological

issues, including the problems o reliability, consistency

and aggregation. Insurers consequently need to develop

documentation and improve the quality o their data and

data-gathering techniques.

Table 2: Operational risk categories and insurer

exposure

Operational risk category Example o insurerexposure

Internal raud Employee thet, claimabrication

External raud Claim raud, alsiyingapplication inormation

Employment practices andworkplace saety

Repetitive stress,discrimination

Clients, products and busi-ness practices

Client privacy, bad aith,redlining

Damage to physical assets Physicaldamagetoownoce, own automobilefeets

Business disruption and sys-tem ailures

Processingcentredowntime, systeminterruptions

Table 3: Diculties and challenges concerning operational risk at insurers

Loss data Risk sel-assessment Techniques, togovernance

Lack o internal loss data Risk sel-assessment processis labour-intensive

Biases o intervare not underst

Quality o internal loss data Static view o risk sel-

assessments

Chasing chang

dataApplicability o internal lossdata

Inconsistent use o risk sel-assessments

Techniques andare not shared insurance rm

Aggregation o internal lossdata

Qua lit y o results Te chnique s havt with tools

Reliability o external lossdata

Subjecti vi ty o resul ts Coordinat ion odata volumes

Consistency o external lossdata

Assessments are onlyrereshed annually

Linkage betweetative approachscenario analys

Applicability o external lossdata

Approaches tend to ocus onexpected losses

Governance o department vearial departmen

Aggregation o external lossdata

Low-requency, high-impactassessments can be arbitrary,resulting in signicant overor understatement o sol-vency and economic capitalrequirements.

Keyriskindicatnot link back toactors identie

Risk sel-assessment (scenario analysis) can be an

extremely useul way to overcome the problems o inter-

nal and external loss data. It can be used in situations in

which it is impossible to construct a probability distribu-

tion, whether or reasons o cost or because o technical

diculties, internal and external data issues, regulatory

requirements or the uniqueness o a situation. It also

enables insurers to capture risks that re late, or 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 oten too complex,

not used consistently throughout a group and do not t ake

adequate account o the insurer’s strategic direction, busi-

ness environment and appetite or risk.

The techniques and tools that insurers use to support risk

sel-assessments are oten ineective, inecient and not

successully implemented. Research indicates that 19.5%

o current practices are oten not shared within the group,

while 22% o respondents are dissatised and 11% very

dissatised with the quality o their inormation technol-

ogy support services. Another question that can be raised

is the governance o risk management. H ow, or example,

are the risk and actuarial departments aligned?

Conclusions

In this article we discussed operational risk in the context

o Solvency II. Operational risk is possibly the largest

threat to insurers. This is because operational risk losses

result rom complex and non-linear interactions between

risk and business processes. Unbundling operational risk

rom the other types o risk in risk management and risk

measurement can help prevent uture ailures or insurers.

SII is on track to put greater emphasis on the link betweenrisk management and risk measurement o operational

risk. We have addressed the most important diculties

and challenges in operational risk management: loss data,

risk management, tools, techniques and governance.

Those insurers able to ensure an eective response to

these major diculties and challenges are expected to

achieve a signicant competitive advantage.

About the authors

Dr. ing. Jürgen H.M. van Grinsven is director

Deloitte Enterprise Risk Services and author

books Improving Operational Risk Managem

Risk Management in Financial Institutions.

Drs. Remco Bloemkolk works at ING corpora

management.PriortojoiningINGhework

ReandErnst&Young.RemcoBloemkolkh

this article in a personal capacit y.

Operational risk mayrepresent the greatestthreat to insurers



8

FSI magazine | #5

Driven by stakeholder demands or transparent riskmanagement, nancial institutions are increasinglyhaving to work with a balanced Tax ControlFramework. The benets o such a rameworkare obvious: risks are identied promptly andopportunities are made use o more rapidly, whilethe tax unction also becomes more eectivelyrooted in the organisation.

inancial institutions seeking greater efciency and insight in tax unction

Towards a moretransparent tax position

y Caroline Zegers and

obbert Hoyng

Over the past ew years, nancial

institutions across the world have

become increasingly interested

in the issues o 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 o

IFRS, has resulted in European company directors wanting

and having to establish a more in-depth understanding o

the money fowing through their organisations. And this

also means ensuring a proper understanding o tax pay-

ments, both in terms o the risks and the opportunities

they create.

