Now that the Dodd-Frank Wall Street Reform and Consumer Protection Act is the law of the land, financial institutions are beginning the difficult job of sorting out what the new legislation will mean for their organizations. While the final rules emanating from the act are still being drafted, the focus on identifying, managing and documenting risk will be more important than ever.
For example, new regulation of over-the-counter derivatives contracts, an area largely unregulated in the past, will create new risk management scenarios and requirements for many financial services firms. The new mandates will result in higher capital requirements and will require trading firms to execute transactions electronically, clear through a clearing house and report to a trade repository. Another focus area for regulators will be on the management of liquidity in the organization. In addition to enhanced requirements for stress testing of liquidity gaps, this would also include requirements for structural and short-term liquidity ratios.
Financial institutions must also navigate a new approach to capital reserves with a move to countercyclical calculation. This transition will require new levels of insight to ensure compliance while optimizing opportunities for available capital.
Banks must build a comprehensive infrastructure for risk management that can provide visibility across the entire enterprise and deliver insight when and where it is needed. Aggregating all of an organization's risk-related data in a single environment is an essential first step.
Regulators are also likely to ask the financial community to calculate the outcomes of more diverse and rigorous scenarios, and adhere to accelerated timetables for completing stress tests.
The organizational structure of a bank's risk management operation is just as important as the systems that underpin this function. Banks must reassess how they structure their risk management operations.
Cross-functional teams will be increasingly important, especially as stress tests become more complex and comprehensive. For example, regulators may ask a financial institution to assess the impact of a particular scenario not just on risk-weighted assets but also on liquidity risk and profitability. Today, in many organizations, the resources needed to determine the impact of each might reside in separate teams that do not regularly collaborate. Some banks may even consider creating a new team dedicated solely to managing and responding to regulatory inquiries and requirements.
While regulators turn to rulemaking, financial services organizations have an invaluable window of opportunity to bolster their risk management environment. Those that take advantage of this time to chart a path that ensures diligence and flexibility stand to benefit greatly from a smooth transition when the dust finally settles.
