Legal Data for Banking

Business Optimisation and Regulatory Compliance

Akber Datoo

• Publisher: Wiley
• Year: 2019
• Print ISBN:
  9781119357162
• Edition: 1
• eBook ISBN:
  9781119357223
• Topic: Business
• Subtopic: Finance
• Index: Business

A practical, informative guide to banks' major weakness

Legal Data for Banking defines the legal data domain in the context of financial institutions, and describes how banks can leverage these assets to optimise business lines and effectively manage risk. Legal data is at the heart of post-2009 regulatory reform, and practitioners need to deepen their grasp of legal data management in order to remain compliant with new rules focusing on transparency in trade and risk reporting. This book provides essential information for IT, project management and data governance leaders, with detailed discussion of current and best practices. Many banks are experiencing recurrent pain points related to legal data management issues, so clear explanations of the required processes, systems and strategic governance provide immediately-relevant relief.

The recent financial crisis following the collapse of major banks had roots in poor risk data management, and the regulators' unawareness of accumulated systemic risk stemming from contractual obligations between firms. To avoid repeating history, today's banks must be proactive in legal data management; this book provides the critical knowledge practitioners need to put the necessary systems and practices in place.

• Learn how current legal data management practices are hurting banks
• Understand the systems, structures and strategies required to manage risk and optimise business lines
• Delve into the regulations surrounding risk aggregation, netting, collateral enforceability and more
• Gain practical insight on legal data technology, systems and migration

The legal contracts between firms contain significant obligations that underpin the financial markets; failing to recognise these terms as valuable data assets means increased risk exposure and untapped business lines. Legal Data for Banking provides critical information for the banking industry, with actionable guidance for implementation.

1
The Role of Data in a Financial Crisis

This first chapter serves to provide context for the rest of the book – setting out the causes of the 2007–2008 Financial Crisis (the Financial Crisis) that swept the global financial markets well over a decade ago and has substantially impacted the banking and finance industry as we know it today. It was this turbulent period that provided the impetus for the substantial body of financial regulation that has been introduced over the last 10 years, as well as the enhanced legal data requirements that this body of regulation imposes, extending beyond the business and operational needs for such legal data.

In subsequent chapters we will further examine the Financial Crisis through various lenses, as some of the more pertinent aspects of recent financial regulation (such as regulatory capital requirements, margin for uncleared derivatives and recovery and resolution planning) are considered in detail. It is impossible to adequately consider legal data within the banking industry without reference to the Financial Crisis. The substantial regulatory change that has occurred affects how banks conduct business; therefore, legal data, once initially important for business optimisation and business processes, is now mandated for regulatory compliance.

For the purpose of this book, any reference made to the ‘Financial Crisis’ should be taken to mean the financial crisis of 2007–2008 and its subsequent impact. In the context of this book, by legal data, we are usually referring to legal agreement and/or legal opinion data, or that representing financial rules and regulations.

The Financial Crisis – Looking Back

The world of finance has undergone a tremendous period of change, including much retrospective questioning and attempted diagnoses, since the Financial Crisis. Albeit with the benefit of hindsight, the seeds and signs of impending trouble were undoubtedly present and grew in the build‐up to the dramatic events of 2007. Many of the effects of the issues that came to light during the Financial Crisis unexpectedly compounded each other, catching out investors, dealers, banks, regulators and politicians.

Most put the cause of the Financial Crisis down to the rapid expansion of the securitisation markets and a backdrop of accommodative monetary policies serving to heighten the value of the housing market prior to 2007. Sub‐prime borrowers were encouraged to take out more and bigger mortgages – in effect, creating an inflated ‘housing bubble’.

Some also attribute the Financial Crisis to finance professionals who lost track of the risks they were generating by entering into securitised deals, compounded by a lack of regulation. Bank regulation in respect of the level of capital that banks need to hold based on the Basel Accords played a part in encouraging unconventional banking practices to optimise regulatory capital treatment, contributing to the Financial Crisis. The repeal of the Glass‐Steagall Act removed the previously mandated separation of investment banks and depository banks, effectively providing a stamp of approval for a universal risk‐taking bank model. Financial firms were allowed to move significant amounts of assets and liabilities off‐balance sheet, into complex structures such as structured investment vehicles (SIVs), having the effect of masking the real risks, in particular, capital and leverage involved, only to be unmasked and unravelled during the full force of the Financial Crisis. Furthermore, the over‐the‐counter (OTC) derivatives market was substantially unregulated, however, it increased exponentially in volume and complexity. From supposedly being a risk‐mitigant tool at heart, their usage quickly became a significant source of systemic risk in the midst of the Financial Crisis.

Overall, the explanations given for the Financial Crisis are still hugely contested. Perhaps this is because of the undeniable complexities of the subject and the banking system as a whole, leading to an oversimplification of its causative features, or maybe it is because of the tendency to lay blame or scapegoat on particular actors in the financial markets.

It is crucial, however, to remember that banking is ultimately about taking risks. Without the assumption of risk by those financial firms best placed to assume and manage the risk, there is no banking business and therefore no financial intermediation system. The issue was the inability to identify activities that were too risky for the banks to undertake, both by the banks themselves and by their regulators.

Within the financial markets, there was a natural incentive for the underpricing of systemic risk by financial institutions. Absent regulation, they were not commensurately burdened with the costs of the broader systemic risks, fostering and, in many cases, rewarding risky behaviour. Through the Financial Crisis, the public at large ultimately bore the burden of the market failure, due to the ‘too big to fail’ view of the largest financial firms.

