June 27, 2012

As we approach the second anniversary of the Dodd-Frank Act becoming law, it is appropriate to ask how much, if at all, financial institutions have reformed their risk management practices.

Two years after Dodd-Frank became law, the financial reform package appears to be dying a slow death, and many experts suggest that the Volcker Rule — perhaps the most important and controversial aspect of financial reform — will never work. Advanced Trading's July digital issue looks at what, if anything, on Wall Street has changed since the credit crisis and examines the challenges regulators face in enforcing the ban on proprietary trading.

Following the 2008 crisis, Dodd-Frank was thought to be the most far-reaching and influential financial reform since the 1930s. The act aims to serve as the regulatory foundation for stability and transparency; however, the markets have demonstrated that it requires more than just legislation to reduce risk in the financial sector. In 2010 alone, two major Irish banks requested a bailout after passing a European stress test only a few months earlier.

It is therefore absolutely necessary for financial institutions to scrutinize their internal controls and valuation and reporting procedures in order to take steps to prevent another financial crisis from reoccurring. From credit risk reforms (knowing your exposure across all holdings) to central counterparty reforms (knowing your full counterparty exposure), the buy side must take a holistic risk management approach.

The State of the Industry

Recent SimCorp polls of North American buy-side firms generated disturbing results. Buy-side firms are woefully underprepared for adjusting their internal controls to keep in line with the objectives put forward by Dodd-Frank.

[Starving Dodd-Frank One Dollar At a Time.]

To gauge collateral risk, we asked participants if they still support collateral management on spreadsheets — more than half (52 percent) stated that they do. OTC derivatives reforms now make collateral management a critical part of calculating risk. It is shocking that firms still rely on manual processes with a high potential for human error and inefficiency.

Further, a substantial economic shock can have an immediate widespread effect, causing positions to change quickly. Yet 30 percent of buy-side respondents stated that it would take days or weeks to generate a report calculating their firms' credit exposure across all holdings. Risk managers need to do more than confirm that they are able to calculate their firms' credit risk exposure; they need to be able to do it quickly and accurately.

Record-keeping practices on the buy side are out-of-date and no longer satisfy the demands of the industry. When asked, 56 percent of buy-side firms admitted that they are not confident in the accuracy of their accounting systems, which are the heart of record-keeping. A lack of confidence in the accuracy of the data recorded would be of great concern to investors.

In addition, 68 percent of survey respondents either cannot or do not know if they are able to capture all OTC derivative positions, transaction and contract data in a single repository. The consequences of this lack of centralization are significant and surprising given Dodd-Frank's focus on OTC derivatives.