Thursday, December 23, 2010
When the generation of my parents opened an account with a bank, they were looking for a long-term relationship. Key factors for deciding which bank fits best were trust, the branch network, i.e. branches close to home and the size of the bank because that meant the bank had to be of great renown. Customers were loyal to their chosen bank. They usually did not close their accounts to move to a different financial institution, they sticked with their bank a whole lifetime.
The product portfolio a bank could offer differed at that time as well. Structured finance and complex derivatives were not introduced to the market or at least not considered as a valid option for the majority of private clients. That was also partly caused by the strict distinction between retail and investment banking in most countries.
The internet as well as the globalization and deregulation of the financial sector changed that situation fundamentally. The ability to collect immense volumes of information, enabling the individual customer to compare different financial products, analyze benchmarks without having to contact a financial councilor, doing online banking without talking to a bank clerk, revolutionized the banking business. Customers are not longer dependent on their bank; the relationship strings are loose and can lead to higher churn rates.
Generally, customers are satisfied when purchased products or services agreed upon fulfill their expectations. Nowadays, that does not necessarily lead to the conclusion of customer retention. That is one of the biggest challenges of the financial industry, especially of online banks.
According to a recent study of the (German) Gallup-Institute in autumn 2009, 65% of retail banking customers do not feel bound to their bank, only 14% are loyal and 21% consider themselves as bound to their financial institute but not loyal. These numbers are even worse for direct banks, since their customers are only interested in efficient service, low fees, fast transactions and the independency of opening hours. They normally do not need guidance from an advisor. This independence makes those customers volatile. As soon as another bank comes up with an allegedly attractive offer or lower fees, they consider moving away from their current bank.
It is therefore pretty tough for financial institutions to keep their profitable customers. That is the reason why banks are developing Churn Management or Customer Loyalty Systems respectively.
An example for such an initiative can be found at the German DAB (specialized on online banking). They started by analyzing the importance of customer loyalty on behalf of their executive board. Based on the results they determined alternatives for action, not just to identify likely churners but also to trigger loyalty campaigns.
In that context it is very important to achieve a common understanding of what loyalty means to the organization and how a bank can determine early in the process if a customer has a tendency of closing his accounts with the bank. Examples of wantaway customer scenarios are:
• Customers that alienate their cash and stocks completely and do not perform any transaction, at least for a segment-specific timeframe.
• Customers that reduce trading by a specified minimum percentage per defined period.
• Customers that reduce – with their own transactions – their total asset value more than a specified minimum amount.
• Customers that went inactive but were categorized in an active customer segment before
Once that understanding of a likely churner is established, the banks can analyze their customer information in their data warehouses, using business intelligence, do identify the risk of losing profitable customers. Each bank has usually thousands of different parameters that could play a role in that analysis.
Based on the historical information of each customer, an individual trend analysis can be established to show the development of each customer, his lifetime value. The marketing and sales team, who need to have a clear view of potential churn-threads in order to react quickly, can get a monthly dashboard showing the key performance indicators of each customer, like
• Customer Value (past performance and asset value)
• Performance Rating (based on thresholds and benchmarks)
• Risk of Churn (on a scale of 0 – 100)
• Customer Portfolio Development (trend, total assets, variance analysis, product split)
Prepared with this information in an easy consumable way, e.g. in dashboards that show the information in graphs, using traffic light indicators and other widgets to demonstrate the trends in a flexible manner (and maybe a more detailed overview of the customers’ portfolio), the sales department can trigger actions to retain their profitable customer base. Marketing can package specific incentives for their most valuable customers, knowing that simple fee reduction would not solve the underlying thread. The call centers will get a better feel for the importance of their customers and can prioritize the incoming requests. Last but not least, the management will get a tool that allows them to make better informed decisions regarding product strategy, customer relations and other strategic investments.
Coming back to the example of the DAB in Germany, they implemented such a loyalty system and are already seeing the positive impact such an analysis tool and management system has on their business and their customers. They expect to retain up to 30% of their customers with a high churn risk through to proper micro-campaigns based on the customer analysis provided.
