FIRM yearbook 2020

From machine learning to risk culture


RiskNET [Editor-in-chief]
FIRM yearbook 2020: From machine learning to risk cultureNews

The digital revolution is advancing. Technological developments are rapid and are changing the way we get information and communicate. In the age of digitalisation, it's only right that the ninth edition of the Yearbook will again be released as an e-book, in parallel to the printed version. Up to February 2020, the previous eight editions of our Yearbook have been downloaded almost 350,000 times.

Not for the first time, digital transformation in the world of financial services is a theme that runs through many of the articles in this 2020 Yearbook. Traditional service structures are gradually being replaced by digital structures and by distributed and networked information. The digital platform economy is causing rapid and disruptive change in the financial sector.
For example, in recent years the Alibaba Group, based in the Chinese city of Hangzhou, have developed Ant Financial and Alipay, digital business models for an online payment system and for insurance services.

In October 2018 Ant Financial launched a new health insurance product called "Xiang Hu Bao" (which means mutual protection), the subject of an article by Frank Schiller in the last Yearbook. It covers specified services for around 100 serious illnesses. Just nine days after the product launch, ten million customers had bought it. Within around six months, Ant Financial had gained 65 million customers, around 10 percent of Alibaba's total customer base. In two years, the health insurer's portfolio is set to expand to 300 million customers.

When the contract is concluded, only a very simplified risk assessment based on an existing AI system, Alibaba's "Sesame Credit Point" system – i.e. with no medical risk assessment – and only a very general age differentiation are carried out. All processes are fully digitalised – arrangement, claims and assessments are carried out based on AI methods in an app.
The premium amount is no longer guaranteed in advance; instead the actual claim payments incurred across the board are charged to all customers in equal fortnightly instalments. As a result, the entire business model is a kind of cooperative approach to a contribution system. Claim assessments are carried out completely digitally by around 50 employees, with the assistance of the community where required.

Around 60 professionals and academics have contributed to the FIRM Yearbook 2020 as authors. As in past years, it is edited by the editorial team of the RiskNET competence network.

It's no secret that banks have to digitalise their business. Although commercial institutions have invested heavily in front end applications such as lean customer interfaces and mobile apps, only a few have addressed what is actually a bank's biggest capital – its core data.

The article "Credibility of bank resolution regimes and market discipline: Evidence from business customer deposits" by Florian Balke and Mark Wahrenburg (both Johann Wolfgang Goethe University, Frankfurt am Main) presents the results of a study that examined changes in market discipline in European business customer deposit markets as a response to various crisis periods and regulatory initiatives in the European Union. The results strongly indicate that reforms have helped to strengthen market discipline in the Euro zone.

In their article "A new approach to management of market risks" the authors Stefan Bochtler, Thomas Pfuhler, Christian Schmid and Stephan Süss (all from Boston Consulting Group) illustrate that rigid IT systems and fragmented data flows mean that rapid solutions are almost impossible. In a time when banks are exposed to significant compliance challenges, a turbulent operating environment and increasing competitive pressure, only a few of them are in a position to make farreaching changes to their data management systems.

The causes of the last financial market crisis have been exhaustively analysed, meaning that banks should now be better prepared for a possible downturn in many areas, both in terms of breadth and depth, than was the case in 2008/09, which should increase their resilience, according to Michael Berndt and Gorden Mantell (both from Ernst & Young) in the article "Preparing for the down cycle: From a credit risk management perspective". At the same time, these improvements mean that experience from past downturns is only of limited relevance for a future downturn. Therefore, banks should start now to reassess their own credit risk management and their preparedness for a future downturn and to scrutinise their adaptability.

