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Cyber security will stay at the top of our risk factor list, says Deloitte’s Global Risk Leader, James Caldwell


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Cyber security will stay at the top of our risk factor list, says Deloitte’s Global Risk Leader, James Caldwell


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“How safe our technology is, is going to be an important risk for the industry to consider”, says Caldwell. 
Every 7 to 10 years the world is gripped with a big financial crisis leading to a huge economic impact – be it the Asian crisis of 1997 or the global financial crisis of 2008. While it’s almost 10 years since the global financial crisis hit the world, we are still reeling under it. Mahesh Nayak of Business Today met James Caldwell, Global Risk Leader for Financial Services at Deloitte to understand what the risks or financial threats are that surround the global economy and can impact or bring down economies, threat from cyber attack in the financial world, threat of rising rates in the bond market, which countries are vulnerable and where the next crisis is brewing. Caldwell also spoke on the health of the Indian banking and financial sector, large and SME corporates and his view on the new regulation for the resolution of NPAs.
Edited excerpts:
Where is the crisis brewing this time in the financial sector and why do you think so?
It’s hard to predict the next “crisis”, per se.  There are a few friction points I see that could have the potential to shift the competitive landscape: cost commoditization, profit redistribution, experience ownership, platforms rising, data monetization, bionic workforce, systemically important techs, and financial regionalization.  An interesting aspect of the change in the landscape would be the ‘incidental’ or indirect lenders that are, what I believe, to be posing quite a problem in credit today. What I mean by incidental is lending from a non-traditional lender (with programs, robust processes including underwriting, collections / recovery, maintenance and monitoring of the credit).  Take for example, fintechs – they are lending to keep their client base happy and serve their needs.  However, they do not have the governance structure, policies, or risk management in place to scale or speed up to the size for the types of loans they are getting into. These new financial system participants could lead to a potential credit challenge that will need to be addressed down the road.


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Can cyber attack in the financial sector bring down or affect economies around the globe?
Cyber attacks do not have boundaries and can permeate different markets, jurisdictions, and demographics. Take for example the WannaCry cyberattack that happened in May of 2017 – it affected nearly 100 countries around the world. The ransomware attack appeared to exploit vulnerability in Microsoft Windows, which was identified by the U.S. National Security Agency and later leaked on the internet.  This wide spread attack highlighted the need for governments and businesses to strengthen their security infrastructure, in addition to calling attention to the need to mandate security updates and educate lawmakers about the intricacies of cyber security. With the new digital era we are entering, cyber security will stay at the top of our risk factor list.  How safe our technology is, is going to be an important risk for the industry to consider.  Additionally, customer preferences are continuing to evolve and a cyber attack also hurts a financial institutions brand and reputation (including both how they react to the cyber attack and how they earn or re-earn the trust of their customers).
Why do you see financial crisis brewing in Canada and Australia?
It’s best to clarify that there may be impending challenges but not necessarily a crisis. Both Canada and Australia were able to avoid the initial crisis in 2007-2009, but they may not be so fortunate in the near future if their challenges go unaddressed. These two countries were warned by international observers to prepare for financial shocks.  This would include housing bubble and credit problems waiting to happen.