Retaining 30% of your profitable customers that you normally would lose is quite an achievement and key to the success of a financial institution. You can make the math!
Friday, September 10, 2010
In practice, Basel II attempts to accomplish this by setting up rigorous risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices. Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability
Even though the European banks and most banks in the global markets have implemented the Basel II rules, analyzed the risk exposure and the value at risk, the financial crisis revealed that the capitalization and liquidity of many banks is not enough. Financial institutions like the Hypo Real Estate in Germany, RBS in UK or Fannie Mae in the US had to be saved by the governments because their reserves were not sufficient to cover for the credit losses and massive depreciations on toxic assets.
The main goal of the Basel committee is to prevent the next financial crisis. Hence the members of the committee came to an understanding (on September 7, 2010) to keep a tighter rein on the banks. Those new regulations will constitute the third accord of the Basel Committee on Banking Supervision, also known as BASEL III.
While the chairmen of the central banks and financial supervision organizations of 27 countries will have the final saying (they will meet on Sunday, September 12), the core elements of the new regulations are known:
- Minimum quotas for the Core-Tier-1 capital of publicly traded corporations which – according to the plans – in the future, will only consist of ordinary shares and revenue reserves.
- Special rules apply for savings, cooperative, and regional banks, which are not publicly traded corporations. Under certain criteria’s (e.g. profit-and-loss distribution) certificates and silent participations can be added to the Core-Tier-1.
- The required core capital ratio is expected to be 6%.
- In addition, BASEL III will probably dictate the installation of two capital buffers for financial distress, each in the amount of 2%. The Basel Committee suggests a leverage ratio of 3%. This means the balance sheet total can only be 33 times larger than the core capital, i.e. the raising capital is limited.
What does that mean for the financial institutions and the economy?
The banks have to hold out a capital reserve of 10% and can only raise limited amounts of capital in the market. To give you an example: for the top 10 German banks alone this means an increased demand of more than $ 130 billion. In addition, if the banks in Germany want to do their business to the current extend in the future, they need to increase their capital base considerably. If that does not work out, the granting of credits in Germany could decline dramatically, probably in the range of $ 1300 billion (according to the banking association). Therefore the Basel Committee wants to install the deficit limit only for a test. It will not become binding before 2018.
In any way, it will have a negative impact on the economic growth in Europe, the USA and other markets. The banks have to redesign/enhance their risk models and analyze their equity ratios and liquidity risk more closely.
Wednesday, August 4, 2010
What makes CoCo bonds so attractive?
Regulators and bankers are keen to avoid a repeat of the recent financial crisis, when existing forms of hybrid finance were shown to have serious failings. An inherent problem within banking finance is the risk of panic: when a bank needs to convert hybrid debt into equity, it sends a clear signal to investors that the bank is in trouble. These investors are then tempted to withdraw their investments, making the initial problem much worse. CoCo bonds are emerging as the most concrete new idea for solving these inherent problems, but many issues remain to be solved, not least how to define the trigger that causes the bonds to convert automatically.
CoCo bonds are debt instruments with the special feature that they will convert mandatorily in ordinary shares or similar instruments of the relevant issuer, mostly banks, when one or more triggers are met. Such a trigger could be for example reaching a certain threshold in the required capital ratio of the bank. In this aspect capital insurance bonds resemble more catastrophe bonds than convertible bonds. Hence they are also called Capital Insurance Bonds. However, as an emerging asset class there are still no clear market standards visible.
Holders of borrowed capital become regular stock holders, which increases the capital base of the institution. The investors are getting compensated for the risk of becoming a share holder at an unfavorable time through increased interest rates (in comparison to regular bonds).
The first CoCo bonds were issued by the partly government-owned Lloyds Banking Group in November 2009. If the capital ratio of Lloyds falls beneath 5%, the bonds (worth 10 bn Euro) will be swapped into shares. The Dutch Rabobank followed this example with the issuance of CoCo bonds in February 2010.