Management of a bank is based on economic indicators that represent the organisation's business performance and are used both to define the institution's objectives and to measure its achievement of those objectives. In their article "Integrated Bank Management – Are Banks Flying Blind on Regulation?", Maik Frey, Thorsten Kaiser and Przemyslaw Noetzel explain that in recent years the financial industry has seen a constant increase in the complexity and scope of regulation Regulatory requirements, for example in the area of liquidity, such as the liquidity coverage ratio and the asset encumbrance ratio, or in the capital area with the leverage ratio, are complex and, at the same time, are closely intertwined with economic indicators. Therefore, for economic decisions it is not only the earnings side that has to be considered but also the impact on compliance with regulatory requirements.

During the last financial market crisis, banks' risk culture became the focus of increasing attention from companies, regulators and researchers. For guidance, the FSB divides the risk culture into four areas, all of which have to be taken into account to ensure successful management. The article "Risk culture – Making the unmeasurable measurable?" by Jennifer Kunz (University of Augsburg) and Carsten Heineke (KfW Banking Group) addresses the question of which of these areas banks can effectively measure and manage and where there is a need for further action. The analysis comes to the conclusion that banks are faced with major challenges, particularly in promoting transparency and managing open communication.

The issue of compliance is no longer something that is only relevant for large businesses and corporations; it now also impacts SMEs and smaller companies. Many companies have introduced compliance management systems (CMSs) and employ compliance managers. As recent developments in legislation and legal decisions demonstrate, when it comes to how positively they are considered, it is less about the mere existence of compliance measures than about their effectiveness in preventing or reducing non-compliance; this is the argument put forward by Martin R. Schulz (German Graduate School of Management and Law / CMS Legal Office) in the article "Effective compliance management: Human beings as a risk and opportunity". The author recommends devoting greater efforts than previously to analysing the causes of human misconduct and to prioritising the development of a functioning compliance and integrity culture.

The current megatrends digitalisation, globalisation, regulation (governance, risk and compliance management) and a lack of specialist staff result in tough new requirements for governance structures put in place by a "prudent businessman" to be successful in the long term. In the article "Prudent businessman 4.0: Low risk, high value in uncertain times", by Josef Scherer (Deggendorf Technical University), the "prudent businessman" concept is used as a synonym for a conscientious manager.

Strategic risk is one of the most important risks in the context of non-financial risk management. In the article "Management of strategic risks", authors Volker Liermann and Nikolas Viets (both ifb) outline their view that driver-based planning and projection of the risk situation can act as a crucial bridge to financial risk management with its quantitative nature. These two instruments enable an improved approach to the uncertainties that form the basis for decision-making in many dimensions and also provide important analysis options for risk when defining strategy.

The authors of the article "Activity-based risk management for consistency in management and leadership", Roland Erben (Stuttgart Technical University), Andreas Fornefett and Bernhard Kessler (both plenum AG), argue that with all the current discussions surrounding the issue of digitalisation, there is a growing danger of exaggerating the use of object orientation in modelling and neglecting people and their free will. Decisions are linked to responsibility for the effects they provoke. And it is ultimately people who have that responsibility. It has only been when discussing questions relating to responsibility for autonomous driving or artificial intelligence that many people have become cognisant of the fact that without human "free will" any discussion of fault is simply obsolete. Managing risks (opportunities and threats) should enable people to make responsible decisions and take responsible actions.

Sustainability is an issue in management research that could hardly be more current. In particular, there has not yet been a comprehensive and scientifically sound analysis of the currently available resources to facilitate a transition to a resource-conserving recycling economy. In the article "Corporate social responsibility and bank risk", the authors Florian Neitzert and Matthias Petras (both University of Cologne) examine the extent to which CSR activities can influence idiosyncratic bank risk.

An increasing number of banks are completely or partially replacing their existing organisational structures with agile models. On the one hand, this brings opportunities in terms of competitiveness but on the other hand it influences the non-financial risk profile in the transitional phase and on an ongoing basis, according to Thomas Kaiser (Johann Wolfgang Goethe University, Frankfurt am Main) in his article "Influences of agile structures on management of non-financial risk". These risks need to be appropriately managed. In addition, it is essential to ensure that structures and processes take sufficient account of the governance aspects of non-financial risks.

