Post-crisis financial order sets new IT systems criteria

Intent on rebuilding profitability after a turbulent 2008 and tough 2009, investment management firms must consider restructuring their cost base in their choice of IT platform to become more flexible and profitable. Amid tightening regulations, the ‘new normal’ raises the bar in distribution, and investment managers must adapt to a more challenging environment.

by Managing Partner Cornel Bender, Capco

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The investment management industry is currently under attack on several fronts. Although the threats were already discernible prior to the financial crisis, it intensified the shortcomings and the need to act. Faced with a loss in investor trust, investment managers have had to handle an enormous reduction in assets under management (AUM).

Instead of trying to do and offer everything, investment managers need to focus on core competencies and to automate workflows. Additionally they have to create transparency to meet regulatory requirements and to regain investors’ trust. What is required is a strict industrialisation of all processes including an improvement in risk management and reporting, supported by an agile IT platform. Establishing the right platform will also help to cope with future regulatory requirements as yet unknown but certain to come.

DEALING WITH THE CRISIS

The capital markets have been dealing with the financial crisis for well over a year now. The good news is that the impact on investment managers has not been as dramatic as on many investment bankers. The bad news is that it remains a major threat.

Nevertheless the crisis can also be seen as an opportunity. It clearly points out the shortcomings in the investment management industry – already known for almost a decade – and therefore serves as a catalyst to spur pressing action to be taken in specific areas such as focusing on core competencies, improving processes and workflows, reducing costs, and creating more transparency.

But how specifically has the crisis impacted investment managers? The first and also biggest is the vast reduction in AUM. This owes to different factors:
• Investors’ loss of confidence and faith in the markets (private investors as well as institutional).
• Various market crashes sparking weak fund performance and resulting withdrawal of investor capital.
• Investors’ mistrust in derivatives allocated in funds. The belief that investment managers were able to understand and handle the risks was tarnished.

The table in Figure 1 gives an indication of the reduction in AUM for the Ger¬man market.

Although the number of funds (apart from institutional funds) increased between 2007 and 2008 by roughly 640, total AUM decreased by around €205bn. Of course the reduction in available investment capital increased competition among market participants. But also the competition among different products on offer has become more intense. The struggle between traditional funds, certificates and exchange-traded funds (ETFs), which already began before the crisis, grew more intense during the crisis as investment capital dried up.

What has the investment management industry done so far? The main response has been to reduce costs. This has varied from curbing internal services to initiating huge outsourcing projects. In addition to this, some banks have sold off their asset management businesses. But for any one party selling, there is also one who buys. And these are clearly using the crisis to strengthen their market position.

Figure 1. Funds and AUM in Germany from 2006-2009. Source: Zeitreihe Fondsvermögen/Mittelaufkommen 1950 – April 2009 (http://www.bvi.de/de/statistikwelt/Investmentstatistik/download/zrfvma_dt_invbr_1950-Apr2009.pdf)

SPECIALISATION WILL CONTINUE

In the post-crisis environment it will be mission critical to identify core competencies. Based on this strategic decision, specialisation and outsourcing of non-core competencies have to be realised in order to reduce internal costs. Certainly this trend will continue. We see the most crucial specialisation categories as follows:
• Boutiques focusing on portfolio management. These companies are known to have a high competency in research and portfolio management and an excellent market reputation. Nevertheless they will have issues achieving critical AUM mass and face high processing costs due to lack of scale. Specialists focusing on sales and distribution. Additional specialisation could either take the form of product offerings (i.e. retail funds, hedge funds, fund administration), investors (agent pools, online banks, institutional investors), or even just one service provider. For these specialists it will be crucial to find a suitable selection of products and back office service providers.
• Big players in the market. The industry agrees that the biggest investment management players will have AUM of over $1.5trn in the near future. This will be the result of ongoing mergers and acquisitions as well as organic growth. Big players have the advantage of critical mass in every area in order to achieve economies of scale and cost advantages. However, the downsides are lack of specialisation and often highly complex portfolio management.
• Back office insourcers. Of the four categories, these have the most need to build a processing factory. As they are at the lower end of the value chain, they have to be highly client oriented and face low margins.

