Fintech – News and Analysis

Risk groups produce tons of pertinent information that can be used by portfolio managers to generate superior returns, says a recent report from Woodbine Associates.  Yet, because risk management is often viewed purely for control or regulatory purposes, a lot of great information that is produced is simply overlooked and wasted.

Risk management groups that calculate VaR for regulatory and/or control purposes also produce a host of timely information that could benefit groups charged with investment return generation, writes Jerry Waldron, director of risk and portfolio analytics at Woodbine. “But in firms that treat risk management as a control function, this information is walled off from the investment process.  The result is missed opportunities – day after day after day.”

The risk management function aimed at regulation misses the upside opportunity in its focus on potential loss, he added.

“Return distributions need not be symmetric and due to sound portfolio construction frequently display positive asymmetry. In our example below, the return distribution displays positive asymmetry in that there is a 5 percent chance of a 22 percent return, compared to a 5 percent chance of a 19 percent capital loss.

“The 95th VaR loss of 19 percent enters the regulatory capital adequacy framework.  However, the equally likely 22 percent return frequently does not enter into the investment process.”

Waldron said that improved organization and communication between the risk management group and the investment units could overcome this.

The question is also one of culture, Waldron said.

“What are you running the organization for — compensation schemes, mark to market, P&L or for the shareholders? The front office guy says I can put money on the table right now, and risk management said it is a long-term problem. The front office guy wins. You take the money upfront.”

It’s hard to change the culture of a bank, he added. “If they didn’t change after the chaos of 2008, it’s a long haul to get them to use all the information embedded in the risk management function.”

Investment firms are letting regulators drive the process and the focus is on when do firms need to inject capital.

“There’s a whole industry of models to minimize regulator capital rather than focus on good business.”

Indeed, at a risk panel I covered at SWIFT Sibos conference in Dubai a few weeks ago, a couple of risk managers from banks asked why they didn’t push back harder against regulators, or work together to make regulation more rational.  One of the issues they complained about was zero tolerance rather than risk-based compliance which would admit that some errors would occur. Zero tolerance was driving banks out of some businesses, and the business was moving to less regulated firms or going underground, neither outcome exactly what regulators had in mind.

Waldron said that hedge funds have a mix of approaches. Some are becoming more like banks and do risk as a check-box for regulators, but others have skin in the game and use risk for economic gain.  

“Giving regulators what they ask for, banks are also silo-ing risk management so it doesn’t overly constrain the business, but then it doesn’t improve the risk/return investment decision.”

VaR doesn’t address which business decisions help a firm generate capital more efficiently. Many banks, however, calculate VaR and report it to regulators, but the risk department isn’t looking at how to generate internal capital efficiently. ????IS THIS RIGHT?

“Risk management can be seen as the control panel of a race car,” Waldron added. “You can move aggressively and safely, but if you think of risk management as just brakes, you have a problem. Risk people contribute to the problem by focusing on the wrong issues for the business. They look at fat tail distribution, but that’s not what the front office needs to focus on. Although regulators are very interested  in what the tail looks like, they aren’t interested in which distribution generates capital internally in the best manner.”

The information is there for the asking, added Waldron.

“The information can be developed by risk functions but it is not being requested and risk management doesn’t present it well. Risk management has been siloed into a control function, so the information isn’t designed to help decision-making.”

He blames the senior people at the banks, because they are the ones who have decided that the risk function is oriented toward regulation rather than business.

Banks are spending a lot on risk, and their exclusive focus on regulation is costing them.

“Financial institutions are not getting what they paid for from their risk management functions,” his report said. “This failure is largely a reflection of the perception that risk management is a control function more focused minimizing regulatory capital than providing investment value.  This perspective is unfortunate and need not be the case.  The analytical framework and infrastructure necessary to satisfy regulatory requirements also can be used to improve the investment decisions at no additional cost.

Although it is unlikely anyone at Wall Street Network (WSN) would say so publicly, this year’s hurricane season must be something of a disappointment. The company has developed a sophisticated application that predicts hurricane threats, shows areas and buildings at risk, can suggest safe housing areas for people in the storm’s path and assess damage afterwards. The system hasn’t gotten much use so far this year, although WSN predicted that this would be a relatively quiet season for hurricanes. .