There is currently no further CoCo bonds issuance because the rating agencies are lacking confidence to evaluate the CoCo bonds due to the equity like character of the bonds. While the British Financial Services Authority (FSA) accepted those bonds as equity, the official announcement of the BASEL committee is still pending. The BASEL committee wants to declare in September 2010 if and in which form those CoCo bonds can be attributed to the equity of the financial institution. If that will be the case those bonds will most likely become extremely popular.
Wednesday, May 5, 2010
On the other hand, internet banking and online transactions are primarily used by the younger generation and are not generally accepted across all generations. The percentage of internet banking users in Germany may be higher than some of their neighbors (e.g. Belgium and Poland), but compared to countries like the UK, the USA or South Korea the customer behavior is still pretty conservative.
This may change with the iPhone.
71% of the Germans who have internet access also possess a web-enabled mobile phone. This is an increase of 14% in comparison with last year. The main driver behind this development is the iPhone. Even though a standard for representing online information already existed for about 10 years it was considered slow, inflexible, not user friendly, and costly. The market launch of the iPhone in 2007 brought relief by introducing the first intuitive usable mobile browser. In addition, the other barriers were removed, i.e. the telephone companies increased the data throughput significantly and developed affordable call charge models.
The introduction of the iPhone came along with a variety of applications in the iTunes store to enhance the functionality. Other vendors, like Google and Nokia, followed lately with similar smart phone concepts, broadening the spectrum. According to an article I read recently every fifth sold mobile phone in Germany is already a smart phone.
Anyhow, so far the mobile banking business did not capitalize on this development. In 2009 – referring to results of a recent survey from Steria Mummert Consulting – only 11% of the mobile internet users handled their banking transactions via mobile phones. The demand, however, is much higher. One out of three would like to use this kind of service but only a few financial institutions can fulfill their needs.
That does not mean that the financial services organizations will not jump on the bandwagon. The survey (conducted with banking executives) “Branchenkompass Kreditinstitute 2009” from Steria Mummert indicates that 42% of all German banks plan to invest in mobile banking (M-Banking) in the near future. 15% of the banks already provide some sort of mobile application but those applications are still very simple. They provide customers with guidance to the nearest branch office or a dictionary of contact persons.
While these applications may be useful, they do not use the potential of mobile intelligence. Why should a bank point their customers to the next branch when instead they can manage their transactions online? There are many M-Banking applications economically reasonable which can simplify the life of customers but also give banks an ideal vehicle to interact with them.
· Monthly Financial Statement (for free). The customer can check the settlement of his accounts
· Portfolio Analysis (maybe for free or for a fee). Customers will get a daily/weekly view of their investment portfolios
· Multi-Banking (chargeable offering). Management of multiple accounts of the customer,
including those outside of his house bank. This functionality could be very attractive to customers with multiple accounts in different banks, especially with those that do not offer smart phone apps yet. The only requirement: each bank need to support the HBCI-protocol for online banking.
· Marketing Campaigns. The bank can include actual product information as part of new applications, as long as the customer does not suppress this feature. This will not only improve customer loyalty but can also serve as sales vehicle.
These applications are already available in the market. Other M-Banking features that customers could benefit from and are accustomed to using online banking, have not reached market maturity yet, e.g.
· Management of Standing Orders
· Portfolio Management
· Personalized Stock Information Services
· Live News Ticker
The disposability of these applications will enable customers to react quicker and to use otherwise unproductive time more efficiently. By offering these apps the bank will generate added value for their customer base and will benefit through increased customer satisfaction and retention.
The developments in the mobile phone industry will continue. While the various applications mentioned above can be realized with current technology, the next level of smart phone innovations is already in the making, mobile phones as means of cashless payment.
The next generation of smart phones will – according to industry observers – contain a Radio Frequency Identification chip, short: RFID-chip. This technology allows a wireless data transmission on short distances, thus making the mobile phone a functional currency.
By now this technology is only implemented in a few mobile phones and rarely used. In contrast, being part of an iPhone and using the hype around it could mean a breakthrough for the technology. The debut of the next iPhone generation is expected in summer 2010. If the prevalence rate of the next iPhone is similar to prior generations or the current run on the iPad, banks have to be quick, reacting to these new market conditions in order to keep their customer base.
