Corporate Living Wills: The Potential Revolution in Banking and Technology

Across the globe, governments and regulators continue to work on increasingly complex and impactful changes to the control and support mechanisms that currently manage the financial services industry. Many of these existing checks and balances, some put in place prior to the financial crisis and some following its advent, have been found to be unfit for controlling an industry that has historically flourished by managing risk and leveraging instability and uncertainty.

The crisis-driven response is an ever-increasing mass of regulation and control that has the potential to significantly restructure the industry, as well as restrict the operations of many of its participants. Responding to these new regulatory requirements will be difficult, not necessarily because of their content, but often because of the uncertainty that underlines their adoption and imposition — there is no clarity as to specific requirements and the applications and technology that will support these new requirements.

This uncertainty raises problems and questions for bankers and technologists:

How to prepare for something when no one, including the authors of those changes, has a clear idea of the detailed proposals?
How to avoid these changes from becoming yet another series of mandatory projects, prioritized internally on the basis of risk avoidance rather than proactive risk management, and with little or no positive impact on business revenue?
How to avoid the implementation of such risk management applications becoming a drag on the company?

Using the example of one of the higher profile of these potential recovery and resolution plans — "living wills," the regulatory concept being positioned particularly within the U.K. market to help strengthen the financial services market moving forward — we identify the likely impact of this renewed regulatory change. However, rather than serving as a simple narrative on the passive acceptance of this regulation by the financial services industry, this research links to previous Gartner research to highlight areas where such a regime has been transported from a cost to the business to become a valuable and active asset. Such a change will require an aggressive and imaginative adoption of the technology, and will need to be linked to significant changes in the roles and responsibilities of many involved in the risk management and control functions within banking groups. Rather than being passive programming roles, these roles will need to become more integrated into the daily operational functions within those banking groups, adding value through enhancing the agility and flexibility of both the technology and the applications.

The concept and definition of living wills stems from the real-life need to help individuals who, through illness or old age, may lose the ability to make rationale and reasonable decisions at some stage of their lives. Living wills are an attempt by those individuals to prepare for the future and — while they have the time and the competence — establish a series of constructs that will allow others to take over the running of their lives, if and when they become unable to do so themselves. Recognized to varying degrees by the legislatures of different countries, the legal concept of living wills allows those individuals to establish, in advance, their wishes and requirements as to how they will be treated if and when they lose the ability of rational thought. Living wills will differ in complexity depending on the wishes of the initiator; some will be relatively "lite" in touch, merely laying out a high-level framework for their ongoing care and treatment. Others will be much-more-complex documents that may include detailed specifications including financial arrangements, and instructions for the final moments of one's life.

Within the financial services world, this concept of living wills is being positioned as part of the possible regulatory regime to help manage and control banks. Initially proposed by the Financial Services Authority (www.fsa.gov.uk) in the United Kingdom, the initial concepts underpinning such a regime are currently the subject of review by interested parties (see http://www.fsa.gov.uk/pages/Library/Communication/PR/2009/142.shtml.) A discussion document of the subject closed for comments at the end of February 2010, and a response from the regulator is awaited. In summary, the objectives of such a "living will" regime are simple:

To establish a set of rules, procedures and resources that would be readily available to any third party from outside the bank who may at some stage in the future be required to step in and run the bank, either in the event of its financial demise, or some regulator or state-initiated intervention.
To minimize the threat of systemic banking failure by mandating banks to "prepare for possible failure," and in doing so ensure a controlled unraveling and settlement of liabilities and commitments.

It is important to recognize that the adoption of living wills is likely to form only a part of the regulatory environment that will be imposed on banks — other aspects of regulatory change will focus on bank structures and restrictions on deployment and the use of capital. However, the adoption of living wills has the potential to demand a significant shift in the way that banks manage and measure future risk, moving the emphasis from managing risk only when the business entity exists to managing risk after the entity may have failed or folded. In shifting this emphasis, regulators will require major changes in the way that technology is managed and deployed throughout banks. Their adoption would also offer the chance for technology and technologists to react in a positive way to regulatory change — this research focuses on the opportunity to leverage the requirements of living wills to deliver better and more flexible technology solutions moving forward.

It is also important at this stage to call out two key positions from Gartner on living wills:

The exact construct and deliverables stemming from such living wills regulations are still far from certain, and will likely take many months, if not years, to be established as a formalized structure. Here, we present our best interpretation as to where the potential regulatory burden is heading. Consider this as guidance on the broad direction that regulation will take, rather than as an exact way point on the regulatory road map.
The adoption of livings wills may initially appear to impose a significant regulatory burden on banks. Actually, living wills represent much more than a regulatory burden, and focus heavily on revised process and transaction management. One can equally argue that many of the demands of living wills will, in fact, form the strong basis for running a business more efficiently and effectively. Banks may find that a proactive adoption of many of the living wills' requirements, and an integration of these demands into their day-to-day infrastructures and processes, may actually result in a more efficient and agile bank.