Called XtremeGIS, (http://www.xtremegis.com/) it uses information from AccuWeather to provide forecasts — from years-ahead looks at the potential for the season to minute-by-minute tracking of the storm’s path including winds and rainfall in specific areas.

“For the 2013 Atlantic and Gulf tropical cyclone season we forecasted a mild season with 9 to 13 named storms while all other forecasts named 15 to 19 storms with 4 major events,” said Lester Pierre, chairman of WSN, “because our research and data indicated a high probability of a mild season. As of today, there have been nine named storms in the north Atlantic and Gulf-basins. So you can see, we are quite satisfied about our forecast.  Having a mild tropical cyclones season has a very big impact on the economy.”

WSN’s knowledge management software, which uses the ArcGIS Online mapping and analytical tool from Esri, can show companies office buildings, manufacturing sites, distribution centers retail outlets and transport links that could be threatened by a storm, and show them in time for companies to act on the information.

 “The bottom line is you don’t have to be a meteorologist to understand a hazard or a rocket scientist to understand property risk,” says Kristina Mazelis, chief operating officer at WSN. “We do the science and analytics assessing risk and provide access to it through ArcGIS Online, giving everyone the opportunity to assess their own risk.

The first three components available now include Xtreme Tropical Cyclone, which has historical data and real-time storm tracking; Xtreme Proximity which allows users to look up perils such as flood zones, and an alerting system for users in geographic areas they specify.  Through a subscription service, users can use ArcGIS Online to create maps with additional layers of proprietary company information such as offices and service territories and then share the maps over the Internet or to mobile devices. Companies can keep their proprietary information confidential while using it with the WSN Web-based mapping tools.

“This is a real game changing, disruptive technology,” says Simon Thompson, director of commercial industry, Esri. “Currently, when a catastrophic event occurs, everything shuts down. XtremeGIS gives businesses the advantage of insight so they can take control of their own activities and rethink where and how they grow.”

Lowe’s, for instance, used advance warning of a storm to buy up the available inventory of batteries, making it the place to go for storm-preparation supplies. A Mexican railroad used weather forecasts to pre-position repair supplies so they could keep their trains away from danger, restore tracks ahead of the competition and pick up business while the other lines were in repair mode.

AccuWeather provides updated forecasts for approaching events approximately every four hours. Jeff Masters of Weather Underground, looked at forecasting of Hurrican Rita in 2005 and concluded that improved accuracy of storm track and wind speed forecasts can reduce unnecessary evacuations, saving millions, or even hundreds of millions of dollars.
Once the province of a few specialists, risk is now spreading across the enterprise with GIS tools and iPad displays.  A Microsoft partner, WSN has built its application into Azure for two-way information flows and subscribers can share maps internally with SharePoint. It also uses i-cubed (www.I3.com) imagery to survey storm damage, often supplemented with images form social media and YouTube.

To develop an easily used risk system requires building out and aggregating all the different sets of data available in the marketplace, said Pierre.

“The challenge is finding the data sources and combining them,” he explained. “The app helps the users from a simple point and click to get all the information they need to manage risk. Being able to see the risk and understand historical probability it is at your fingertips..”

Then, in the aftermath of a storm, the user can look at images, whether from a flyover or a data provider, and measure damage down to the tiles on a  rooftop.


“So you don’t have to dispatch an inspector; you can do that from your desktop.” By comparing claims across a damaged areas, an insurance company can see if the claims fall within a normal range and pay them without costly site visits by inspectors.

By subscribing to just the data needed for a particular task, a user can measure potential risks and prepare for them. For example, an insurance company interested in writing property coverage in the Midwest can query the system for hail storms over the past two years, or narrow it down to hail which was two inches or larger.

“Or they might find there were no hail storms so they can underwrite the policy. GIS can help them understand the risk they are underwriting.”

WSN is also looking at ways users can become proactive around risk. A major disaster that affects hundreds of thousand of people might mean that payments such as mortgages and credit cards are going to be late. Both insurers and emergency management organizations need to understand damage as early as possible to assign the right number of people to an area. Retailers need to understand how their business could be affected by the losses incurred by area residents. Banks could inform residents of storm-prone areas that they should load a payment app on their smartphone to prepare.