What will be the impact of this specialisation process on IT? First of all it is important to note that an IT platform always has a history. Built often over decades the platform is usually very complex. Replacement is costly and difficult and therefore often avoided. But redefining the business model can also be seen as a chance for optimising the IT architecture. And it is vital for reducing costs as the business is mainly driven by IT processes. Often enough a selected IT application defines the business processes. But the urgent need to adapt to markets means that investment management requires systems that support future processing needs. The new system’s flexibility and ease of integration will be key to the industrialisation of investment management.

INDUSTRIALISATION OF INVESTMENT MANAGEMENT

The industrialisation of investment management will go hand in hand with specialisation and it will be vital for back office insourcers to build up a processing factory. According to the ‘Report on Global Investment Management Cost Survey 2009’ published by SimCorp StrategyLab, 41% of industry decision-makers think that automation of processes is the most important cost-cutting strategy over the coming three-year period. Several high-volume low-margin industries like the food industry went the same route: a few years ago they industrialised their processes in order to cope with squeezed margins.

Through automation of processes, investment management will be able to boost productivity, thereby leading to rising profitability and freeing up resources for core investment management work. We see the biggest potential for automation for the big players and back office insourcers. As their main focus is to realise economies of scale, they are dependent on a consistent and integrated backbone implementation. In the back office area securities settlement and processing are already highly standardised. However, a great deal of manual processing is still evident. The processes for less complex over-the-counter (OTC) products have a high straight-through-processing (STP) rate and also external service providers are in place. The highest potential and need for automation are for complex OTC derivatives. The processes here are very often complex and manually driven. Some service providers have set the first standards for matching, settling and handling of documentation.

Automation requires an open, flexible and integrated state-of-the-art IT platform. A back office insourcer will communicate with several external parties. Therefore interfaces and protocols are unavoidable and the use of standards is self-evident. A high STP rate is vital as manual processes are always cost intensive and error prone and especially their business will be high volume. It would be a clear advantage if the involved parties use the same standard software as the data model would be identical and complex mapping could be avoided.

It is also important to note that from a reporting perspective a well-organised data warehouse is essential to meet existing and upcoming requirements. Due to the fact that most IT platforms are rather heterogeneous, it is usually quite challenging to identify and gather the necessary data from the right source with the proper timing. Often the gathering process and respective interfaces include a great deal of business logic to provide the required data (i.e. regulatory reporting, IFRS, Basel II, factsheets, individual client and internal reports). As the basic data is needed for several purposes it makes sense to organise the data warehouse in different tiers. The first one should be a ‘simple’ gathering tier, where the data is captured from the source applications as it is. On a second level it can be clustered (i.e. P&L figures, accounting figures, static data), and on a third level the business logic can be integrated. Now the different reports can either build a fourth tier or take the data directly as required.

RETURN OF THE INVESTOR

We know it will be a hard job to win back investor trust. In addition to basic prerequisites, such as excellent decisions in portfolio management and allocation, investment management will have to focus on two areas to regain and prove their credibility:
• risk management
• reporting

Risk management is well established in the investment management industry. Nevertheless it will be vital to improve methodology and to convince clients that the industry is able to handle the risks. A state-of-the-art application is as mandatory as adequate and understandable reporting. In addition the new product process will come to the fore. New products frequently imply new structures, new components and require complete implementation in all relevant areas. Impacted are very often front office, middle office, back office, risk and compliance.

It will be vital to process products in a coherent way so that the components and respective figures are distributed properly. In an ideal world it would be possible to enter the components individually as part of a super ordinate product. For the processing, each downstream department can decide if it requires the data and figures at component level (i.e. risk management, IFRS reporting) or aggregated for the superordinate product. Again we see how important a flexible and integrated IT platform is to provide the necessary STP support. Also collateral management and other risk-mitigating measurements (i.e. break clauses, netting) will be important steps to reduce market risk as well as counterparty risk.

Reporting will be an important instrument to reestablish investor trust as this is one of the very few ways to be in direct touch with the investor. Hence a glossy marketing flyer is not enough; delivering the facts and demonstrating transparency are essential. Explanations of the product strategy have to be made understandable as well as the risk strategy and the respective figures. With the Internet in everyday use, it is very easy nowadays to compare data and to obtain additional information, so overtly dressing up figures will be quickly seen and penalised by the market.