Horizontal monitoring

This trend o gaining a greater understanding o c ash

fows is refected in the changing attitudes o stakeholders

such as shareholders, tax authorities and CFOs. They, too,

are increasingly ocusing on nancial institutions’ internal

risk management and control processes. A good example

o what this can result in is the D utch Tax and Customs

Administration’s decision a ew years ago to introduce

'horizontal monitoring'. The traditional approach, where

inspectors ocused primarily on tax inormation in t he

returns, is now rmly in the past, with the tax authorities

switching rom control based on an absence o trust to

monitoring through trust. The term “horizontalisation”

illustrates that the government, and thereore also the

Tax and Customs Administration, is no longer seeking to

position itsel 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' o their tax aairs.

In other European countries, too, we have seen tax

authorities moving in this direction. The Netherlands and

UnitedKingdomareleadingthewayinintroducingthe

TCF, while other European tax authorities are currently

working on such rameworks or similar ones. The various

countries’ tax authorities get together every two years to

discuss tax risk management in the O ECD Forum on Tax

Administration. The most recent meeting, held in January

2008 in Cape Town, culminated in the orty participants

issuing a communiqué emphasising the crucial importance

o risk management processes, o senior and ex

management taking a greater interest in their co

tax strategies and o the need to extend regulat

ing tax strategy and good corporate governance

Risks create opportunities

However, it is not only external stakeholders wh

pushing or more transparent risk management.

we have seen a gradual change in at titudes to ta

management within the nancial institutions the

sincearoundtheturnofthecentury.Previously,

institutions thought o tax risks in terms o the r

paying too much tax, or the risk o nes as a res

non-compliance. Now, however, they are increa

aware that tax risk management actually means

optimising and planning tax-related opportunitie

issue o social responsibility is also important. In

UnitedKingdom,forexample,itisnowperfect

to publish inormation on which sectors pay mo

(three-quartersoftotalUKcorporatetaxrevenu

attributable to nancial institutions and the oil in

Given the importance o proper management o

and the extensive range o risk s (see box 1) to w

nancial institutions may be exposed, it is recom

classiying these risks in a risk portolio. One wa

this is to use a transparent tool such as the tax d

web (see gure 1), which helps nancial instituti

visualise their risks and the extent to which they

wish to be exposed.

Each TCF is tailor-made

What do these developments mean or nancial

tions’ management? Managers need to monitorcontinually and to conrm in an 'in control state

that they are managing the processes within the

organisations properly, including those relating t

Implementing an Internal Control Framework (IC

describe how all the business processes are man

very important in this respect. And one vital elem

this is the Tax Control Framework, which ocuse

nal control o tax processes. The orm o such a

depend on the nancial institution’s size and com

Each TCF is tailor-made and based on the need t

organisations and, thereore, their stakeholders

The Netherlands andthe United Kingdomare leading the way inintroducing the TaxControl Framework



0

FSI magazine | #5

ongoing and up-to-date view o the tax position. The

Dutch Tax and Customs Administration does not stipulate

any specic model or the TCF, but does provide guide-

lines. These are designed to ensure proper insight into the

structure chosen or the TCF so that the Tax and Customs

Administration can determine whether the ramework is

equal to the task o providing the required degree o reli-

able inormation. This results in greater eciency as the

Tax and Customs Administration no longer has to check

all the inormation provided. All it has to do is analyse and

evaluate the TCF. This means the nancial institution’s tax

position can be established quickly and accurately, which

in turn avoids unpleasant surprises or other stakeholde rs.

TCF building blocks

These developments mean that major changes in nancial

institutions’ tax unction are inevitable. Institutions will,

or example, be under increasing pressure to establish

a TCF. And this ramework will have to meet certain

general requirements. The rst building block involvesestablishing the tax strategy, which will be b ased on the

business strategy. In other words, what the organisation

is seeking to achieve. This in turn should result in a series

o objectives being set or the chosen tax strategy. These

objectives will vary rom business to business. They do not

only involve hard parameters such as cash fows o r prots,

but also issues such as integrity and the degree o socially

responsible entrepreneurship as, since the start o the

credit crisis, the corporate reputations o nancial institu-

tions have become more crucial than ever.

