Introduction
Having worked in a few banks as a programmer, I want to distill some central notions of money and how it fits into the banking function. This post won't deal so much with computer programming. But it is written in the spirit of banks simply becoming information processes, and looking more like software companies. I will try to describe the context and constraints within which such banking software must operate.
The Mechanics Of Money Creation
Money is i) a medium of exchange for people and groups, within a given society. It should also act as ii) a unit of account (divisible, fungible, a specific measure or size), iii) a store of value, and iv) a standard of deferred payment.
However, our focus in this article will be on how money is created and circulates through our socio-economic context. So that means a look at money creation and various banking systems, particularly the US Federal Reserve.
In economics, money creation is the process by which the money supply of a country or a monetary region (ex: EU) is increased. Changes in the quantity of money may originate with actions of a central bank, depository institutions (principally commercial banks), or the public. The major control, rests with a central bank. The actual process of money creation takes place primarily in banks (see here and here).
So a central bank may introduce new money into the economy by purchasing financial assets or lending money to financial institutions or governments. The majority of money in the modern economy is created by commercial banks making loans or demand deposits. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money (see here and here). Banks must have a certain percentage of their deposits, available upon demand. This is the reserve requirement, and freezes an important percentage of their deposits in mandatory reserves at the central bank. The remainder of their deposits act as collateral, against which they can make loans to people, at a prescribed multiplier. This is the process which multiplies base money through fractional reserve banking.
The US Central Bank is The Federal Reserve. The Federal Reserve System was established by Congress in 1913 to ensure that the public retained confidence in its money and the financial institutions where it is held. “The Fed”, is a network of twelve Federal Reserve Banks located in major cities across the U.S. It is administered by a Board of Governors. Its seven members are appointed by the U.S. President. The Board of Governors is assisted by the i) Federal Advisory Council whose members are selected by the directors of the twelve Federal Reserve Banks, and ii) the Federal Open Market Committee, which consists of the Board of Governors and representatives from five of the Federal Reserve Banks.
The Federal Reserve System serves several functions. i) It operates as the federal government’s bank; it receives Treasury deposits and extends short-term loans to the government if necessary. ii) Its critical responsibility is to oversee banks and the nation’s money supply and make sure that the public retains confidence in both. To accomplish this, the Fed pursues several interrelated tasks.
- It serves as a centralized clearing house for checks. The Federal Reserve System facilitates the transfer of funds from one bank to another by serving as an intermediary bank. Since banks are required to deposit a certain portion of their funds in the Federal Reserve Bank, funds from one bank’s reserves can simply be transferred to the reserves of another. Not all checks are cleared in this way. Some banks use different types of intermediary institutions—either clearinghouse corporations or correspondent banks.
- The Federal Reserve System sets reserve requirements. It determines the percentage of a bank’s deposits that it must keep on hand or place in the District Federal Reserve Bank and, consequently, what percentage the bank is allowed to lend out.
- The Fed serves as “the bankers’ bank.” The nation’s banks are required to keep a portion of their reserves in the District Federal Reserve Bank. In return, the Federal Reserve Banks extend loans to local banks when they do not have enough cash on hand to handle daily transactions or, more commonly, to meet their reserve requirement. When the Fed loans money to a private bank, it charges them interest known as the discount rate. Commercial banks can also borrow from one another in order to meet the reserve requirement. When they do, the interest rate charged for these short-term loans by the lending bank is known as the federal funds rate.
Central banks monitor the amount of money in the economy by measuring monetary aggregates such as M2. The effect of monetary policy on the money supply is indicated by comparing these measurements on various dates. For example, in the United States, money supply measured as M2 grew from $6.407 trillion in January 2005, to $8.319 trillion in January 2009 (see here).
There's much more to consider. But this context allows us to begin thinking about a commercial bank's core function and constraints, and the systems it should implement to perform it.
Core Banking
Here we will look at a Bank’s core operations. The focus of any bank’s systems efforts, should be on it’s core banking, or depositing and lending of money. CORE banking, or “Centralized Online Real-time Electronic” banking software is the heart of any banking operation. It's the behind-the-scenes engine that processes all deposits, payments, loans, most bank transactions and customer data. So deposits made are reflected immediately on a bank's servers and the customer can withdraw the deposited money from any of the bank's branches throughout the world.
Some banks still use core software purchased 30 or more years ago, and have layered on top of it "ancillary" products such as online banking and mobile banking software. This is likely the source of a complex IT environment. With this setup, it is hard to manage and upgrade to launch new products and comply with emerging regulations.
From this premise, we can also view a bank’s operational efficiency as not simply about cost, but how effective the return is on initial and ongoing investment. Banks with legacy core banking environments often have a very high cost of IT which impacts the overall cost / income ratio – the most commonly used means of measuring operational efficiency.