“We aim to be thought leaders,” said Pierre. “This is one of the things we have done on the Web site we are about to launch to help folks collaborate around risk and build a community.”

The WSN software is available in the cloud, installed on premises behind a company firewall, or in a hybrid solution.

Fresh from being named the top global innovator at SWIFT’s Innotribe event in Dubai, Waratek is heading to the Gartner Symposium/ITxpo in Florida today with a new announcement — JSleep for enterprise Java servers.

“JSleep works like closing the lid on a laptop, allowing applications that are not in use to go into sleep mode, freeing up memory resource for use by other applications,” the company said in a statement. “When an application is called on, it is instantly available with no human involvement.  This offers a dramatic cost saving in infrastructure costs.”

In talking to large enterprises which are interested in Java virtualization, Waratek learned that servers are left running even when they have nothing to do because it is difficult to turn them off and back on again without losing work.

The development and test people and system administrators were very interested in finding a solution, said John Matthew Holt, a co-founder of the company.

“They reported startling statistics that at any given point in time at a development-test environment, a significant proportion of the app instances are idle, with no I/O. But the way most development-test environments work, they can’t take advantage of the idleness to drive down the footprint cost or hosting, so they leave it running. In extreme cases they will shut it down, but then a developer may not be able to rely on it.” Or get it turned back on when needed.”

Cloud installations, whether private or public, had similar issues.

“People have a deploy and forget mentality,” said Holt. “They will deploy an app that is only used at end-of-week and has vast tracts of time when the app is idle, but computing systems have no way to take advantage of it.”

Enterprises need to identify the apps that aren’t using their capacity, he added.

“When you deploy an app it reserves memory and unless you destroy the app, that memory consumption is there; it can’t be used to start another app process unless you shut the app down.”

Brian Maccaba, Waratek’s chief executive officer, said in had worked in a company running electronic trading systems that were up 24×7 for major banks. They had to be live even if there were no dealers active so they could mark to market.

“But for every one of those, you would have five to seven other environments live and consuming computing resources.”

The problem is whenever you run a complex app, something scripted and highly automated, it needs to be set up by a person who knows how to do it. You might need to re-link to other systems and do security or connect to data feeds. Every time you take down an app it is a pain to put back up again.”

JSleep can bring resources back up in under a second, including backup failover systems.

“If we can sleep failover and bring it up sub-second, that is fantastic. We can compress seven to eight systems to tiny footprints. Reasonable estimates are that it could save 80 percent of data centers’ resources.”

In addition to test systems, admin systems like HR, compliance and training that are not used continuously could be put to sleep.

The Waratek JSleep will suspend threads on the CPU but not destroy them, and it keeps all the file descriptors open. If there is any activity at a socket, the system wakes up in under a second.

Banks face flat-line growth in online banking unless they can persuade customers to do more on their bank sites rather than going to billers, according to a recent Javelin report. Online banking adoption is flat because it is saturated, said Mark Schwanhausser,  director of multi-channel financial services at Javelin. By 2018, 89 percent of American households will use online banking, up from 84 percent today. He suggests that banks focus on a segment he calls Digital Drifters, younger, tech-savvy customers who could be persuaded to pay bills at their financial institution. But for now, 70 percent of them prefer to pay at the biller site.

That may be because banks, said Schwanhausser, are 10 years behind.

“Banks have been sitting there on legacy services and haven’t upgraded. Right now they have to recognize how fast the whole mindset is changing. They have to adapt to providing services not only in mobile, but then they have use what they learn in mobile to reinvent and invigorate their online service.”

The trouble for bankers is that online doesn’t have a clear and attractive return on investment, he added. This is not a new story in banking; each new channel from ATM to drive-through to credit and debit cards and then online and mobile, has added costs without getting rid of other channels. Although now the decline in branch traffic has allowed banks to reduce their size and number.

“You don’t get a lot of money from it [the online channel] directly, but it is a sticky surface that keeps customers coming back. It builds relationships, but you have to justify it with a different kind of math from being able to charge someone $3.”