A second building block in each TCF is 'Tax Operations

&Risk'.Inotherwords,understandingallthebusiness

processes that interace with the tax unction and then

dening 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 de cision-making proc-

esses, while also providing insight into risks and mak ing

them quantiable.

ThethirdTCFelementis'TaxAccounting&Reporting'.In

other words, recording the tax position in the organisa-

tion’s administration and correctly accounting or it in

quarterly and annual reports.

The ourth and nal building block is 'Tax Compliance',

which involves detailing how and where the nancial

institution obtains its tax inormation. Financial institu-

tions can support these compliance activities via an

electronic platorm that transers inormation rom their

annual nancial statements to their tax re turns. This in

turn signicantly reduces their margin o error.

Internal integration o tax unction

In view o these developments, tax risk management

should be high on nancial institutions’ management

priorities. A comprehensive understanding o risks and

opportunities is essential i 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 o the importance o man-

aging tax risks, many nancial institutions’ energies are

still being consumed by day-to-day concerns. They eitherail to involve their tax directors or involve them too lit-

tle in relevant business processes. All too oten, the tax

department is still seen as a separate department ocusing

primarily on completing tax returns and reducing the t ax

burden. Stakeholders, however, want nancial institutions

also to be 'in control' o their tax position and expect tax

departments to be involved in rele vant business proc-

esses. And indeed this is also the basis o good tax risk

management: making sure that tax management is inte-

grated, wherever possible, into the other unctions and

processes within the organisation. Just as tax departments

gure 1: The tax risk decision web

these days also have to be close ly involved in developing

and launching new nancial products, given the possible

tax consequences that these products may have.

Create involvement and insight

Propertaxriskmanagementgenerallydemandsafar

more pro-active approach rom nancial institutions’ CFOs

and tax directors, and that is obviously not always easy

to achieve. Where do you start? The rst step is to get

together around a table to create greater involvement and

understanding o the tax unction. 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, or example, rom imple-

mentinganSAPsystemtoHR’sreimbursingofexpenses.

There are oten ar more aspects involved than might be

expected, certainly in nancial institutions. Just think o

the major write-downs that are being seen on so many

nancial instruments. Once the processes have been ana-

lysed, it is time to prepare an action plan outlining how

to improve the way the tax unction is integrated into the

business and business processes.

These are the rst steps in the process o establishing

an inormative and customised TCF constituting part o

a solid tax risk management system. The benets are

obvious: satised stakeholders (tax authorities, sharehold-

ers, CFOs) and greater eciency in and understanding

o the tax unction. And the n there is the issue o cost.

Establishing a TCF will certainly take a considerable

amount o time. The question that each nancial institu-

tion has to answer or itsel is whether and, i so, to what

extent tax expertise should be brought in rom outside.

The long-term benets o a TCF are evident: risks are iden-tied promptly and opportunities are made use o more

rapidly, while the tax unction also becomes more eec-

tively rooted in the organisation.

Box 1: Risks or nancial institutions

Key risk areas

• Operationaltaxplanning,strategictax

• Compliance:processandpositions

• Legislation:governanceandbudgets

• Deals:corporateeventsandmajortrans

• Corporatestructure:internationaltaxp

• Operations:day-to-dayprocessesandm

ment decisions

Specic risks include:

• Upside/downsideofexternalnancing

ments or use o nancing instruments im

on tax or interering with group t ax plan

• Taxexposureandmissedopportunities

ing rom insucient interdepartmental

communication

• Incorrectlyimplementedtaxplanning

• Unexpectedtaxcostsormissedopport

resulting rom inconsistencies between

cial divisions’ and tax department’s goal

• Environmentalchangesthreateningtax

sustainability

• Taxinefcienciesresultingfromlowap

risk or inadequate resources

• Lackofinvolvementorlateinvolvemen

product development

• Localtaxissuesoverseas

• WHTerrorsordeemedroyaltiesarising

lectual property rights in contracts

• Complexityofgroupstructurehavinga

impact on tax management• InadvertentcreationofCFCsorsubpart

income; ailure to meet CFC exemptions

• Uncertaintyandresourceimplicationsa

rom accounting and regulatory change

• Incorrecttaxcalculationsattributableto

sheet errors

• Failuretoperformcomplianceprocess

(refected, or example, in late returns)

• Taxlawandenvironmentalchangesim

group tax prole

Major changes infnancial institutions’tax unction areinevitable

About the authors

CarolineZegersisLeadPartnerFSITaxandRobbert

Hoyng is an expert on tax strategy and Tax Control

Framework or Deloitte Netherlands.