Transparency and ease of fund choice are also important. Simply too many funds have been produced in the past. Due to the crisis and resulting drop in AUM many funds have already been merged or even closed. Nevertheless fund offerings remain excessive and this complicates the selection for investors.

CHOOSING THE RIGHT IT PLATFORM

We have seen in the past that standard software applications have become more and more powerful. This applies to IT applications, which were part of a best-of-breed solution, as well as all-in-one solutions, which embrace several business areas such as order management, portfolio management, matching and settling, risk management, compliance, collateral management, fund accounting, etc.

The strategic choice of a particular IT platform depends on the positioning of the investment management company. The business functionalities comprise one major criterion for determining if a best-of-breed or all-in-one solution is preferred. From a technical point of view additional criteria are the in-house integration (this is relevant for the STP rate; in general a best-of-breed solution also requires good middleware), as well as communication with third parties (external interfaces). This might tip the scales in favour of a system that is already used by several external parties. Also if a system is very common in the marketplace there is a greater chance of finding trained staff than for a system that is less common.

The discussion about best-of-breed and all-in-one solutions is hardly new, and each solution has advantages as well as disadvantages. But with respect to what we have stated before, the all-in-one solution has one major advantage in the form of an integrated data warehouse/pool. This provides a good consistent basis for risk management or reporting and also leads to a reduction in internal interfaces and complex reconciliation processes. It is important that the applications are integrated in the whole IT landscape with a high STP rate and that they are sufficiently flexible to quickly adopt new products.

FINANCIAL MARKETS IN THE POST-CRISIS ERA

US President Barack Obama’s proposal to limit the size and complexity of banks, as unveiled in January, bars commercial banks from owning or investing in hedge funds and private equity companies, or running a proprietary trading desk. It also foresees a market share limit for banks so that there will be no ‘too big to fail’ any more. Although it remains unclear if the proposal will become law, it already shows the direction things are going. The Financial Stability Board (FSB) is singing the same song and it indicates that the financial markets are in for change.

Certainly it remains to be seen how the financial markets will look in the future, precisely whom the participants will be and therefore how liquid the markets will be. Politicians are still discussing different scenarios for regulating the markets and its participants. But investment management and asset allocation are certain to be impacted.

MAIN AREAS FOR ACTION

The past was a golden era for the invest¬ment management industry. Already a few years before the crisis this era was beginning to fade. New products like certificates and ETFs forced the industry to take a closer look at costs and specialised providers offered services at lower prices. The crisis has increased these cost pressures and forced the industry to act. We see three main areas where the industry has to act:
• specialisation
• industrialisation
• rebuilding investor confidence.

It will be vital to identify core competencies and to automate processes and workflows. This requires flexible and integrated IT platforms, not only to cover existing needs but also to be able to accommodate future and as yet unknown requirements. These may come from new products as well as from regulatory authorities, for example, in the form of European harmonisation and standardisation.

Winning back investors will be tough and also mission critical. The keyword here is transparency. Investors have to feel confident that the industry is capable of handling the risks. This has to be communicated in a clear and understandable way. In addition, reporting requirements for private investors have to be enhanced. A simple factsheet will not suffice any longer.

The investment management industry faces many challenges, but it is our view that they are manageable. Old structures have to be discarded. IT platforms have to be adjusted accordingly and – we cannot stress it often enough – the solution has to be agile. This is a healthy process. It will help the industry to position itself and build a stress-tested business model. The crisis presents a unique opportunity for investment managers to review what they do, adjust their business models and en¬sure the viability of their institutions for the future.



Cornel Bender is Managing Partner for Capco in Germany. In addition to heading the CEE region of the Package Integration business unit, his responsibilities cover the capital markets industry, including asset management, exchanges/infrastructure and investment banking. One of his major consulting areas is the asset management/investment fund segment with its high demand for strategic business and IT decisions that are reflected in process redesign, blueprints and systems-implementation. Cornel Bender joined Capco from KPMG Consulting/BearingPoint where he was head of Capital Markets EMEA.