The concept of living wills is being considered as a direct result of the fallout from bank failures during the past 18 months. Regulators and government agencies discovered that the impact from the failure of major banking groups was exacerbated by an inability to "manage" those banks after their initial collapse. Post-collapse, administrators entered banks to discover "empty shells" of companies, with no internal documents or facilities to allow those organizations to continue running and a series of impediments to the administrators' objective of taking on the role of the previous management:

No staff in place to help explain the means by which the business was run and to help unwind complex financial exposures and positions.
No up-to-date procedures or process maps available to help understand the technology or business processes that underpinned the business.
No obvious means of identifying and unwinding clearing and settlement positions, including liabilities due to individual clients. For example, unwinding the many complex derivatives positions lodged with Lehman Brothers posed significant problems for the administrators entering the bank after its collapse.
No easy access to third-party and outsourced contracts, with limited or no clear understanding as to the liabilities and commitments embedded within them.
No ring-fenced funds to continue running the business on a day-to-day basis, including retaining necessary staff and maintaining third-party contracts.

The adoption of the living wills concept would force banks to plan for the possibility of their future demise and establish procedures, technology and funding to help manage and mitigate these shortcomings and allow others to manage such a calamity. For many banking institutions, the concept of planning for failure does not sit well, that the idea being that such planning adds little short-term value to the organization. However, as discussed here, Gartner believes that benefits can accrue to participating organizations, so long as the corporate approach to adopting living wills is positive and integrated into ongoing business planning. Ignoring the wider arguments of indirect benefits to the participating banks, such that regulatory control leads to a more healthy financial services market in which those banks are better able to flourish and generate profits, there are potentially more-direct benefits to banks that embrace the concept. Additionally, given the regulatory drive underpinning this drive for change, banks cannot ignore these moves toward a stronger regulatory hand.

Clearly, the primary objective of implementing living wills for banks is focused on the ability to ensure that those banks will be able to manage their business to a satisfactory conclusion, should they suffer a catastrophic financial meltdown. However, there are potentially some significant and more immediate benefits that may accrue to banks — and specifically to the IT divisions of those banks — through implementing many of the requirements needed to satisfy living wills. Given the significant costs that will be associated with implementing living wills, banks must ensure that they maximize the return on that investment. By focusing on the business advantages that may be delivered through this regulatory change, internal risk managers and compliance staff can start to add real business value, while also satisfying the requirements of the regulators.

Four potential functional areas will specifically benefit from adopting a living wills approach:

Enhanced process and technology maps
Single customer view
Enhanced clearing and settlement systems
Greater legal and procedural certainty for business process outsourcing

It's clear from many Gartner interactions and inquiries with bank and financial services clients, that most of those clients recognize the potential benefits that can accrue from maintaining accurate and up-to-date process flow models for their businesses. Gartner is seeing an increasing role for strategic technology maps with some clients. In addition, architectural and technology frameworks can deliver immense benefits to IT departments, albeit the benefits of such methodologies and plans are not always well articulated to business colleagues. However, the current reality for most businesses is that the development and maintenance of such maps and frameworks remain a low priority for businesses that have many other demands on resources in today's tight economic climate — indeed, even before the onset of the current more constrained financial climate, in the majority of financial services institutions the role of these tools were as low-priority nice-to-haves, rather than mandatory requirements that were key to the efficient running of the business.

However, within a living wills regime, the bank would be required to maintain such maps and plans as a part of their day-to-day business. Yes, such an approach would prove costly and initially something of a burden, adding considerable additional work for many institutions that currently have no real level of documentation. However, the potential benefits to the business — beyond the obvious impact of satisfying the regulatory requirements, could potentially be huge. The key to this success will lie in how such plans are adopted and where the responsibility for the development and maintenance of such plans will fall. If the key drive for this initiative comes from within the regulatory department of the institution, then the likely outcome will be regulatory compliance but business failure — the bank will satisfy the regulators but simply add another cost to its bottom line, with little or no business benefit.

