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Back to the Future in Financial Risks of Banking - A Dimensional Test Approach

Back to the Future in Financial Risks of Banking - A Dimensional Test Approach. Murthy Yerraguntla Srilatha Ganapati Vasu Nagendran N Infosys Limited (NASDAQ: INFY). Abstract.

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Back to the Future in Financial Risks of Banking - A Dimensional Test Approach

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  1. Back to the Future in Financial Risks of Banking - A Dimensional Test Approach Murthy Yerraguntla Srilatha Ganapati Vasu Nagendran N Infosys Limited (NASDAQ: INFY)

  2. Abstract Today’s banking world faces the toughest challenges than any industry and they must take calculated risks to outshine the competitors. Failure to balance between risks and profit results definite catastrophe in terms of financial liability, stakeholders wealth and trust. This is precisely why the Financial Risk Management and control has gained more prominence in the recent past. It has become one of the core disciplines to identify measure and monitor profile of the banks. Supervisory Committees such as Basel have been coming up with more rigorous control measures to safeguard the banks and stakeholders from the pangs of financial risk. Every financial player in the market must provide accurate and timely updates to the regulatory bodies and abide by the rules of compliance. In order to comply with this, banks rely upon software applications to generate reports and assure the risks are hedged appropriately. Testing plays a crucial role in ensuring that the various risks have been thoroughly analyzed and observations are reported to management.

  3. Abstract (cont..) • This tutorial highlights the progression in the profile of a tester during the implementation of Basel Accords. It envisages the potential role of QA during the implementation of Basel III • Contents of the tutorial will elaborate on • Types of critical risks being encountered by Banks • Regulatory bodies like Basel Compliance (II & III) • Approaches to monitor risk (Standard, Internal and Advanced) • Various tests to analyze the risk appetite (Stress testing, Back testing) • Roles played by QA during the first 2 Basel Accords • Progression in the profile of QA during Basel II • Anticipated role of QA during Basel III • Best practices

  4. Target Audience • This tutorial can benefit: • Test Managers : To comprehend the potential role of QA during Basel III implementation • Test Leads/Engineers : To recognize the relevance of dimensional testing approach while validating the risk applications • Beginners: To showcase how exciting the QA role in the field of risk is going to be in future --

  5. Outline of the Tutorial • 5. Transformation of QA profile during Basel II (20 mins) • Scope of QA during Basel 2 • QA Phases • 6. Anticipated Role of QA during Implementation of Basel III (15 mins) • Introduction to Basel Capital Accord III • QA with Key Objectives of Basel III • QA at the end of Basel III • 7. Best Practices (15 mins) • Best Practices • 8. Summarization (5 mins) • Quick Re-cap • 9. Closure (10 mins) • Revisit the objectives • Q&A • Objective & Expectation (5 mins) • Objectives of the session • Expectation from Audience • Introduction of Financial Risk (15 mins) • Types of major Risks • Sub Categories of Risk and Measurement approaches • Major financial failures post Great depression • Introduction to Basel and Role Of Quality Assurance (10 mins) • A brief history of Basel committee • Basel I Capital Accord • Basel II Capital Accord • Transformation of QA profile during Basel I (10 mins) • Scope of QA during Basel 1 • QA Phases

  6. Objectives, Expectations… • Objectives of this session : Is to touch upon the concepts of risks and role of QA while validating the risk applications in the past, present and future… • Your Expectations for this session are …

  7. Introduction of Financial Risk Types of major Risks Sub-categories of Risk Major Bank Failures

  8. Types of major Risks • Credit Risk: • This is one of the risks which has been shattering the financial firms. Credit risk denotes the risk of default from the borrower’s end. The scenario or the event which would cause the borrower to default would be referred to as Credit event. • Market Risk: • This risk deals with the adverse price fluctuations and volatility of the markets. The earnings of a financial institution would become uncertain due to the changes in the market conditions. There are multiple factors which would cause this to happen such as changes in political scenario, interest rates, equity and FOREX prices etc., • Operational Risk: • Operational Risk is the occurrence of loss due to inadequate or failed internal processes, incorrect decisions made by the senior management, or from external events. It also includes the exposure to litigation from all aspects of a firm’s activities.

