Managing Operational Risk of Financial Services Processes – part 1/ 2

Financial institutions view compliance as a regulatory burden that incurs a high initial capital outlay and recurring costs. By its very nature regulation takes a prescriptive, common-for-all, approach to managing financial and non-financial risk. Needless to say, no longer does mere compliance with regulation will lead to sustainable differentiation.  Genuine competitive advantage will stem from being able to cope with innovation demands of the present economic environment while meeting compliance goals with regulatory mandates in a faster and cost-efficient manner.

Let’s first take a look at the key factors that are limiting the pursuit of the above goal.

Regulatory requirements are growing, driven in-part by revisions to existing mandates in line with cross-border, pan-geographic, nature of financial value chains today and more so by frequent systemic failures that have destabilized the financial markets and the global economy over the last decade.  In addition to the increase in regulation, financial institutions are faced with pressures of regulatory overlap and regulatory conflict.

Regulatory overlap arises primarily from two things: firstly, due to the blurring of boundaries between lines-of-businesses with complex organizational structures and secondly, due to varying requirements of jurisdictional directives across geographic boundaries e.g. a securities firm with operations in US and EU would be subject different requirements of “Know-Your-Customer” (KYC) as per the PATRIOT ACT in US and MiFiD in EU.

Another consequence and concomitance of regulatory change is regulatory conflict, which again, arises primarily from two things: firstly, due to diametrically opposite priorities of line-of-business and secondly, due to tension that regulatory requirements create between shareholders interests of tighter due-diligence and customer concerns of privacy. For instance, Customer Due Diligence (CDD) as per KYC requires eliciting detailed information from customers to prevent illegal activities such as money-laundering, terrorist financing or identity theft. While new customers are still more likely to comply with such stringent background checks at time of account opening, existing customers baulk at such practices as a breach of trust and privacy.

As mentioned earlier regulatory compliance addresses both financial and non-financial risks. Operational risk is a non-financial risk that stems from business execution and spans people, processes, systems and information. Operational risk arising from financial processes in particular transcends other sources of such risk. Let’s look at the factors underpinning the operational risk of financial processes.

The rapid pace of innovation and geographic expansion of financial institutions has resulted in proliferation and ad-hoc evolution of back-office, mid-office and front-office processes. This has had two serious implications on increasing the operational risk of financial processes:

·         Inconsistency of processes across lines-of-business, customer channels and product/service offerings. This makes it harder for the risk function to enforce a standardized risk methodology and in turn breaches harder to detect.

·         The proliferation of processes coupled with increasingly frequent change-cycles has resulted in accidental breaches and increased vulnerability to regulatory inadequacies.

In summary, regulatory growth (including overlap and conflict) coupled with process proliferation and inconsistency is driving process compliance complexity

In my next post I will address the implications of this process complexity on financial institutions and outline the role of BPM in lowering specific aspects of operational risk of financial processes.

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