Unbundling the Banks: A How To Guide:
Talk of unbundling the banks is all the rage these days (if we believe the fintech startups). Yet upon closer inspection one gets the feeling that these optimistic people might not necessarily know exactly what they are trying to unbundle, the true complexity of a medium to large bank, which in turn reflects, at least in part, the complexity of our modern financial system.
A more petulant question is whether anybody knows how to unbundle a bank, whether be it its management or the regulators. We certainly know that it can be done, because it must be done when a bank fails completely. In such a scenario the firm must be dismantled piece-by-piece to its constituents business lines and assets (which are sold away or otherwise disposed of) and this is a process that can take years. Yet even this rather crude approach does not really solve our problem as we don’t want a body parts catalog of a dead bank, but a description of a living one!
Why bother with such unbundling questions? Well, one would think that understanding the bundle would also be help with its risk management, if that is what we want to do. While unbundling is typically explored in terms of client segments and services provided, there are significant benefits to a risk based unbundling. It happens that being informed about what you try to risk manage helps a lot in stress situations. To wit:
You can certainly drive a car without any knowledge of how its made and how its systems interact. But riding down a long curvy downhill can be fatal if you don't know that the brakes are made of material that can overheat and lead to failure.
This post is an exploration of a risk based unbundling of banking services.
The science of risk management starts with naming things
Risk managers, assuming they have enough time to get around to this type of question, would probably think of themselves as artists rather than scientists - the daily risk management grind is mostly about the art of the achievable. Yet our downhill brakes example suggests that a comprehensive knowledge framework about the components and workings of a bank, how they interact and how they might fail should be at least an aspirational target if we want to improve risk management.
So how do we get started with a scientific approach to the question of how the bank works? The history of science (similar to the cosmogonies of many peoples) suggests that in the beginning you have to go around naming things. Enumerating the visible components of what you are interested in and making lists and catalogs is the start of trying to make sense.
In the second step you start classifying, identifying similarities and differences, aiming to identify any common patterns that may suggest intrinsic linkages. After such linkages are hypothesized you need to test them empirically, possibly using mathematics for technical support. If your hunches turn to be true, you suddenly understand how your system works!
Can we apply this approach to risk management? Enumerating the components, classifying them and then finally trying to understand them? Some people have thought that yes we can
The unfinished risk taxonomy
Man in the street: How far are we in this process for understanding the components and processes of a typical bank?
Philosopher: Only as far as regulators have pushed for in order to identify and thus help manage some of the key risks.
Man in the street: This surely can’t be true, people must know what they are doing in a multi-trillion industry?
Philosopher: If they do, they certainly keep it to themselves and don’t write much about it.
Man in the street: Right. So what is the regulatory minimum?
Philosopher: They looked at all the historical causes of significant loss and they classified them under market, credit and operational risk.
Man in the street: And what about the recent liquidity and conduct risks? Philosopher: Aah, those are being added as we speak.
Man in the street: There must be a better way than just wait for the next calamity.
Philosopher: Yes, its called Enterprise Risk Management.
Man in the street: So? Why isn’t this discipline getting more attention?
Philosopher: That is a very good question
How to conceptualize a financial services firm
The blind men and elephant metaphor is very apt for describing the available partial descriptions of a bank (or other financial services firms). Here is a list of partial ways of thinking about what constitutes the banking bundle:
The bricks and mortar view: Glass buildings, people, computers etc. The very evident problem with this view is that it is not really capturing what is going on from our perspective. The firm can go bankrupt with little physical evidence to show for it - besides a few employees leaving the building with cartons full of personal belongings. On the other hand physical disasters can certainly put the bank at risk, so this view must be part of our true view.
The balance sheet view: This is a powerful paradigm as the balance sheet aims to capture all significant contributions to the firm’s monetary value. There are two problems though:
- Problem 1: There are more risky components to a firm than what is captured in present value (e.g. the ethical standards of its people would typically not figure as a balance sheet item)
- Problem 2: The same present value can evolve into very different future states. A fixed contract and a stock option may have the same value but will lead to different behavior, precisely because they behave differently in different future states
The contracts view: Fixing problem 2 requires constructing a legal contracts documentation database that captures the full content of the firm’s current business. Once we have this database, in a machine readable form, the risk in different states of the future can be assessed in an integrated manner.
How about problem 1?
The information processing view: Completing the contractual picture with these less rigorously defined elements of the firm must focus on identifying the core business processes and describing them as carefully (and insightfully) as possible, with a focus on the human factor (the role and incentives of any people involved). Indeed we may think of the firm as a collection of information processing units where a number of business processes interpret data flows and convert them in tangible contracts (assets or liabilities).
Where to next?
Unbundling the banks (and developing true enterprise risk management) will be a long journey. Here are some tools to help you along if you are interested.
A white paper on risk taxonomies
An online app that helps you understand the risk taxonomy and even contribute your views to the Risk Manual (if you want!)