2

FSI magazine | #5

Never beore has the IASB moved so switly to issue anamendment to a standard as it did last October. However,although the amendments announced will certainly havea material impact on nancial statements, the debate onpresenting nancial instruments is still ar rom over.

mendments to IAS 39 and IFRS 7 – Reclassifcation o fnancial assets

Unprecedented actionby IASB

y Carl Verhostede

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 ollowed on 24

October by some clariying guidance on the eective

date o the amendments and tra nsitional provisions. This

guidance was subsequently incorporated in an additional

amendment dated 27 November 2008.

These amendments were a response to calls rom constit-

uents, particularly within the European Union, to create

alevelplayingeldwithUSGAAPregardingtheability

to reclassiy nancial assets, primarily out o categories

where air value is applicable. In the general context o

the current nancial crisis, the IASB acted with unprec-

edented switness, and or the rst time an amendment

to a standard was issued without due process (but with

the consent o the IASCF trustees).

The changes to IAS 39 allow an entity to reclassiy non-

derivative nancial assets out o the air value through

protorloss(FVTPL)andavailableforsale(AFS)catego-

ries in certain limited circumstances. Such reclassications

require extensive additional disclosures under IFRS 7 to

permit users to understand the nancial statements had

the entity not reclassied.

As the amendments are eective as o 1 July 2008, sev-

eral nancial institutions in Europe started applying them

rom the third quarter o 2008.

Impact o classication on measurement

For a better understanding o the signicance o these

amendments, it has to be appreciated how important the

classication o a nancial asset (investments in loans,

bank deposits, bonds, equity shares and the like) is or its

measurement in the nancial statements (balance sheet

and income statement). Financial assets can be classied

in our basic categories:

• Atfairvaluethroughprotorloss(FVTPL)

• LoansandReceivables(L&R)

• HeldtoMaturity(HTM)

• AvailableforSale(AFS).

Commerzbank reclassi-ed €44 billion o bondsrom AFS to L&R, whileDeutsche Bank trans-erred €12.8 billion otrading assets and €12.1billion o AFS assets toL&R

The rules or attributing a nancial asset to any

categories at initial recognition are quite comple

partially based on:

• intent(forexample,assetsusedintradinga

tiesareHeldforTrading(HFT)andfallunde

classication);

• speciccharacteristicsoftheassets(equity

example,canneverbeclassiedasL&Ror

• adeliberateclassicationchoicemadebyth

when the asset is rst recognised in the bala

sheet (examples include the Fair Value Optio

voluntaryclassicationasFVTPLispossible

conditions are met, or classication as AFS,

is available or every type o non-derivative

asset that is not held or tra ding purposes, e

classication in another category would be a

LoansandReceivables(L&R)arenancialassets

(or example, xed interest) or determinable (or

foating rate interest) payments that are not quo

active market, do not qualiy as “trading” assets

notbeendesignatedasFVTPLorAFS.Typicale

would be a term deposit with a bank, a trade re

or an investment in a non-quoted corporate bon

Held to Maturity (HTM) investments are nancia

with xed or determinable payments and xed m

otherthanL&R,forwhichthereisapositiveint

and ability to hold to maturity and which have n

designatedasFVTPLorAFS.Aninvestmentina

bondwouldtypicallybebarredfromclassicati

but could be classied as HTM i the entity dem

a positive intent and ability to hold t he investme

matures.

Beore the amendment, a nancial asset classie

FVTPLatrstrecognitioninthebalancesheetc

be reclassied out o that category. This applied

there was no longer an active market or the ass

trading the asset had de acto become impossib

Similarly, initial classication in the AFS category

not be changed at a later date, with only a very

and limited exception or certain assets that are

maturity (HTM).



4

FSI magazine | #5

The measurement o a nancial asset depends on its

classication:

• FinancialassetsatFairValueThroughProtorLoss

(FVTPL)aremeasured,asthedesignationimplies,at

their air value on each closing date, and all changes

in air value are immediately recognised in prot o r

loss.