  9. Sub Categories of Risk and Measurement approaches

  10. Major Financial failures post Great Depression

  11. Introduction to Basel and Role Of Quality Assurance A brief history of Basel Committee Basel I Capital Accord Basel II Capital Accord

  12. Introduction to the Basel Accords • Basel I (1988-2003) • Minimum Capital Requirement • Standardized Approach • Reasons for failure • Basel II (2004 – Present) • Enhancements to Basel I • Three Pillars • Internal Based Approaches • Reasons for failure Fig 1 – Pillars of Basel II

  13. Transformation of QA profile during Basel I Scope of QA during Basel 1 QA Phases

  14. Scope of QA during Basel 1 • The following are the key areas of testing during Basel 1: • GUI applications which would compute Tier Capital , Regulatory Capital and the Adequacy ratio. • Systems which would ensure that the Credit Risk weightage is grouped into the appropriate buckets • Applications to compute Collateral and margin requirements • Applications which are designed to report the exposure limits to authorities • Data migration for the firms involving in Mergers and Acquisitions. Basel 1 compliance post migration had to be validated.

  15. QA Phase 1

  16. QA Phase 2

  17. QA Phase 3

  18. Transformation of QA profile during Basel II Scope of QA during Basel 2 QA Phases QA Progression into Two dimensional Are we there yet???

  19. Scope of QA during Basel 2 • The following are the additional validations done on top of Basel 1: • Applications which would compute Operational and Market Risk charges using various approaches. • Systems to validate the efficiency of Internal risk models and Back testing • GUI applications to validate the disclosure content and reporting format • Validation of applications migrating to advanced DB versions and ensuring system is Basel 2 compliant post migration.

  20. QA Phase 4

  21. QA Phase 5

  22. QA Phase 6

  23. Are we there yet??? • Will the testers be able to comment upon the efficiency of Backtesting implemented and make suggestions to the business? • Will the firms involve QA in the business oriented discussions such as IRB Approaches to be followed (Foundation, Advanced) or the frequency of the Stress tests? • Will QA be able to recommend efficient Stress and VaR scenarios to the firms?

  24. Language of Business and QA Scenario 1 QA: Market Risk Charge is zero for some records in Source system Business : All the records reported are for historical data. Source is Basel1 compliant and VaR estimates will not be available. IMA implemented only after 1998. Scenario 2: QA : There are 100 mismatches in the Location field between Source and Target. Business : This is branch roll up which is common across OTC instruments. Not an issue. BAU

  25. Anticipated Role of QA during Implementation of Basel III Introduction to Basel Capital Accord III QA with Key Objectives of Basel III QA at the end of Basel III

  26. Introduction to the Basel III • Basel 3 (2012-2019) • Enhancements to Basel II • Areas of concerns Fig 3 – Changes done to Basel II

  27. QA with Key Objectives of Basel III • To ensure that the firms focus on their core areas and cut down the infrastructure costs • To ensure that the Stress data is centralized and quality of the risk estimated are improved • To ensure that the performance of the risk applications is up to the international standards and the system down time is significantly reduced • To improve upon the quality of reporting • To ensure that there are no reciprocating effects due to other policies such as Dodd-Frank, Solvency II, especially in case of US firms

  28. QA at the end of Basel III

  29. Best Practices • Standard Templates • Checklists • Reuse • Scripting knowledge • Documentation • Test Management • Process Adherence • Configuration Management • Knowledge Management

  30. Summarization Quick recap…

  31. Quick recap • Introduction to Financial risk & categorization • Basel I, II & III • Progression of QA from Basel I to beginning of Basel III • Best practices • Tester’s profile in Basel III

  32. Closure Did we meet the objectives?

  33. References • http://bis.org • Infosys project experience • Infosys resources (www.infosys.com)

  34. Q&A: Murthy_Yerraguntla@infosys.com, Srilatha_Vasu@infosys.com, Nagendrann@infosys.com 34

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