Banks should adopt a componentized, incremental approach to architecting their core banking systems. In fact, many industry participants are adopting a Service Oriented Architecture (SOA) as part of a suite of best practices, delivering maximum operational efficiency.
There would be a core banking ‘platform’, or an environment that puts in place the basic core banking capabilities quickly. Then, gradually, the bank can add components sourced from many different vendors. This is done in a way that ensures open standards and keeps the bank open to make future investments.
The benefits of this approach are that the bank gets to choose the best tools for it’s needs. These will be tools and technologies that let management ask key questions pertaining to assets, liability, liquidity, risk, etc, in a timely manner.
- Core Banking
- Best Practices For An SOA Implementation And Application Integration
- Can Big Four Core Banking Vendors’ Oligopoly Be Broken?
Risk Assessment & Management
Another important focus, to maximize operational efficiency, is assessing and managing risk. Bank Director, sponsored by FIS, produced a Risk Practices Survey. Based on the survey findings, they have uncovered Five Risk Management Best Practices for 2014.
1 . Establish a Separate Board Risk Committee
Banks who do this perform better financially (in terms of ROE & ROA). This includes appointing a Chief Risk Officer to identify and manage those risks. The Committee’s tasks would include
- establishing risk appetite
- oversee risk dashboard reporting
- review stress testing results
- review enterprise risk assessment
- compliance of risk policies / procedures
- approve risk policies
- review strategic plan & risk mitigation strategies
2 . Review the strategic plan and risk mitigation strategies
The committee should perform this task, as it enables the bank to link strategies to risk exposure. It also enhances overall risk governance.
3 . Establish a Risk Appetite Statement
This risk appetite should cover all risks faced by the bank. Using the determined risk appetite, the committee should also establish limits. Don’t just use the risk appetite as a guide. You ideally want to use those limits as a way of analyzing how it impacts the banks performance and strategic objectives. You’ll want to minimize any risk to earnings, capital or reputation.
4 . Establish a Risk Dashboard
Committees (and management) should have an immediate view of key risk metrics. You’ll want to monitor existing and emerging risks, as well as evaluate bank performance. A risk dashboard will provide the data & metrics that allows the board committee and management to evaluate bank performance. This will let you know whether existing policies enabled obtaining strategic objectives, and minimized any risk to earnings, capital or reputation.
5 . Board & Management Review of Risk Profile
Both the board and management should take to reviewing their risk profile on a monthly basis. This includes going over key metrics, enabling timely adjustments to strategy and risk management. You should be able to ensure strategic objectives are being met, and avoid any surprises and identify emerging risks.
Secure Banking Practices
Another key concern is ensuring any new system, or system upgrade, has the highest level of security. Best practices and tools are necessary for ensuring robust core system security. But it is ultimately the implementors, who must ensure everything is properly in place (see here and here).
All software development projects should involve business analysts, software developers, testers, operations personnel, as well as product and executive management. Additionally included may be members from security and audit teams. The Information Systems Security Certification Consortium has outlined 10 Best Practices for Secure Software Development. These are good guidelines, and points of reference, when designing your core systems change process.
The National Institute of Standards and Technology (NIST) has also released a Cybersecurity Framework. It provides best practices for voluntary use in all critical infrastructure sectors, including, banking. It’s a catalog of tools, designed to help organizations develop information security protection programs to help mitigate growing cyber threats to the US' critical infrastructure.
There’s also government efforts to identify vulnerabilities in smaller community banks. The Federal Financial Institutions Examination Council (FFIEC) is a group responsible for developing banking standards and principles. FFIEC announced that it will work harder to try to identify vulnerabilities in smaller community banks and raise awareness to cyber threats. FFIEC stressed it needs to build a “security culture” in order to identify, measure, mitigate and monitor risks in their industry.
Compliance
Compliance is a central challenge to many banks. For example, the recent introduction of the “Dodd–Frank Wall Street Reform and Consumer Protection Act” (as well as EMIT, et al.) has added a significant burden to many banking operations.
Dodd-Frank is designed to prevent a recurrence of any event like the 2008 Financial Crisis. However, it is also the most significant new financial regulation since the Great Depression. This means a high degree of complexity for firms, required to comply with the law. These and other regulatory compliance burdens, can impede ongoing business and new business development. Generally, there are four main themes associated with these regulations:
- Market Transparency
- Systemic Risk
- Regulatory Complexity
- Straight-Through Processing.
Summary
As programmers, I think it's important to understand the purpose and constraints of the systems we're building. We've looked at Core Banking and some peripheral domains: Risk Assessment & Management, Secure Banking Practices, and Compliance. All with the knowledge of what money is, and the systems in which it circulates. I find this context useful when doing even basic data design. Or designing a price calculation engine, trading engine, or a risk assessment and management system. Hopefully it helps your practice as well.