Building functional wall in banking is creating a virtual Chinese wall between key functions. It is one of the effective tool for risk management in banking.
Continuing increases in the scale and the complexity of Banking institutions and in the pace of their financial transactions demand that they employ sophisticated risk management techniques and monitor rapidly changing risk exposures. At the same time, advances in the information technology have lowered the cost of acquiring; managing and analyzing data and have enabled the financial institutions to concentrate on risk management and build sound financial system.
Separation of the front office and back office operations is crucial for ensuring effective banking practices. So, financial institutions need to establish appropriate policies that separate those areas of the institution that have access to the confidential information from those areas that are legally restricted from having access to the information. To prevent the misuse of confidential information, employees working in the sensitive areas are sometimes also physically segregated from the employees in the public area.
Links between the front office and the back office operations may range from totally manual to fully computerized system. Close cooperation must exist between the front office and the back office to prevent costly mistakes. While their priorities are different, their functions work towards the same goal of proper processing, control, recording of transactions, which is successful for the success of the banking operations.
Why Functional Separation?
Separation of front and back office duties minimizes legal violations such as fraud or embezzlement or violation of regulations. Operational integrity is maintained through independent processing of financial transactions and their settlements. Operations personnel should maintain a reporting line independent of the customer dealing function.
The collapse of the Barings Bank reminded the financial industry of the essential need to separate the front office and back office operations. A study on the lapses of the Barings Bank after its collapse revealed that an officer was permitted throughout to remain in charge of both the front office and the back office. This was a most serious failing as the need for a separation of responsibilities was fundamental. Financial institutions, therefore, must recognize the danger of not segregating the front office and back office operations. Clear segregation of duties is a fundamental principle of internal control in all business and has been recognized as the first line of protection against the risk of fraudulent or unauthorized activities.
Debate on Functional Separation
There is also a debate on the functional separation in commercial banks. Banks, which are the backbone of the financial system, perform two major economic functions. Firstly, they accept the deposits from public and settle the claim of depositors, which we can call the depositing or transactional functions. Electronic revolution in the recent past has contributed towards increased refinement and efficiency in these transactions.
Secondly, commercial banks channel savings mobilize from the public into the investments in the businesses and the industries. We call this the credit functions, which banks are yet to learn to carry out with comparable efficiency. The basic reason for this is that many banks have not been able to have their credit process into a profit oriented business process and to create structures, which can carry out the process efficiently. If banks must evolve as credible and viable credit dispersing outfits, they must put in place certain essential enabling factors and eliminate hindering factors. One idea in this regard is to examine the separation of depository functions of banks from the credit functions, which will cut through the unnecessary linkage of extraneous matters with credit.
Benefits of Functional Separation
The first and foremost benefit of functional separation in a bank is the specialization, which it allows, in people, in systems and in procedures leading to a greater focus in business operation of banks. Broadly speaking, depository function is technology intensive; follows a laid down procedure, which is fairly stable over time and requires a simple organization of work teams and only routine skills in the functionaries. On the other hand, lending requires greater analytical and judgement skills, in credit offers and a more complex organization to carry out appraisals, review of loan proposals, control of loan portfolios, laying down of credit policies and the overall management of risks and exposures.
In the present framework of which branches are functional units and delivery points for both credit and transactional services, branch offices are called upon to carry out both kinds of duties. This hinders specialization in a particular function. Moreover, Branch Managers tend to deploy most of the available manpower to complete the daily time-bound accounting function and other routine works, which are the necessary part of depository work. They may consider lending function as something, which they can defer. Banks may overcome this problem by entrusting lending activities within large branches having specialised manpower or even opening dedicated branches. The personnel drawn for these specialized outfits should be from specialised in the respective functional areas, not from the same common pool of generalists.
The concept of universal bank is gaining popularity these days. Combination of Commercial banking and investment banking function may lead the banks to get exposed to extraordinary risks. This may lead to a situation where the soundness of bank would be threatened by a fall in the market price of securities held by it due to its underwriting and trading of securities. Combination of commercial banking and investment banking may also lead to excessive speculation in the capital market. With all the investment banks moving towards the concept of “one-step financial services firm” there is also a need for firewalls to insulate a bank and its customers from the likely threats of combining commercial and investment banking. There is also a need to fix the responsibilities for each division so that there is no overlap of activities and each division is clear about its responsibilities.