Sustainability has been part of banking for a long time. The issue can manifest itself in a variety of ways. From a specific sustainability assessment of new transactions to evaluation of possible reputa- tion risks, to participation in public initiatives such as the UN Global Compact or the German Sustainability Codex, almost anything is possible. In their article "Sustainability in banking", Jochen Peppel and Philipp Mettenheimer (both Oliver Wyman) argues that none of these things is new per se.

System risk is defined as the risk of deep-seated problems in a financial system. In emerging nations, this had been an important issue for many years before it leapt to prominence in developed countries in September 2008 following the collapse of Lehman Brothers. Since then, system risk has been right at the top of the agenda when it comes to banking reforms. While microprudential regulation and supervision focus on the security and solidity of individual banks, macroprudential regulation and supervision look at the financial system as a whole. Capital buffers have been created to counter system risks. In addition, financial stability committees have been set up, with the task of monitoring this kind of risk and responding to it promptly. At the request of the German financial stability committee, the German regulatory authorities recently activated what is known as the anticyclic capital buffer. More than a decade after the events of the 2008 crisis, it is fair to say that significant progress has been made and it is apparent that system risk is being carefully monitored; this is the conclusion of authors Dietmar Leisen (Johannes Gutenberg University, Mainz) and Jorge Ponce (Central Bank of Uruguay) in the article "Limiting system risks: Progress and challenges".

In their article "European banking supervision and sustainable development targets", authors Hermann Reuter and Lothar Jerzembek (both International Bankers Forum e.V.) argue that in its first five years the European SSM Round Table has developed into a high quality neutral platform made up of respected members, with the Chatham House Rule guaranteeing confidentiality. Responsible senior management will be equally vigilant in monitoring the changed risk situation as the increasing requirements for financing in the environmental, social and governance fields. Because of these developments, the SSM Round Table set up by IBF and FIRM as a neutral platform for confidential discussions between banks, supervisory and regulatory authorities, and consultants and academics, could become even more important. The next two Round Table meetings have already been arranged – in May 2020 at the Bank of Finland in Helsinki and in the second half of 2020 at the German Bundesbank under the auspices of Germany's council presidency.

During a financial crisis, central banks and governments regularly intervene to protect banks against collapse by injecting liquidity and capital. Although these bailout mechanisms cause significant macroeconomic costs, the justification put forward in the public debate is that they increase financial stability and thus mitigate the real economic costs of financial crises. In a recent study supported by the Frankfurt Institute for Risk Management and Regulation (FIRM), the authors Valeriya Dinger (University of Osnabrück and University of Leeds), Lisardo Erman (University of Osnabrück) and Daniel te Kaat (University of Groningen) looked at the effect of bank bailouts on banks' lending and the real economy. Their article "Bank bailouts and real economic dynamics" summarises the most important results and the political implications.

Sascha Steffen (Frankfurt School of Finance & Management) uses his article "Effects of quantitative easing in the real economy" to highlight the fact that the key effects of the ECB's programme to acquire corporate bonds are indirect in nature. The monetary policy decision to buy large volumes of corporate bonds has led to banks losing lending business with eligible companies and replacing it with lending to other companies. The authors refer to this as the "capital structure channel" of monetary policy. However, they also point out indications that banks' commitments in higher risk segments of the economy are increasing.

Authors Jürgen Sonder (Intrum Deutschland) and Ralph Bender (Intrum Financial Services) are convinced that creating a European regulatory framework such as the NPL guidelines and developing a functioning secondary market are effective instruments for managing future crises more effectively. Their article "Effects of the European regulatory framework on non-performing loans (NPLs) and financial market stability" highlights the fact that harmonised EU standards provide a framework for all market participants, enabling them to contribute to reducing the NPL rate on the banks' balance sheets.

