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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
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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
4
6
12
17
18
22
24
30
34
38
43
48
54
58
62
34
24
6
38
48
I i i l i li i
i i l i I . I -
i i li i
i i i ll i l i i
l l i L
l .
l i i i l i I
i L l
:
- il: l l l i . l
i : . l i . I i
I i i I i
l i i i li i - il
I i l i . l. l ll i
i i : i i i l i i i l l l l
i i i i l -
- il .
l i i
I i l i . l.
illi l - i l
l ill ll ll
i i l L ll
l -
- -
l i
l i
l l i
l li i
l
L
I i
l i
i l i
i
l l i ll
i i li i i
li l i i i
i l i
l i
i l li
i li i
L
l
L
:
:
i : . l i . l
i i l i I
- il : I i l i . li i i l . i i i
. l i . I i l
i .
l i il . ll i .
l i r r r r l i i r i , i r r , ir r i li . i r i i i , i r l
r i r r li ilir i i . r r i
l l i r i r “,” “ l i ,” r r r l
r i r r i r r r ir li l i
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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
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
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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
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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
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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’
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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
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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.
38% o personal and 41% o business customers in
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
50% o personal and 39% o business customers in
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
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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
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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).
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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.
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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
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.
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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
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This article is based on a study recently conducted by
Nyenrode Business University’s Europe China Institute and
Smorenberg Corporate Consultancy (see box). The study
shows that the trends 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
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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.
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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
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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
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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.
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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.
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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
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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,
gure 1: Overview o recent EU regulations
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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.
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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.
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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
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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
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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
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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.
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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
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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
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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
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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.
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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).
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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).
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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
i i i i
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