Ian Hurst, general manager for the global financial services sector, IBM
Technology can only go so far in helping to explain and predict global systemic risk. However, financial services firms must still be able to adapt to the changing environment and their customers' demands.
There has been much debate on the causes of the recent global economic crisis, and the reforms required to enable sustainable recovery and prevent further such crises. While poor-quality mortgages started the credit crunch, lack of transparency and increased global interconnectivity turned that problem into a global economic crisis. Calls for global financial reform have focused first on the need for regulations for strong oversight supported by rigorous transparency and accountability - both within and between financial institutions. And second, there has been a call for global systemic risk supervision - able to provide global co-operation, consolidation and early warning. Such a system could help to recognise the build-up of financial bubbles, and identify risk concentrations and systemic interdependencies.
On the regulatory front there are many obvious areas for reform. For example, enhanced transparency and risk visibility are essential to the revitalisation of debt markets and reform of asset securitisation. This process will need to embrace provenance tracking and monitoring to assure the quality of securities. Active ratings services can then capitalise on this enhanced transparency, enabling better understanding of securities composition.
While there is broad acceptance that greater regulatory scrutiny is required, research by IBM's Institute for Business Value found that 70% of executives are concerned that governments will 'overshoot' and over-prioritise financial stability at the expense of innovation.
Understanding the system
In relation to global systemic risk, debate has centred on the possibility of building a capability that would be effective in modelling the global financial markets. The markets have been described as what is called a 'complex system'. It is argued that the exact values of the initial conditions, variables and relationships within this 'complex system' can never be precisely measured or understood. Some people believe that it is, in fact, a 'complex adaptive system' in which the rules that govern these factors are constantly changing. Whatever the exact definition of the system, exact prediction will never be possible. The reality is that the best one can hope for is to be able to explain and understand the nature of the complex system.
Even doing this, however, requires significant computational power. To date, simplifying assumptions have had to be used to reduce the computational complexity of the problem, but they also made the models less useful. Supercomputers boasting Petaflop or even Exaflop performance, coupled with petabytes of main memory, mean that one no longer needs to use simplified models.
Instead it is now possible to run models and simulations that use real market data - the vast amount of data that flows through the markets every day - as the input. This provides, for the first time, a real capability to understand the nature of the complex system, to detect small changes in economic and other conditions and to anticipate how sensitive the complex system will be to such changes. Exact prediction will still be impossible, but educated interpretation will provide real visibility, insight and understanding, heralding a smart era of informed intraday market supervision and reliable early warning.
Closer client focus
Technology is not a panacea however. Financial services firms still need to address the need for reform closer to home, by adopting a different approach. The latest report from IBM's Institute for Business Value, entitled 'Toward Transparency and Sustainability: Building a New Financial Order', calls upon firms to deliver on what they promise. Most financial services firms have brands that implicitly promise to provide agility and stability, and to focus on the interests of their clients. In practice, however, the opposite is often true. In order to redress these deficiencies, such firms will need to focus on becoming more efficient, managing and pricing risk more effectively and moving closer to their clients.
More specifically, such firms will have to realise economies of scale, integrate their IT more closely with their business strategies and outsource a higher proportion of their back-office activities, and concentrate on understanding how their clients behave, segmenting them and tailoring the services they offer accordingly.
The IBM survey also found that 90% of financial markets executives and government officials believe that the returns of the past are over. Financial firms will have to change their business models to accommodate the trend toward greater specialisation and the shift in the industry's revenue pools, as demand for products that help to create more transparency grows at the expense of demand for opaque products. Tomorrow's winners will be those companies that specialise, not those that try to do everything.
The restructuring pain is far from over. IBM believes that the current wave of finance sector redundancies and divestitures will provide insufficient savings - firms will need to seek further efficiency improvements of 20%. However, a better understanding of the 'complex system' in which they live will at least enable firms to possibly avoid such painful actions in the future.
Ian Hurst is general manager for the global financial services sector at IBM