Because one thing is clear, not only banks and credit card companies target this market. New players will arise with attractive product packages, trying to get a piece of the pie. It is therefore mandatory for the financial services industry to be prepared if they do not want to lose their customers or at least a capital drain.
The main counter-argument of those banks not planning to invest yet in M-Banking: it is a low margin business. The usage of internet banking has a higher net value added (due to the required development effort for M-Banking) and even that technology is not widely used by the customers – as mentioned earlier.
However, business intelligence software like MicroStrategy already incorporates mobile functionality. In addition, more and more effort will be spend on enhancing the smart phone capabilities and providing banks with the right toolset for their business. As a consequence the development costs for the banks can be limited and furthermore, banks will be able to sell these new offerings to their customers (smart phone users are used to pay for qualitative apps), hence reducing their investment and maybe even build new attractive revenue streams.
Mobile banking services will be one of the keys to success of financial institutions and their customer relations in the future. Addressing customer needs is therefore one of the main objectives of mobile banking applications. That is not to say that there is no use for internal apps as well, the typical audience is just smaller. Here are some examples of possible mobile apps in financial services:
· Executive Dashboards. All relevant KPIs for the management available at a glance.
· 360 Degree Customer View. All relevant information of a customer (including product suggestions) directly send to the mobile device of the customer service field representative
· Wealth Management Dashboards. Actual information to manage the portfolio of wealthy customers.
· Risk Dashboard. The most important risk indicators (for the C-level management) to run the business.
· Internal News Updates. Possibility to communicate company news to the workforce.
To sum up, I can say that mobile banking will become more and more important to the financial services organizations, externally to communicate and interact with their customers, internally as a reporting vehicle to their management and employees. Even though I used Germany as an example these deliberations can be applied to the financial services industry as a whole.
Monday, May 3, 2010
The rate of these bonds as well as their solvency decreased significantly especially due to the downgrade of Greece (and later of Portugal and Spain) by the rating agencies and the following disturbances of the markets. According to the newspapers, a 10-years Greece bond of Greece which was noted in March 2010 with almost its denomination value, can at the end of April only find a purchaser with 82% of its repayment values.
Banks that were heavily involved in the government financing business own lots of these consols, like the now government owned Hypo Real Estate in Germany with 39 billion Euro. However, that does not mean that it has an immediate impact on the balance sheets of the banks (i.e. exposure of their equity ratio). It depends on a complex set of rules.
Is the bond part of the trading portfolio of the bank (those consols that are supposed to be traded on a short-term basis) then the volatility of the stock price will have an immediate effect on the profit and loss statement.
Financial services organizations also need to have a foundation of liquid assets. Since government bonds are usually considered to be sound investments – even from the PIIGS countries – they can often be found in the liquidity reserve to serve short-term payment obligations of the organization. The problem here is the same as with the trading portfolio, changes directly impact the P/L.
As a counter measure, to avoid the effect and to reduce the risk of negative impacts on the balance sheet, banks often moved these consols positions into different portfolios, as asset investments. With this trick the investments are labeled as long-term positions with the consequence that the bank can wait with adjustments of their financial statement till the government of the bond is unable to pay the interest or – as a measure of debt refunding – is reducing the repayment value of its debts (called haircut). But that scenario is not likely as the countries of the European Union are willing to help Greece with around 110 Billion Euro of instant loans.
The solvability and Basel II rules demand from financial institutions to hedge their security portfolio with equity in their balance sheet. If the securities rating are going from bad to worse, more and more equity is required as a safeguard. However, government bonds underlie special regulations. As long as the European banks follow the standard principles of capital adequacy, i.e. accessing only external ratings, they do not have to allocate any equity for consols coming from countries of the European Union!
While bonds issued by a company with the same rating as Greece at the moment would result in a requirement to reserve 8% equity on the balance sheet of the holding financial institution, none of this applies to the Greek bonds, under the premises of using standard external ratings. Larger banks, though, do not fully rely on external ratings; they consult in addition their own rating models and hence have to comply with different rules.