The banks instead need to take a much broader view of these regulations and engage all areas of the enterprise in planning and deployment. If banks take a more open approach to the adoption of living wills, then a different, much more positive outcome may occur. By integrating the requirements from a living wills regime for living data, process and technology maps into the daily operations of the institution, the bank may benefit from the added agility to be delivered through ongoing access to up-to-date process flows (assuming of course that they allow the business to use the process as a means to improve and enhance business activities, rather than establishing them as rigid, regulatory-driven impediments to business improvement). Additionally, the development and maintenance of architectural and technology frameworks linked to these process maps have the potential to support moves toward service-oriented architecture (SOA) and technology reuse, enterprise data management (EDM) and enterprise risk management (ERM), and justify their existence through real cost savings to the business.

While many banks continue to strive for a single customer view across their current customer base, the motivation for these projects and initiatives is almost invariably focused on the opportunities to cross-sell additional products and services. Sometimes the drive to a single customer view may indeed have a more customer-centric objective, in terms of ensuring that bank staff have an understanding of the broader relationship that a customer may have with the organization, so at least the customer may be treated with the appropriate level of respect accorded to his or her account holdings. Whatever the outcome, these projects are invariably bank-centric.

However, what became clear from the bank failures through 2009 and into 2010 was that establishing a single view of liabilities due to individual customers at a specific point in history, from within the context of a failed bank was, in fact, extremely difficult. While overall customer funds may have been ring-fenced and protected up to the limits specified by local or governmental deposit guarantees, the outcome was that establishing this single view, so that customers could be refunded, was extremely difficult. Exposure to counterparties and trading partners was another area exposed by the Lehman Brothers failure, including the management of collateralized transactions, with major problems arising in determining the levels of exposures across various business and product lines. What should have been a simple and quick process had been a painful one that had taken considerably longer to achieve than expected.

To rectify this situation, part of the requirements of the living wills regulation may require participating banks to maintain a single, up-to-date (from a real-time perspective) view of the full extent of all assets and liabilities, due to or due from, each of their customers, at an individual customer level. The extent of this customer level is still open to some debate. However, the objective is to ensure:

That customers — predominantly retail and small and midsize enterprises (SMEs) — have a clear view of when their deposits with a bank exceed government or local guarantee schemes.
That should a bank fail, the administrators can act promptly to facilitate or authorize compensatory payments up to limits of any local guarantees.(Note: the compensation payments themselves will likely not come from the failed bank; however, the administrators need the ability to provide the appropriate authorities with customer lists and balances, to facilitate payment by third parties.)

Such a regulatory requirement of banks would, at best, be difficult. For many, it would prove impossible. The inclination then may be to fight such regulation and ensure that the adoption of such an approach is postponed for as long as possible. However, if the challenges of such a requirement for a single customer view are factored into the broader operational and marketing requirements of the banking enterprise, then things start to look a lot clearer. In fact, the desire to understand, on a near real-time basis, exactly what the account holdings are of individual customers, has been an ongoing demand of many marketing and customer-facing departments for many years. What we move to here is a regulatory requirement — and a regulatory cost — that can be leveraged across the enterprise to help drive additional revenue and serve customers more effectively. Compliance stops becoming a pure cost and a drain on the business, and instead starts contributing to the bottom line.

One of the major fallouts from the spate of bank failures has been the ongoing legal actions resulting from uncertainty across the payment and securities clearing and settlement systems of many of the failed banks. While lodging of collateral and the use of real-time clearance systems are designed to manage and mitigate the extent of any systemic breakdowns within the clearing and settlement systems, the reality has been somewhat different, with the increasing global complexity of organizations and legal structures adding to uncertainty over ownership of funds within the payment stream. This complex picture is further complicated by extended settlement and clearing timelines — more than 60 days in some instances — for many of the securities processing systems.

A living wills regime would require banks to maintain a stronger series of controls, and much greater transparency, across their clearing and settlement systems, as well as the ability to potentially "unplug" a bank's clearing and settlement systems from the rest of the bank, such that it might be able to operate separately from the rest of the business at a time of business crisis. The need to separate a clearing and settlement system from the rest of the bank may not initially be clear to all. Once a bank has failed, the administrator requires that all transactional activity must cease, and will focus on "locking down" positions and freezing assets and liabilities at a point in time. At the same time, the administrator needs to be able to unwind and close out positions, pay creditors and make additional payments as necessary, with very limited delay. To do all this the administrator needs access to a fully functioning clearing and settlement system.

For many banks, their existing payment infrastructures would not be capable of such flexibility. In isolation — purely to satisfy a regulatory requirement — such a requirement for a truly flexible payments infrastructure might seem an unreasonable burden. However, many banks have already started to review their payment infrastructures, looking for opportunities to modernize their existing payment technology and operations and migrate closer to a version of the Gartner-defined payment services hub. The additional requirements from a living wills regime may, in fact, prove to be the necessary catalyst to move many of these projects from the planning phase through to the implementation stage.

