What you don't know can hurt you

If there's one lesson from the failure of Lehman Brothers, et al, it's that ignorance is not bliss and what you don't know can hurt you. This seems especially true when you're handling financial weapons of mass destruction. Because playing with WMDs is risky business, and miscalculating the risks can bring a multi-billion dollar business to its knees.



At the heart of the Wall Street woes is a basic failure to measure and manage risk. It started with subprime mortgage lending where banks and brokers sold mortgages on the back of very patchy data about the creditworthiness of the borrowers and their capacity repay. The flames of risky lending were fanned by mortgage backed securities which brought more investors and fresh capital into the market. Investors may have known at a high level that these loans were risky, but with limited visibility into the details of the underlying loans the risks became more opaque. And then it went nuclear with derivatives.

Thanks to OTC derivatives such as credit default swaps (CDS), investors holding risky investments could shift the risk of default to someone else. And with attractive fees on offer for taking on those risks, the CDS market proliferated. It was a nice little earner, as long as you understood and managed the underlying risk. The problem was, many didn't.

And now, with about $62 trillion worth of credit default swaps sloshing around the market in a complex web of private contracts, the scale of the risk and where it falls is shrouded in a deep fog. Counterparties to Lehman CDS contracts are scrambling to understand the scale of their exposure and how to unravel the mess.

All of which begs the question. If players across the market had taken more care to capture reliable risk data, would the current mess have been averted? If lenders had tracked and monitored better data about their borrowers (was their salary verified or were they stretching themselves thin to flip a 2nd home), would they have avoided widespread mortgage defaults? If investors had better visibility into the quality of loans underlying mortgage backed securities (did they all have zip codes in a bubble market like Florida) would they have avoided the junk and managed their exposure? If CDS players had better visibility into their rights and remedies across their portfolio of derivative contracts (what are the bankruptcy or termination triggers in every contract with Lehman) could they move more quickly in a time of crisis to manage and stem their counterparty risk?

In each case, the answer is yes.

But how do you get the visibility? One solution is to apply the magic of XML to portfolios of contracts. The basic mission of XML is that it can make whole documents visible and meaningful to machines. And not just a snapshot of high level data. XML allows you to tag documents with meaning, right down to the fine print on page 42. Which means that you can tell a computer to crunch through a collection of contracts and find every non-standard termination clause or definition of "Event of Default" where Lehman Brothers is a counterparty. And computers can do this much faster than humans.

A similar desire for data visibility sits behind the SEC's requirement for large companies to submit financial reports using XBRL. Once again, XML provides the solution to a visibility problem.

Expect to hear much more about the need for visibility and transparency as the "nuclear winter" of the current financial crisis settles in. And don't be surprised if XML is at the heart of many new systems designed to lift the fog of financial risk.

Related Post:
Bankers: Forget the Regulators, Focus on Risk

Time for banks to innovate?

Only a crazy bank would try to innovate during a recession, right?

Wrong, according to Clayton Christensen's firm Innosight. It might be tempting to batten down the hatches, cut spending, and focus on incremental improvements to your core business. But a failure to keep innovating will hurt your ability to compete in the longer term. In the words of Amex CEO Ken Chenault, "A difficult economic environment argues for the need to innovate more, not to pull back."

That doesn't mean you should blindly pour big dollars into huge "boil the ocean" projects. It's important to keep your projects diverse, and to prune out "zombie" projects so that resources don't get tied up in things that clearly aren't working.

In other words, focus on specific, practical projects, some of which can deliver quick wins. When you find a winner, expand the project and reap the rewards.

So, what are the right innovations for banks and lenders in these times of economic uncertainty?

Here are two suggestions for stealing market share in a recession, both of which use targeted innovation to make it easy for customers to bring business your way.

Innovation 1: Customer-centric account opening

Let's suppose that a customer is in the market for new banking services. Maybe a couple of newlyweds are deciding where to open a joint bank account, link some credit cards, and take out a personal loan for their honeymoon. Or maybe a new startup business needs an overdraft, some business credit cards, a transaction account and a cash management account.

Assuming that one bank's product features and pricing are broadly similar to the next, how to help yourself to win their business? According to The Better Banking Blog, a good place to start would be a streamlined account application process. It makes perfect sense. If one bank makes you fill out the same details about 10 times in 10 different places, then makes you wait around while someone in the bank fills out a few more paper forms, they aren't exactly making things easy. But if the customer can go online (or into the branch), fill out one simple questionnaire, then sign up for a tailored set of products, the experience will be quicker, easier and happier. I know which bank I would choose.

So why not start small? Take your most popular home loan and deposit product and make it easy for new customers to apply for either or both via one seamless interaction. If it works, and customer satisfaction goes up, extend it to other products.

Innovation 2: Broker self-service loan documents

Just as customers don't enjoy writing their name 10 different times in 10 different places and waiting around for hours, neither do brokers. In a recent survey, the single biggest complaint that brokers made about banks and lenders was that they were too slow to approve loan applications.

So if you want to win more business via broker channels, rather than losing that business to more nimble competitors, then one approach would be to give them a fast, intuitive and flexible online tool, so that your bank is the easiest and quickest to deal with, rather than the slowest and most painful. Remember, in the mind of a broker, a quick deal is a good deal.

Even better, when you capture all the important data from a broker up front, you have everything you need to speed things up in the back office. If the customer data fits a safe lending profile, they can be auto-approved, rather than having to wait for the credit review team. And by capturing and validating the data electronically, you can seamlessly generate a full set of tailored documents, so that the customer can be signed up within hours not days.

Sounds good in theory, but what's the ROI? The honest answer is that you won't know at this point. That's why you need to dip your toe in the water with a small proof of concept. As this Mortgage Banking magazine article explains, successful projects share several important traits:

• moderate upfront investment;
• compressed implementation times measured in weeks not years; and
  
• the generation of near-term, measurable savings.

This approach is far more likely to succeed than a "wrenching overhaul of systems".

In other words, start small and go for 'quick wins'. You'll learn a lot about your processes while getting a much better sense of whether there's a compelling business case for progressing further. And it's a much better strategy than simply cutting costs.