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* Similarities: Both Australia and Canada have major housing bubbles and extended consumer credit, both have highly concentrated banking systems, both are commodity currencies reliant on strong commodity experts.
* Differences: Canada has a formal deposit insurance system, strongly connected to the US and Latin America through trade and financial links. Australia is heavily connected through commodity links to Asia (particularly China, Japan, Korea and SEA)
* Canada: Mortgage pressure exists. The era of ultra-low interest rates is coming to a close slowly. The rising rates and the tougher mortgage rules that have been rolled out, are the perfect storm for the mortgage market.
* Australia: House prices have been fluctuating or slowly falling in many areas over the last couple of years. Australia financial institutions, especially the major banks have growing exposure to housing mortgages. Additionally, the new approach to a more comprehensive credit reporting is a step in the right direction to deal with any potential consumer credit challenges.
The road to the future is never smooth; there will be a couple of bumps along the way. We should adapt, looking for opportunities for thoughtful policy implementation.
What is your take on Eurozone? Is the crisis over for the region?
After ten years, the Eurozone certainly wants the crisis to be over, again it’s hard to say for sure.  All I can do is provide my opinion. After the 2008 crisis, the Eurozone has been trying to improve the resiliency of the banking system against future crisis. Major economies are starting to expand, unemployment has decreased in the UK, but there is still fear throughout the Eurozone and the U.S. of asset bubbles due to monetary easing.
I could potentially see the euro crisis raising its ugly head again in the future, especially when the European central bank (ECB) starts to normalize its present monetary policy stance. Massive government bond-buying will need to be scaled back, which would result in less easy financial market conditions than before. A return to more normal European and global interest is also all too likely to refocus attention on two remaining economic vulnerabilities still prevalent in a number of Eurozone countries. The first is the still very high public-debt-to-GDP ratios in countries like Italy, Portugal and Spain. Far from having declined since the start of the Eurozone sovereign debt crisis in 2010, these debt ratios have increased to even more dangerous levels. It would also be interesting to see if Brexit will play a role in the ripple effects of the Eurozone crisis.  
How is the health of the US banks? What can we augur from the rising yield in the US market?


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The U.S. Banks have gone under large transformations coming out of the Great Recession and they are still adapting to and navigating a low interest rate environment. Large banks are now focused on responsible growth, cost efficiencies, and making sure that regulatory compliance is evolving with evolving regulatory landscape (scale and skill in cyber programs). The risk departments within the U.S. Banks have more influence than they did previous to 2008, and the relationship between the business and risk functions continues to grow.  Businesses are currently learning how to maximize profit within the new risk frameworks set up as part of Dodd Frank regulation. Regarding interest rates, as rates rise volatility will rise, as will revenues at banks.  I’d also expect a rise in rates to slow down the S&P. Overall though, a rise in rates is a good thing, the economy is strong so rates can rise.  
It is said that if the US grows, the world benefits, but you are sceptical. Why is that? Please elaborate.
Globalization is lifting economic growth rates and living standards around much, though not all, of the developing world, and in developed countries as well. There are instances where countries are focused on nationalism but it’s quite clear that there is no sign that the pace of globalization will slow down!  Between India, China, Russia, and Brazil the global economy is much larger than just the US.  Yes, the US is still the world leader but the sheer number of people in China and India! I read that the sales for Alibaba sales on ‘Singles Day’ in 2017 was double that of Amazon’s ‘Black Friday’ and ‘Cyber Monday’ combined.  
What are your views on cryptocurrency and the decision of Indian government to not consider them as legal tender?


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Digital currencies and block chain initiatives have taken the globe by storm. I’ve never seen a phenomenon quite like this.  Regulators all over the world have begun addressing the challenges presented by virtual currencies that for the most part bypass regulated banks, financial firms, exchanges and central clearing houses. Because the players including the most popular Bitcoin, operate outside the conventional financial system, regulators are concerned about money laundering, terrorist financing, tax evasion, and fraud. A key issue before regulators is whether our historical approach to the regulation of currency transactions is appropriate for the cryptocurrency markets
* Certain countries such as Ukraine, India, Indonesia do not consider cryptocurrencies as legal tender, while others have considered them to be a property for tax purposes.
* US – the SEC has not approved any exchange – traded products holding cryptocurrencies for listing or trading while the CFTC has designated Bitcoin as a commodity and announced that fraud and manipulation involving Bitcoin traded in interstate commerce and the regulation of commodity futures tied directly to Bitcoin is under its authority.
While many other countries are issuing strong warnings to the public about risks associated with virtual currencies, in general, governments might determine the medium of exchange by coordinating beliefs, employing transactions policy, and punishing users of alternatives. Cryptocurrency supporters will continue to explain the benefits of financial privacy and stateless monies and would benefit further from users requiring membership that has governance, controls, rules and guidelines. It would be logical that all market participants should also support sensible regulation that would preserve most of the benefits from cryptocurrencies while eliminating any threats of outright bans.  
During GFC in 2008 Indian banking and financial system was considered to be robust. What in your view went wrong that Indian banks had to face huge NPA crisis?
In the past, the major segment that had impacted the NPA levels has been the large corporate and project finance segment, particularly the infrastructure loans. We have seen these projects suffering huge delays, partly due to external factors such as delays in approvals amongst others, RBI has also over the years brought in multiple resolution schemes such as S4A, SDR, flexible structuring of project loans etc., which always had the potential downside of being used for delaying recognition of NPAs. Now we have seen that the RBI, on February 12th, has revised the entire stressed asset management framework by withdrawing all the earlier schemes and has put more focus on resolution of stress or referring the same to insolvency board. While this may have a short term impact, in the long run this has the potential to change the way banks deal with borrowers in trouble. This coupled with the enactment of the Insolvency and Bankruptcy Code can really help the banking system in adequately dealing with the issue at hand. We need to see how this evolves in the coming years.
Currently how are you viewing the Indian banking and financial system? And why?