Some institutions have therefore most likely added more equity as a risk provisioning due to the lowering creditworthiness of Greece. Most others however, did not follow that path and appeal to the fact that companies that follow their own rating guidance in general can still assess parts of their portfolio according to external ratings. Allianz, the German insurance heavy-weight for example, has heavily invested in Piigs-bonds but still does not see a reason for depreciation, since none of them has defaulted yet.
What does that mean for the industry?
The European governments are trying to get voluntary support from the private banks to take on parts of the credit burden. The financial institutions have a lot of risk hidden in their balance sheets that is not hedged by equity reserves. That is why they may be willing to help the EU to some extent, but I doubt that they will accept taking on a large portion of the additional credit risk, they will leave that to the politicians.
Even though most financial services and insurance companies used the accounting standards to their advantage, avoiding additional equity reserves as risk mitigation for the unsafe consols, they are aware of the risk involved. This leads to additional reporting needs:
· Companies always differentiate between external and internal reporting to cater to the various stakeholders’ needs. The authorities are interested in a public view of the business according to the accounting standards, while the internal view gives the management a different overview based on other criteria.
· The principles for external reporting follow tax law and other regulations, like Basel II compliance. External reporting is therefore strict and formalized. The accounting tricks mentioned above are reflected in the external reporting.
· Internal reporting on the other hand is more flexible. Here the management can use the reporting for strategic purposes, for different views of the business (e.g. using an organizational structure to-be) and is not limited in the usage by regulations. The added risk of government bonds is taken into account and separately shown in the balance sheet. In addition, it is very likely that the executives want to see specific dashboards qualifying the impact of government bonds in terms of value at risk.
Tuesday, February 16, 2010
· Advanced Analysis & Ad hoc Reporting
· OLAP Analysis
· Scorecards & Dashboards
· Alerting & Proactive notification
While reporting, the classic discipline of BI, i.e. predefined operational reports with perfect layouts and ideal for printing, is widely used in financial services and also the ad hoc analysis, advanced analysis (including data mining) and OLAP reporting is getting more and more popular, dashboards still represent a relatively new discipline in financial services. This has partly to do with the fondness for Excel in the various departments, but is also contributed to the fact that users have not fully grasped the possibilities a dashboard can provide, which a standard report is not capable of.
These are all important factors and business users saw the value dashboards could add and really liked them. Nevertheless they often hesitated to implement them and stick to their two dimensional standard reports.
A standard report / grid can provide information in a two dimensional fashion. With OLAP reporting you have the ability to drill down by multiple dimensions but you can still see only a limit amount of information in one screen. With dashboards, this limitation is not longer a problem.
· Operating Margin
· Return on Equity (ROE)
· Net Income
In a two-dimensional standard report we would build this as a grid, with periods in the column and the KPIs in the rows. We would then build a filter into this report so that we can select a segment. A comparison of all segments at the same time is not easily possible. We can also not easily identify trends over time, especially if we have more data (multiple segments with lots of periods) to analyze.
In general companies are trying to be up to date with the software releases as much as possible in order to utilize new functionality and to get the latest bug fixes. This is especially true for business intelligence software that gives the organization a competitive advantage by delivering invaluable insight into the business. Those companies are therefore pretty open when it comes to install new service packs, hot fixes or patches.
This is different for most of the larger financial services organizations.
I am not talking about mayor releases here, i.e. a totally new version with new functionality, enhancements and maybe a better GUI (Graphical User interface). Those migrations usually need very extensive preparation time but for most software companies these mayor releases only occur every 2-3 years.
Larger banks require even for minor releases or service packs a long preparation phase and intensive testing before an upgrade can be implemented. This has to do with the restrict risk & compliance rules, the sensitivity of the data, the business model of financial institutions and with the fact that banks have often outsourced the IT service handling the migration.
They are installing the software typically in a sandbox environment; test the software thoroughly until the results for all their test scenarios are satisfactory and then they plan the technical steps for the upgrade. Part of the testing on the IT side includes carry out random installations in their machines and test for no compatibility issues with other standard applications at the bank.