Regulators' forecasts of serious problems and ‘dire prophesies’ years in advance of the Financial Crisis were largely ignored, partly because of the successful lobbying by the very financial institutions that are today either bankrupt or had to be rescued with government funding. For instance, the failures of the two federal agencies (Fannie Mae and Freddie Mac) were preceded in 2005 by a successful $2 million campaign by Freddie Mac to lobby Congress from restricting their own investments in higher‐risk mortgages. These same agencies, banks and other institutions provided assurances that their lending practices (including those enabling loans without adequate documentation) were ‘safe’ based on evaluations of past data.

Data played a significant role through a failure to provide business intelligence on the underlying causes of the Financial Crisis, occurring not only at the individual firm level but also at the broader industry and supervisory level, and being unable to aggregate and derive the required intelligence in relation to the rising systemic risk beforehand. At the individual firm level, it is a significant failure that the data available and used to supposedly optimise the business decisions, in fact, could not even ensure survival in many cases.

Given this, it is welcome, and not surprising, that a number of the regulatory responses to the Financial Crisis have been to increase the banking data requirements, from transaction to trade and legal agreement‐level reporting.

There have been issues identified concerning:

• the scope of data available (i.e. that within the shadow banking system, such as hedge funds and the OTC derivatives market);
• the understanding and governance of the data available;
• the quality of the data; and
• the way in which the data was used to derive the required business intelligence.

To better understand the role data should have played prior to the Financial Crisis, and needs to play going forward, from both business optimisation and regulatory perspectives, it is worth considering in more detail some of the causes of the Financial Crisis.

Causes of the Financial Crisis

The economic backdrop of the financial system is particularly crucial to explaining the onset of the Financial Crisis. Some commentators attribute the start of the Financial Crisis to the American Federal Reserve's change of policy post‐2001. In the wake of the dot‐com bubble bursting, the American Federal Reserve lowered their interest rates to 1% in an attempt to keep the economy strong. The implication of this low rate was a low return on investment for investors, causing them to limit their investment activities, but also an increase in borrowing. Many banks used this abundance of cheap credit as leverage. Essentially, this involved borrowing to amplify the outcome of a deal; using debt to, for example, buy larger quantities of a product than cash flow would otherwise allow and then selling that product for a huge profit, even after the cost of interest (see Figure 1.1).

Figure 1.1 The impact of the 2007–2008 Financial Crisis on global GDP growth

The monetary policy increased financial institutions' willingness to take on risky assets, driving the demand for collateralised debt obligations (CDOs) and collateralised loan obligations (CLOs). These combined risky mortgages together with other financial assets before slicing them into different tiers, or tranches. Each slice – or tranche – would be made up of securities with different financial terms, meaning that they could then be marketed to investors based on the presumed level of risk. These tranches were prioritised such that the most senior tranche related to the lowest risk assets – offering safer assets, but a lower return. The most junior tranches would relate to the riskiest assets (and offer the highest returns), and if underlying assets defaulted, the tranches affected first would be the most junior ones, rising to more senior tranches as the level of losses increased. The aim was to construct a portfolio of well‐diversified assets and reduce risk through diversification. However, the quality of the CDO/CLO depends on the quality of the assets in the portfolio and most importantly, on the correlation of different tranches, which is managed by a CDO/CLO manager.

Furthermore, there was an increased use of synthetic products – for example, a synthetic CDO where the underlying asset, such as a mortgage, is instead replaced with a synthetic equivalent, such as a credit default swap (or other derivatives). With a limited number of actual assets to meet the demand of these products (surely another data metric of note in assessing the build‐up of systemic risk), these synthetic products thrived, being cheap and easy to create. In fact, synthetic issuance jumped from some $15 to $60 billion in the space of a single year in 2005, valued notionally at around $5 trillion. For example, the value and payment stream of a CDO would be replaced with premiums paying for ‘insurance‐like’¹ credit default swap protection on an underlying reference asset(s) from defaulting. This allowed speculative views to be taken on the underlying assets, even when they didn't ultimately exist. These assets hence offered a way to obfuscate the true risks being introduced into the global financial system and amplified, for example, the sub‐prime mortgage bubble. The data available – used by the regulators and market participants – was incomplete, inaccurate or simply not fully understood in terms of the caveats to it (partly due to the sheer complexity of financial products and engineering).

In 2006, interest rates in the USA started to rise in an attempt to control inflationary pressures. This meant that homeowners began to struggle to make mortgage payments, especially in respect of sub‐prime mortgages that had grown in the previously easy credit/low‐interest‐rate environment. Bank traders started to feel the impact of declining interest in CDOs/CLOs based on the growing issues with t...

Table of contents

• Cover
• Table of Contents
• Preface
• Acknowledgements
• 1 The Role of Data in a Financial Crisis
• 2 The Law, Legal System and Basics of Contract Law
• 3 Structured Finance and Financial Products – Derivatives
• 4 Data, Data Modelling and Governance
• 5 BCBS 239 – Legal Data in Risk Aggregation
• 6 Capital and Netting
• 7 Collateral – Enforceability, Reform and Optimisation
• 8 CASS – Client Assets and Client Money
• 9 Liquidity Risk Management and Reporting
• 10 Contractual Impediments – Recovery and Resolution Planning
• 11 Document Generation/Data‐Driven Contracts
• 12 Smart Contracts
• 13 Electronic and Digital Signatures
• Appendix A
• Appendix B
• Appendix C
• Index
• End User License Agreement