Especially in the specific form of currency overlay, overlay management has been well known and widespread for a long time. However, the general concept of overlay management – in terms of its economic function, organisation and implementation – frequently remains unclear. In large part this could be due to an often confusing variety of terms. In spite of this, both professionals and academics attribute considerable benefit to it. In the article "Overlay management: Why and how?" the authors Steffen Bankamp (Georg-August University Göttingen), Bernhard M. Baur (BBConsulting) and Olaf Korn (Georg-August University Göttingen) examine the economic basis for these perceived benefits of overlay management. The answer has an impact on how overlay management should be integrated into the investment process.

In the recent past, geopolitical risks have repeatedly caused major shifts on international financial markets. In this environment, investors have repeatedly had to rapidly adapt their risk appetite in response to the latest news (risk on / risk off). This investor behaviour has implications for the currency market. In this context, the distinction between low and high beta currencies is hugely relevant. The article "The US dollar – A safe haven on the currency market? Considerations from a risk management perspective" by Christoph Dieng, Tobias Basse (both NORD/LB) and Christoph Wegener (Leuphana University, Lüneburg) looks at this concept from a risk management perspective and empirically analyses it.

Litecoin, NeuCoin, Dodgecoin – there are now hundreds of blockchains, each with its own cryptocurrency. Behind them are various strategies, from exchanging money between private individuals through to attempts to substitute national currencies. But are blockchains really suitable for use in payment systems without creating new or additional risks? This question is answered by Carsten Lehr (EFiS) and Christian Schwinghammer (EFiS Swiss) in their article "Blockchain as a replacement for conventional payment systems?".

Research supported by FIRM shows that digital footprint variables have a strong link to customer's probability of default and thus represent a valuable alternative data source for risk classification in retail banking. However, according to authors Tobias Berg and Maximilian Kreft (both Frankfurt School of Finance & Management) in their article "Digital footprints in credit scoring – A comparison of traditional methods with machine learning methods for credit scoring based on digital footprints", as well as the information value of the borrower characteristics, the classification method used for modelling the empirical relationship also has a critical influence on the discriminatory power of a scoring model.

The wealth of data held by insurers is a treasure trove. Technologies such as AI and data analytics enable the industry to create a world of products that can adapt more individually and more quickly to customers' needs in their life situation than ever before. Strict data protection requirements give existing players in Europe a huge market advantage. In his article "New life assurance products thanks to big data and AI?", Frank Schiller (Munich Re) critically notes that those tempted to rest on their laurels with this data protec- tion buffer ought to consider the opportunities that an agile company can create for themselves and their customers, while external providers across the world are starting to make their way into the digital world.

Big data, predictive analytics and machine learning have become ubiquitous buzzwords amid claims that they will revolutionise business models and society as a whole. The aim of using big data methods and data analytics is obvious. They help to measure the world and customers, create personality profiles and make real time predictions based on increasing volumes of data. Data analytics is all about analysing and visualising information obtained from large data volumes using statistical methods. The article "Data analytics for fraud detection and early risk detection" by Hans-Willi Jackmuth (addResults) and Frank Romeike (RiskNET) provides an overview of the use of data analytics and some of the tools devel- oped for fraud detection and early risk detection.

For years, financial service providers have unanimously agreed that exogenous risks such as low interest periods, regulatory obligations and digitalisation have been their biggest and most urgent chal- lenges. In particular, digitalisation will have a lasting impact on all areas of the financial services business, its organisation and pro- cesses, its products and services, and its pricing and sales policies. A digitalisation strategy will change business models in the financial services industry in general, and the insurance industry in particular, in terms of theoretical perspectives on unconditional risks that can be actively influenced and conditional risks that have to be passively accepted, and will require an adapted form of digital risk management focusing on data mining, statistics and mathematics; this is the argument put forward by Matthias Müller-Reichart (Rhein- Main University) in the article "Digitalisation of risk management in the insurance industry".

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[ Source of images: RiskNET GmbH / FIRM ]
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