Perhaps more to the point, a bank without online access is soon going to be struggling for business, or it will be going out of business as its remaining branch customers die off.

Put these elements, such as no clear ROI together with conservative banker mentality and you can see why banks are 10 years behind, he added.

Consumers want convenience and, perhaps, some tools to manage their money. If the bank services are clunky, their customers will go somewhere else, whether that is a biller, an aggregator or a personal financial management site.
Mint, said Schwanhausser, has stagnated since it was acquired by Intuit in 2009.


“It gives you alerts, but you can’t act.” He thinks that Check is better for consumers because it aggregates bills and provides a dashboard view and lets the user pay directly from the site.

“They are very innovative, but when you think about activities and how to manage your money, there are other places consumers will go.”

Banking customers who use online and mobile banking and bill pay through their financial institution are the most profitable for the bank. They are also the path to the future and probably the most adept at moving accounts if they are dissatisfied.
“They are defining banking for the rest of it, and if you can satisfy them, you will satisfy other customers. They are hungry for personal financial management tools, but they won’t wait around for a bank to provide them. They are as likely to look outside a bank.”
Banks have built their business on face to face interactions in the branch, but now they need to reach out through digital channels.

“It’s easier to talk about big data than do it effectively,” he said. “Banks need to look at the transactions they control and see where customers are spending and where they can provide alerts and personal financial advice.”
Banks can help customers save money, lock in deals, cash in a coupon or grab a refund, he said, citing BankAmeriDeals from Bank of America as an example of using customer data to deepen relationships.
To understand customers and offer them appropriate deals will require wider use of predictive analytics, he added. Some vendors, such as Fiserv and FIS, are beginning to get into the business.

“In relationships, how do we use the phone to have a more proactive personal relationship than we did in the day when we waited for people to come to the branch and sit down face to face?” Banks need to ask if they are using mobile phones to their full potential. He looks to features such as geo location for authentication, merchant rewards for loyalty and biometrics for greater security.
Legacy IT is an issue, so is legacy thinking.

“How long since the iPhone, and people are still asking if this mobile banking thing is real. We should be years past that question.”

    Somewhere in northern New Jersey, Hudson Fiber Network has cut nearly one kilometer from its fiber route, giving it the fastest time to deliver trading information from the NYSE, according to its CEO, Keith Muller.
    That’s because the NYSE operates from a data center in Mahwah, NJ, up against the border with New York. It has to communicate trading information to other New Jersey-based exchanges such as Direct Edge in Secaucus, NASDAQ OMX in Carteret and BATS in Weehawken.
     Traffic going to the futures exchanges heads west, not to Chicago but to the CME Group’s data center in Aurora, IL, west of the city.
    HFN built out the link to Mahwah in anticipation of NYSE’s opening up its data center to multiple carriers. The prior legacy routes had higher latency, Muller said.
    “We built a route that was designed to cut down latency and cut down hops to connect with the other critical data centers and exchanges in this area.
    “We recently took out a jag in the route just south of Mahwah. We were able to straighten it out a bit through some private easements and pull the fiber in a more direct fashion.”
    HFN has also put in fast connections between Cermak (the old CME data center) and Aurora. Cermak is still a major hub with a lot of gear, Muller added.
    “So people aren’t going to uproot everything.” The new data centers are expensive for co-location, he added, so users will often take fewer server racks into the new exchange facilities and keep more processing power at less expensive centers.
    Fanancial firms  are looking for shorter direct routes and redundant routes. Latency isn’t as critical on the backup route, he added.
    Trading houses want primary and backup terrestrial fiber, added Muller, although HFN is also workinng on RF or microwave links between some New Jersey centers. They are fast, but not reliable enough to be the sole methods of communication since they can suffer interference form bad weather or birds.
    Despite its Hudson Fiber name, the company is based in Paramus, NJ — the state’s shopping center capital, and closer to the Hackensack River than the Hudson. But hey, what’s in a name besides branding? No plans have yet been announced to renamed NYSE for Mahwah, or CME for Aurora, after all.
    HFN is a partner with Spread Networks, which in 2010 built a custom fiber route linking Carteret to Chicago’s South Loop, cutting the round-trip time by three milliseconds to 13.33 compared to other routes that tended to follow railroad lines.
    “Spread uses us for last mile connectivity because we have a dense footprint here,” Muller explained. “They have long-haul routes and come to us for local access.”
    He thinks financial institutions have reduced their emphasis on the fastest speed available.
    “Spread may not be getting the premium for Chicago they once did,” he said. “Financial institutions won’t pay through the nose for lower latency.” Many are content to be within 10 percent of the peak speeds available because they are using trading approaches, such as algorithmic trading, that don’t rely purely on speed.
    “When the market developed it was the fastest trade wins and then it got more sophisticated. Algorithmic traders don’t have to be the fastest, as long as they are up there in speed,” he said.
    HFN has master service agreements (MSA) with more than 50 percent of the big financial firms, he added, so when it rolls out a new service it can offer firms a trial without going through all the legal hurdles that a newcomer would have to deal with.
    “That makes it easier to propose a new product, bring a new solution. The firms tend to buy from the carriers and vendors they have MSAs with, and we have been able to leverage that in our growth”.
     Brett Diamond, president of HFN said: “Our customers have overwhelmingly selected to automatically upgrade to the new route, which we have been able to provide at no additional expense.”