• LoansandReceivables(L&R)andHeldtoMaturity

(HTM) investments are measured at amortised cost

(that is, basically at cost, but recognising interest

income on the basis o the eective interest method,

which can lead to the dierence between the ini-

tial cost and maturity amount being amortised by a

regular adjustment to the carrying value o the asset).

Any impairment loss (discussed below) is recognised

immediately in prot or loss.

• AvailableforSale(AFS)nancialassetsaremeasured

at air value in the balance sheet at each clos-

ingdate(asforFVTPLassets),butchangesinfair

value are temporarily recognised in equity (Other

Comprehensive Income – OCI) and recycled to prot

or loss only when the asset is realised (i.e. sold or

repaid). Nevertheless, eective interest income is

always recognised directly in prot or loss on interest-

bearing debt instruments. Any impairment loss

(discussed below) on debt or equity instruments is

also recognised immediately in prot or loss.

All nancial assets have to be assessed or impairment.

Under IFRS, this is a two-step process. The rst step

consists o establishing whether an impairment loss has

occurred: the entity has to assess whether there is any

objective evidence that the nancial asset is impaired. This

requires identication o any 'loss event' that will have animpact on the estimated uture cash fows o the asset

that can be reliably measured (indicating that the original

investment will not be ully recovered). I such a loss event

is identied, the second step is to determine the precise

amount o the impairment loss.

The calculation o an impairment loss varies, depending

on the categories o nancial assets:

• FVTPLassetsdonotrequireseparaterecognitionof

an impairment loss as this loss will already be included

in the air value. But air value also includes other ele-

ments, such as the impact o any intervening changes

in interest rates and changes in market expectations

o uture losses (refected in market credit spreads and

liquidity premiums).

• ForL&RandHTMinvestments(carriedatamortised

cost), the impairment loss will be based on a calcula-

tion o the present value o the estimated uture cash

fows – excluding uture credit losses that have not

been incurred – discounted at the asset ’s original

eective interest rate. This means that the calculation

is not impacted by changes in market interest rates,

including credit spreads and other market actors,

occurring since the asset was rst acquired.

• ForAFSassets(carriedatfairvalueinthebalance

sheet), the ull amount o unrealised losses based on

the current air value should be recognised in prot

or loss immediately. That is, all amounts pre viously

recognised in OCI should be transerred to prot or

loss. All subsequent decreases in air value are consid-

ered to be impairments and will impact on prot or

loss (and not equity only) or the ull 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 o dierent impairment models means

that, or AFS debt instruments, income is recognised in

prot or loss on the basis o (historical) amortised cost, in

linewithL&RandHTMassets.Once,however,thevalue

o the asset becomes impaired, impairment losses are rec-

ognised using a method that refects not only the impact

o the cash fows estimated to be lost – as in the case

ofL&RandHTMassets–butalsotheeffectofchangedmarket actors on the present value o the cash fows still

expectedtobereceived–asinthecaseofFVTPLassets.

Inotherwords,reclassicationsoutoftheFVTPLand

AFS categories, as the modied text allows, will have an

impact on day-to-day income recognition o non-prob-

lematicnancialassets(foralltransfersoutofFVTPL),as

well as on the precise amount o loss taken at the report-

ing date or nancial assets where an entity does not

expect to ully recover its original investment (or transers

outofFVTPLorAFSintoL&RorHTM).

Transers out o FVTPL and AFS categories allowed by

IAS 39 amendments

Asstatedabove,transfersoutoftheFVTPLcategorywere

prohibited beore these amendments, while transers out

o the AFS category were allowed only in certain specic

circumstances and or certain assets, providing the very

strict conditions or classiying them into the HTM cat-

egory were met. No other transers were permitted.

TransfersoutoftheFVTPLcategoryarestillnotallowed

or derivatives (such as orward contracts, swaps and

options) and nancial assets that were voluntarily clas-

siedasFVTPLwhenrstrecognised(applyingthe'Fair

Value Option'). This leaves only non-derivative nancial

assets Held or Trading (HFT) as potential candidates or

transferoutoftheFVTPLcategory.

FinancialassetscanonlybereclassiedoutofFVTPL

or AFS i they meet specic criteria. These criteria vary

depending on whether the asset would have met the

denitionofL&RhaditnotbeenclassiedasFVTPLor

AFS at initial recognition.