As the payment business moves further up the bank product and service value chain, with the use of payment data to allow clearer understanding of customer needs and better risk management across the enterprise, the ability to support the bank in complying with some key regulatory demands will heighten the role of the payment professionals charged with modernizing their bank payment systems.

As the outsourcing of core functions becomes a growing reality for many banking organizations, the role of those outsourcing partners and the functions that they manage become increasingly key to the ongoing risk management for the banking groups. It is now common practice to include some form of risk assessment as part of any ongoing outsourcing arrangement. Rightfully, much of the focus of current risk assessment is focused on the potential failure of the outsource partner that is taking on the work.

Increasingly, the demands of regulatory controls such as living wills will see a greater focus on the sustainability of the outsourced processes and services, not just the viability of the outsourcing provider. To emphasize — this is not about optimizing processes for outsourcing. This is about the accessibility and the transparency of processes, whether they are optimal or not. This shift in focus will require a framework and planning that will allow those products and services to be delivered beyond the potential failure or default of the sponsoring bank. The ongoing delivery of such processes and services will require:

That the sponsoring bank allows ready access to contractual and procedural documentation to any potential administrators of the post-failure bank.
That the contractual relationship with outsourced providers makes specific provision for the failure of the sponsoring bank.
That the sponsoring bank puts in place a procedural and financial structure to ensure that those outsourced services remain accessible to any potential administrators of the post-failure bank.

The organizational and technology impact of regulatory change, such as that envisioned by living wills advocates, will very much depend on the approach of individual organizations to the adoption and implementation of such change. Those organizations focused solely on implementing according to the letter of the new regulations may find themselves waiting a long time to establish the exact extent of any new regulatory requirement. The overall approach or focus of the organization will be unlikely to change, and much of the drive and responsibility for compliance will come from within the risk and compliance teams within the bank. Banks focused on the letter of the law will likely find themselves building yet more regulatory silos, with little or no enterprise involvement in deployment. The resultant significant expenditure on new compliance technology and applications will ultimately become a burden on the business, rather than actually strengthening the overall capability of the bank's organizations.

However, organizations that choose to focus on the spirit of such regulations are more likely to adopt practices and principles that work for their own businesses, as well as for those potential requirements from the regulators. These banks will recognize that it is not possible to cross every "t" and dot every "i" from a regulatory point of view — instead, they need to understand the strategic imperative underpinning such regulations and ensure that they deploy solutions that work for both the bank and the regulator. Instead, they will look to identify those areas of their businesses that will benefit from the implementation of living wills, focusing on the four functional areas of benefit we highlighted. By aligning the requirements of living wills with an area of business strength, or an area of potential improvement, these new regulations will make the move from regulatory cost to revenue support.

A recognition and a quantification of the business benefits that may accrue from adopting a living wills approach will be key to successful integration of such approaches into mainstream business and technology decisions and deployments. The demands required of a living will need to become mainstream requirements for running the bank on a day-to-day basis, adopted and used by departments and individuals across the enterprise, and not simply within the risk management team.

The living wills regulation has developed most fully within the United Kingdom market, and, as such, the early specifics of the living wills requirements will be tailored to financial institutions operating within the U.K. While this will directly affect a large number of banks, whether they are national players or subsidiaries of overseas banks, it will also impact many other institutions, even if they do not operate within the U.K. financial markets.

This indirect impact will take two specific forms:

Other regulators may look to the U.K. market and seek to emulate the approach taken by the U.K. regulator. As a consequence, banks globally need to look for signs that their local regulator may seek to copy or at least take direction from such living wills regulation and apply them to their own domestic markets. Early warning of such moves — and indeed early adoption ahead of regulatory mandates — will be key to successful adaptation.
Initially, many of those affected by such living wills regulation may be concerned that investment in such strategic initiatives may impact their effectiveness and competitiveness while they adapt to the new regulatory regime; e.g., developing process and technology maps, or refreshing their payment services applications and technology. However, once these changes have been implemented, then those banks will be in a stronger competitive position, better able to adapt promptly to changes in market demand and more able to establish longer-term partnerships with suppliers and customers. These banks will be stronger competitors in both their domestic markets and the global markets in which they choose to compete.

Living wills regulation has the potential to shake up the competitive environment and add a degree of market dynamism in a way that previous regulations have failed to do. All areas of the banking enterprise — not just the compliance units, must assess the needs, requirements and benefits of living wills to ensure that they take advantage of the potential benefits that this new regulatory environment may bring.

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