Banks Need to Turn Black Boxes into Glass Boxes

By David Sherriff, Microgen

Traditionally, many financial services companies have treated their internal operations like the black box on an aircraft: only when the plane goes down do outsiders get a glimpse into what happened leading up to the crash.Now, however, just over a decade after the repeal of Glass-Steagall, Wall Street is under intense scrutiny. Inquiries over ethical decisions regarding firms' investment strategies have set the scene for unprecedented legislative action as members of Congress, the judiciary and the general public call for those black boxes to be opened.

Smart, forward-thinking banks are already realizing that once opened a black box cannot be completely shut again and, like Pandora's, can be very dangerous when opened in an unmanaged way. These companies are quickly turning their black boxes into glass boxes, transparent systems that demonstrate to internal and external stakeholders that the firm is trustworthy, compliant and - most importantly - solvent, for the long haul.

A glass box is not a piece of equipment. It is a way of designing, packaging and presenting data that regulators, customers, partners, investors and legislators are all demanding. Designed correctly, a glass box generates a level of transparency and operational openness that creates confidence in a bank's ability to make the correct decisions about lending, borrowing and creating new products.

The "box" is really a set of processes and systems that reveal a bank's inner workings in a way that is both clear and secure: clear enough to satisfy the demands of external regulators and observers, but secure enough not to threaten a bank's competitive position. Ideally, the box includes reporting mechanisms for risk, liquidity and other balance sheet items, mechanisms which are defined by business rules that match strategic objectives.

For example, a major North American bank realized in September 2008 that, as the fallout from mortgage-backed securities (MBS) was poisoning Wall Street, the bank did not have enough transparency into its own exposure to MBS and other derivatives to know how badly its structured mortgage business would be affected. This was not a failure on the bank's part - with modern mortgages going through many layers of securitization, involving multiple organizations, financial instruments and legal entities, tracking actual profit, loss and liability on a mortgage business is extremely challenging. So it has been almost impossible for many financial institutions, particularly when external parties in mortgage web fail.

At the same time, the organization's management team recognized that a new wave of global regulatory change and public scrutiny would follow the meltdown. Rather than waiting to react to those changes, the bank decided to implement processes that would bring far greater transparency to mortgage-related risks - even if those risks were painful and costly to face in the short term.

Part of the bank's strategy was to implement software that formed the infrastructure for "glass box" reporting. The system has helped the firm standardize accounting events derived from securitized mortgage products and standardize the information flows from various business units in the Capital Markets business. Every flow is separated for each level of securitization and resale, providing a consistent and accurate view of exposure across its mortgage business. With this system in place, the bank's financial operations team can quickly see and analyze current financial position and liabilities, including the risk of default or loss within any level in the mortgage securitization hierarchy.

The system is also linked via business rules to external reporting processes, so that the transparency available to internal stakeholders also supports external scrutiny. This is crucial: the transparency of glass box reporting both helps the business see and quickly correct for unwanted exposure, and supports more accurate and timely reporting to the outside world.

Once a firm decides to transform its black box, a few challenges can arise, most of which fit into one of three categories: technical, operational and cultural. Technical and operational problems tend to be easier to fix. Assessing legacy system compatibility, meeting regulatory reporting requirements, reallocating budget and managing business/IT user uptake can take time and effort, but these are all challenges that affect most banks undertaking technological changes, from installing new email applications to changing vendors for a derivatives pricing library.

Cultural challenges, on the other hand, tend to be the most difficult to overcome, because they are so deeply embedded in an organization's or business unit's character. A bank known for an extremely high level of discretion on clients' behalf, for example, is not likely to have an open and frank conversation about risk and transparency. A business unit head that has made her success and reputation on the back of risky but profitable and ethical deals might balk at the idea of collaborating with IT and other internal stakeholders on a system that might shed unflattering light on those risks. This program of change therefore needs to be driven from the very top of the organization.

A simple way to address cultural and operational concerns is to demonstrate the measurable benefits of a glass box approach to internal stakeholders. Specifically, the advantages can include:

• Increased risk intelligence - more transparency is not just about putting firms on the defensive - it is also a way to make smarter decisions with better information, which is at the heart of all successful market activity.

• Reduced reporting workload and timescales - once the right business rules and technologies are in place, the amount of manhours associated with digging through data for external reporting purposes decreases significantly, saving both time and money. Speed of reporting can affect a bank's credit rating.

• Reduced cost of ownership - software licenses for systems that enable glass box management are much less expensive than in-house development or custom-built solutions. By enlisting the latest the latest generation of Business Process Platforms and embracing a Service Oriented Approach (SOA) within a glass box strategy, banks also reap the benefits of agile, flexible architectures that could make future changes easier and less expensive whilst protecting the investment made in their existing systems.

Ultimately, the success of a glass box transformation will depend on multiple factors. A bank that is culturally inclined toward greater transparency might find the transition easy in theory, but if its existing systems are rigid or archaic, the implementation will require some re-education for the CIO and his team. On the other hand, a bank with a closed-kimono culture but progressive IT strategy could identify the technology needs easily but face an uphill climb when it comes to adoption.

There is no hard-and-fast rule for how a bank should open its black box, but the benefits are clear and measurable. Close collaboration between IT and the business is key to making a glass box implementation work, but long-term success depends on the organization's ability to adapt based on what it sees in the glass. Being able to see data more clearly is important, but making smart decisions based on that transparency is what will separate the leaders from the followers in the new regulatory age.