Guest Opinion Piece

By Michael Ruvo, President, DPC Data

Community banks have to take a more active role in selecting and monitoring the municipal bonds in their portfolios under new Dodd-Frank regulations which went into effect in January. In the past, community banks have been able to rely on ratings agencies’ grades. But rules from the Office of the Comptroller of the Currency (OCC),  which took effect in January, say that the ratings are no longer enough and banks have to take greater responsibility for due diligence.  

It’s not entirely clear what the bankers will be allowed to rely on — few community banks have a staff of analysts prepared to run the fundamentals of a municipal bond issue. It’s good to see regulators at last making some reduction in the role of the rating agencies which played a significant role in the financial crisis. Matt Taibbi at Rolling Stone who drew on court documents in a recent report on the agencies which including this illuminating quote:   

“Lord help our ******* scam. This has to be the stupidest place I have worked at,” wrote Elwyn Wong, an S&P executive, in an email. Ironically, Wong was later hired by the OCC. 

 So what’s a community bank going to do? It looks like they have three options: Banks can conduct their own financial analysis, use a third party firm to conduct due diligence, or perhaps they will be allowed to depend on their dealers’ advice.    

This rule change comes at a time when the municipal bond market is unsettled with bankruptcy or threats of bankruptcy facing large governments — Detroit, Jefferson County in Alabama, Stockton, California.  Governing magazine reported 28 public bankruptcies in 2011 and 2012. As larger government entities flirt with bankruptcy, it may become a more attractive route for municipalities facing huge liabilities.  

Does California lead the way in changing attitudes toward bankruptcy? Moody’s suggested that could be the case in a report it issued last year. 

“The inability and unwillingness to honor obligations to bondholders is relatively new in US public finance and still remains rare,” said Gail Sussman, Moody’s managing director. “The emergence in California of bankruptcy as a tool to extract bondholder concessions as part of a budgetary solution is a significant new risk for bondholders.”

However, Brookings’ Tracy Gordon suggested the concerns could be overdone and most of the problems may be limited to California, Texas and New York. The complexity of the muni market and the habit of many investors to buy and hold could also reduce volatility, she wrote. 

“A silver lining of less-than-perfect information and higher transaction costs in muni markets may be that shocks are transmitted slowly through the system.”

Just how imperfect that muni bond information is was described in an SEC investigation into issuers and underwriters in California, where more than one in four issuers failed to file their annual financial reports on time. The SEC, which has no jurisdiction over municipal issuers, could be indicating that it is going to hold underwriters and dealers responsible. It does have considerable clout with them, after all. 

In a choppy market, community banks need up-to-date information about their current holdings and the prospective purchases. Are bonds added to the portfolio three years or five years ago still investment grade and how was that determined? Where can banks go for the information? Ask your broker to explain recommendations and don’t be afraid to request evidence. The dealers who do have the research are happy to explain their recommendations. 

Michael Ruvo is president of DPC DATA, Inc., which leading municipal bond dealers use to keep ahead of market developments.