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I believe that the Indian banking and financial system currently has the fundamentals in place. We have seen the Insolvency and Bankruptcy Code enacted and we have seen the same evolving in the past year. There is now strong credit bureau mechanism in place for micro, retail, and SME loans. The large borrower database in CRILC, setup by RBI is being updated regularly by all the banks now. As such there are strong foundations for sharing of credit information across the banking system.
We are also increasingly witnessing the banks evolve out of traditional underwriting methodologies and using the publicly available information for assessing the credit risk. The GST will also bring in transparency on the financial performance of the companies particularly in the SME segment and will only benefit the banks in understanding the true picture of these companies.


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The required fundamentals are in place but we will need to closely observe how these will mature in the coming years. A robust governance mechanism coupled with prudent lending practices, strong internal controls to mitigate operational and fraud risks and sound risk management policies will be key to ensure that the banking system can leverage these fundamentals.
Do you see the mid and SME companies causing trouble due to the policy changes? What will be the solution to avoid the same?


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We have seen policy changes like demonetization, GST etc., having an impact on mid-market and SME companies. For these entities, historically, aspects such as transparency on financial position and banking history, bank’s ability to, have been the critical areas. But as I mentioned now there is more information on these companies in public, increasing comprehensiveness in the bureau and CRILC data. Further policy changes like GST will bring in more transparency on these company’s operations and financial metrics in the long run. The underwriting methodologies and the credit risk assessment of these companies is also something which is evolving in banks as they now hold more information on their historical performance.
Banks should continue their focus on enhancing their portfolio analysis capabilities and building robust models to properly assess the credit risk and underwrite these companies. These aspects coupled with a strong credit monitoring, internal controls in operations and fraud risk management and a robust early warning detection mechanism will be the critical factors in maintaining the portfolio quality.
Banks are going aggressive in lending retail loans especially in the consumer durable segment. Do you think this can be the new area for a new crisis in the Indian banking system and why?


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It is important for banks to understand their profitability of their retail loan products. For this they will need to build in a strong risk based pricing mechanism, cost attribution and credit loss prediction models coupled with strong management of all the aspects of credit life cycle. The underwriting techniques and standards are also evolving with more emphasis on digital underwriting techniques. Further there is now sufficient data available at a bureau level which banks can leverage to strengthen their underwriting and collection mechanisms. All this gives banks more control on understanding the kind of portfolios they are underwriting and the corresponding profitability of the same. Banks need to clearly understand and articulate the risk appetite that they are willing to undertake and have effective governance and policy mechanisms in place to implement the same.


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The areas you have mentioned regarding large corporates are known. But can this segment throw some more surprises which can put further pressure on the health of Indian banks?


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As previously mentioned, for large corporates, the critical aspects will be how the banks assess the credit risk, underwrite these companies and also manage their operational and fraud risks in a concurrent and effective manner. The fundamental elements required in the form of effective data sharing and transparency, insolvency and resolution mechanism are in place. While retaining the focus on resolution of stressed assets, it will be equally important to continue focus on enhancing their capabilities in the areas of articulating risk appetite, robust governance, sound risk management policies, mitigating operational & fraud risks, and adopting prudent lending practices in line with the stated risk appetite. This will be a key determinant to maintain a healthy portfolio.


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