April 22, 2021 - Yesterday, Matthew James Moore (Deutsche Bank), Michael Richardson (Northern Trust) and John Schmidt (Blackstone Credit) joined Ellen Hefferan (LSTA) to discuss why mitigating Operational Risk will require more than *cosmetic* changes to documents.  They recognized that the mistakes depicted in the Revlon case could certainly occur at other institutions because the loan product is so manually intensive.  There is a lack of centralization and standardization, especially with respect to the timing and consistency of payment noticesThe complicated front to back workflow, combined with resourcing issues can manifest as operational risk especially if a firm is not prepared for record volumes.  The case highlights the importance of having an intuitive application for loan processing, properly designed with systematic controls in place to reduce the opportunity for error.  Add to these challenges that we can no longer assume mistaken payments will be recovered.  The loan market seems to have entered a “new normal”.

An unintended consequence of this “new normal” is that banks are spinning their wheels to nail down legal language in credit agreements while buy- and sell-side parties endeavor to add layers of controls to an already manually intensive product.  In fact, there is the potential to add too much control, creating delays in payment which can impact liquidity and result in problems with striking daily NAVs.

But where there are problems, there also are solutions.  A multi-prong, multi-layer approach can mitigate operational risk.  To enhance controls, ensure that facility data and wire instructions are captured correctly using four-eyed checks.  (That is two sets of eyes, not one set of eyes behind glasses!)  Duties are segregated across the middle and back office to process payments, utilizing four-eyed checks.  Payment verification and controls must be in place with systemic checks preferred over manual checks.  Six-eyed checks are recommended for payments exceeding certain thresholds; a large payment requires the additional check of a senior level employee.  It is standard to set the tolerance at the risk appetite.

The cash matching control is equally, if not more, important than four-eyed checks.  Because a position is not held at an agent bank, a payment will not hit its balance sheet.  Therefore, a control must be in place to not release a payment from the bank until funds are received from the Borrower although, in the discretion of a bank that is willing to accept an intraday payment risk, there should be an option to release funds to lenders prior to receipt of payments from the Borrower.  Staff must be trained and supervised to develop the subject matter expertise needed to employ these controls, effectively designed to mitigate risk and add value.

But wait, there is more! Our panelists added that to address antiquated processes and the need for transparency, the market should create a centralized hub/ledger.  Eighty seven percent of those polled in our audience think that the market needs a centralized hub.  And more importantly, 84% of those polled think the right time to move toward automation is now.  Information from the agent bank systems, mirrored in the hub, would contain deal and facility level details including CUSIPs, loan contract details, accruals, lender details including MEIs, settlement instructions, payment information, corporate actions, etc.  Lenders and custodians could use APIs to consume permissioned data seamlessly into their systems, rather than booking the data – a huge win especially in the case of cashless rolls/refinancings.  The ability to plug into real-time data would be massive in terms of transparency and scalability for the industry.  The need for notices and reconciliations would cease.  Extensive agent freezes would be eliminated, and settlements would be expedited.  Taken to the next level, payments could be automated.  Reduce operational risk, allow the market to function more efficiently, and you will increase liquidity and interest in the asset class.

This is a call to action.  Today it is our choice to be proactive and develop a utility in a pragmatic way that makes business sense.   Let’s keep it our choice.

The LSTA would like to thank all the sponsors that made its Ops Conference Series a reality. Please visit them at https://gateway.on24.com/wcc/eh/2869834/virtual-exhibitor-hall

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