New product review

A product risk committee will likely include representatives from the following
disciplines: sales, trading, systems, credit, funding, documentation, legal, risk management,
audit, tax, accounting, compliance, and operations areas. New products
are especially fraught with compliance risk. Many disciplines are involved and it’s
not just the nature of the risk but who buys it and how it’s sold. The targeted client
bases might not be the ones who ultimately buy the product. Assuming it is, however,
in what manner will they use it and what economic and liquidity risks need to be
disclosed? Will the sale of this product curtail the sale of other products or alternatively
spur more sales? Distribution channels are important. Will the sales be direct
or will a broker or third party represent the firm?
Trading must present how they intend to hedge the product and review and
track correlation analysis using historic data. These correlation assumptions and
backtesting must be performed over a sufficiently long time horizon to ensure that
the results provide a high level of confidence.
Systems are typically a weak link and may be inadequate for the new task at hand.
A trade may be jerry-rigged into existing systems and entered in several pieces in
order to capture the position (e.g. LIBOR in arrears originally had to be entered by
section into most systems). Systems must specify how the trade will be captured and
what reports can be created and whether it can be included in the master reports.
Over time, this ‘band aid’ approach may falter. Accurate exposure numbers may not
be available if the system is weak. Additionally, people are often not alert to a
changing product mix or get distracted by other priorities.
Credit should review the expected counterparty exposure and advise whether the
exposure can be netted or treated separately. Compliance will review sales material
and term sheets to ensure conformity with external regulations and internal guidelines.
There may be a need to amend existing general authorizations of the company
in order to market the product.
The funding unit will need to determine how much capital will be used or allocated
for the product. Will the money be needed at inception or over the life of the trade?
Credit exposure may grow gradually or immediately. It may be concentrated in
specific industries and the bank may find itself with an over-concentration of risk. A
related issue is the operations unit’s ability to process the transaction and monitor
it on a regular basis. If market share is concentrated in a few hands, it may be
difficult to competitive pricings.
Documentation staff must determine whether they will be able to use an ISDA
Master Agreement or whether there will be a need for more tailored documentation.
The law department needs to determine that it is a permitted product and how it
should be sold. Compliance must determine how they will they track the new product.
Risk management must determine how they will measure the new risk. One big
hurdle is where to obtain reference prices. If it is a new product, there may be few
players making a market. Typically there are not insignificant liquidity problems
encountered with the introduction of new products.