A debt instrument classied as HFT at initial recogni-

tionmaybereclassiedoutofFVTPLiftheassetisnot

intended to be sold in the near term, providing it meets

thedenitionofL&Randtheentityhastheintentionand

ability to hold the asset or the oreseeable uture or until

maturity.

A debt instrument designated as AFS at initial recognition

maybereclassiedtoL&RifitmeetsthedenitionofL&R

and the entity has the intention and ability to hold the

nancial asset or the oreseeable uture or until maturity.

Any other debt instrument, or any equity instrument,

maybereclassiedfromFVTPLtoAFSor,inthecaseof

debtinstruments,fromFVTPLtoHTMifthenancial

asset is no longer held or the purposes o 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 o 2008 were a

possible example o a 'rare' circumstance.

Sir David Tweed

man o the Inte

Accounting Sta

Board (IASB).



6

FSI magazine | #5

All reclassications must be made at the air value o the

nancialassetatthedateofreclassication.Previously

recognised gains or losses cannot be reversed. The air

value at the date o reclassication becomes the new cost

or amortised cost o the nancial asset, as applicable.

The existing requirements in IAS 39 or measuring

nancial assets at cost or amortised cost apply rom the

reclassication date.

For reclassications out o AFS, IAS 39 requires the

amounts previously recognised in other comprehensive

income (OCI) to be reclassied to prot or loss either

through the eective interest rate (i the instrument has

a maturity date) or on disposal (i the instrument has no

maturity date, i.e. it is perpetual). Amounts deerred in

OCI may also need to be reclassied to prot or loss in the

event o impairment.

When do reclassications take eect?

Reclassications made beore 1 November 2008 could

take eect 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,

or example, have chosen 1 August as the reclassication

date in order to align with its quarterly reporting. Equally,

an entity’s intent to hold assets or trading purposes may

have changed part-way through a period or dierent

loans, say 5 September and 25 September, as a result o

specic events on those dates. An entity could reclassiy

at various dates, providing the criteria are met and evi-

dence is available regarding the change o intent.

Reclassications made on or ater 1 November 2008,

however, are eective rom the date o reclassication.In other words, on a real-time basis, with no backdating

allowed.

What happens in practice?

What does this mean or those trying to understand the

nancial statements o an entity applying the amend-

ments? Several nancial institutions in Europe applied

the IAS 39 amendment in the third quarter o 2008.

Commerzbank, or example, reclassied €44 billion o

bondsfromAFStoL&R,whileDeutscheBanktransferred

€12.8 billion o trading assets and €12.1 billion o AFS

assetstoL&R.Morereclassicationswillfollowinthe

ourth quarter o 2008, and probably additional transers

later still. Deutsche Bank disclosed that, ‘I the reclassi-

cation had not been made, the Group’s income statement

or the third quarter o 2008 would have included unre-

alised air value losses on the reclassied trading assets

o €726 million and additional impairment o €119 million

on the reclassied nancial assets available or sale which

were impaired. For the third quarter o 2008 sharehold-

ers’ equity (position net gains (losses) not recognised in

the income statement) would have included €649 million

o unrealised air value losses on the reclassied nancial

assets available or sale which were not impaired.’

These amendments will clearly have a material impact on

reported realised losses and on the equity o some enti-

ties. Nevertheless, readers o nancial statements should

be able, on the basis o the disclosures, to adjust the

statements to what they would have been i the assets

had not been reclassied. Time will tell whether this is

good or bad.

In the meantime, the European Commission has asked

the IASB to consider allowing the reclassication o

nancialassetsclassiedasFVTPLundertheFairValue

Option on the same conditions as HFT assets, and also

to consider adjustments to the impairment r ules or AFS

assets. In other words, to allow reversals o impairments

on AFS equity instruments through prot or loss, as in

the case o debt instruments, and to limit the impairment

intheincomestatementtocreditlossesonly(asforL&R

assets), while keeping the remaining changes in air value

in equity. So the debate will continue or some time to

come, and we can consider whether e ven a radical revi-sion o the standards will in the near uture be able to

resolve the question o what is the proper way to present

nancial instruments in the balance sheet, income state-

ment and notes to the nancial statements.

About the author

Carl Verhostede is a Director o Deloitte Enterprise

Risk Services, Belgium

i i I i i i i i l

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