This process usually takes 3-4 months.
The duration of the implementation – after the completion of the testing and planning mentioned before – is then dependent on the changes to the software and the internal process. The usual setup includes a development, a test and a production environment and proper procedures to move between those environments. As a rule of thumb such an implementation takes another 2 months. On average a migration to new software versions takes therefore in total ~ 6 months.
While there is software in the market that requires a much longer migration cycle, this is a pretty good estimate for most BI software migrations in financial services organizations.
However, some financial services institutions exceed this time by far and are looking for tools and external support to streamline their processes.
The procedures are especially inefficient when it comes to hotfixes and patches that are supposed to solve immediate issues. In case of a not foreseeable real issue that could be a threat for the daily business even banks are very open to implement patches quickly. This patch still needs to follow certain test procedures in the sandbox but this is much faster (can be done in two days till a week). Nevertheless, the companies try to avoid this as much as possible due to the extensive test scripts.
The required effort also depends on who owns the responsibility for the BI resources. As a rule of thumb, if the BI department is the owner of all the resources, it is usually less problematic and the processes are more promptly. Otherwise you could run into delays since you do not have all the resources at your disposal.
In summary, release management is becoming a very important topic for the financial services industry as it ties up budget, resources for a longer time period. As a consequence, those software vendors that offer a single, integrated tool based on a unified platform architecture – usually those that remained independent without the hassle of product integration issues due to newly acquired software – with a simple migration path for their customer base, will have a huge competitive advantage in the market space.
Saturday, January 2, 2010
The system of the Grameen Bank is based on the idea that the poor have skills that are under-utilized. A group-based credit approach is applied which utilizes the peer-pressure within the group to ensure the borrowers follow through and use caution in conducting their financial affairs with strict discipline, ensuring repayment eventually and allowing the borrowers to develop good credit standing. The bank also accepts deposits, provides other services, and runs several development-oriented businesses including fabric, telephone and energy companies. Another distinctive feature of the bank's credit program is that a significant majority of its borrowers are women.
Professor Muhammad Yunus, who launched a research project to examine the possibility of designing a credit delivery system targeted to the rural poor, can be seen as the founder of the Grameen Bank.
Due to the success of microcredit, many in the traditional banking industry have begun to realize that these microcredit borrowers should more correctly be categorized as pre-bankable; thus, microcredit is increasingly gaining credibility in the financial services sector. Many large finance organizations are now considering microcredit projects as a source of future growth, which is interesting, given that almost everyone in larger development organizations speculated on the likelihood of failure of microcredit when it was begun.
The United Nations declared 2005 the International Year of Microcredit and in 2006 received Professor Muhammad Yunus – in recognition of his efforts – jointly with the then independent Grameen Bank organization the Nobel Piece Price.
In the course of the financial crisis many small companies and entrepreneurs around the globe had problems to get access to a loan. This is especially true in Spain where the real estate market collapsed. La Caixa, the biggest savings bank in Spain, who founded in 2007 with Microbank the first European bank, specialized on microcredit, is very well positioned to help those in need of a small credit. The bank also proved that it can be a very profitable business. In their first two years of existence they financed 48813 projects with a volume of 331.8 million Euro (~ 480 million USD). Of course the financial crisis caused reluctance in new investments and company foundations. Nevertheless, the business of the bank is steadily growing. Microbank, also called “the social bank of La Caixa” generated a net income of 5.2 million Euro (~ 7.5 million USD). Half of the money went to families to overcome their current financial shortages, the other half was put into company projects.
According to a study by Esade, a Spanish management firm, 84% of the company projects financed by microcredit from the Microbank proceed successful. Furthermore, every fifth company hired 3 or more additional heads for their workforce.
I believe that – as a direct consequence of these successes –financial institutions and governments will become more and more interested in this concept to open up new revenue generating possibilities and respectively overcome problems with high unemployment. Needless to say that this will go hand in hand with new process and reporting requirements for the microcredit business.