Operational Risk Fin 129 Drake Fin 129 DRAKE

Operational Risk Fin 129 Drake Fin 129 DRAKE UNIVERSITY

Operational Risk Drake University Fin 129 Risks related to the design and efficiency of internal procedures, systems, and human resources The risk of loss resulting from inadequate or failed internal processes people and systems or from external events. (Basel Committee 2001). Generally this includes legal risk, but not reputational or strategic risk. However, some institutions also consider reputational and strategic risks as operational risks.

BCBS Definitions of Operational Risk 1. 2. 3. 4. 5. 6. 7. Drake Internal Fraud External Fraud Employment Practices and Workplace Safety Clients, Products and Business Practices Damage to Physical assets Business Disruption and system failures Execution Delivery and Process Management This and the next few Slide from Operational Risk , Carol Alexander Drake University Fin 129

Internal Fraud Drake University Fin 129 Losses due to acts of a type intended to defraud, misappropriate property or circumvent regulations, the law or company policy Unauthorized activity – Theft and fraud – Fraud / worthless deposits, Bribes/ kickbacks

External Fraud Drake University Fin 129 Losses due to acts of a type intended to defraud, misappropriate property or circumvent the law, by a third party Theft and Fraud – Forgery, Robbery, check kiting Systems Security –

Employment Practices and Workplace Safety Drake University Fin 129 Losses arising from acts inconsistent with employment, health or safety laws or agreements, from payment of personal injury claim or from diversity/discrimination event. Employee Relations – Safe Environment- general liability (slip and fall), workers comp. Diversity and Discrimination

Clients, Products and Business Practices Drake University Fin 129 Losses arising from an unintentional or negligent failure to meet a professional obligation to specific clients (including fiduciary and suitability requirements) or from the nature or design of a product. Suitability, Disclosure, and Fiduciary –

Clients, Products and Business Practices Drake University Fin 129 Improper Business Practices – Antitrust market manipulation unlicensed activity, money laundering Product Flaws – model errors Selection, sponsorship, and exposure – failure to investigate per client guidelines exceeding client exposure limits Advisory activities

Damage to Physical assets Drake University Fin 129 Losses arising from loss or damage to physical assets from natural disaster or other events

Business Disruption and system failures Drake University Fin 129 Losses arising from disruption of business or system failures Hardware failures Software failures Telecommunications problems Utility Outage / disruptions

Execution Delivery and Process Management Drake University Fin 129 Losses from failed transaction processing or process management, from relations with trade counterparties and vendors Transaction capture – Miscommunication, data entry error, missed deadlines Monitoring and reporting – failed mandatory report Customer intake and documentation – client disclaimers/ permissions missing

Execution Delivery and Process Management Drake University Fin 129 Customer client account management – unapproved access given to accounts negligent loss or damage of assets Trade counterparties – nonclient counterparty misperformance Vendors and Suppliers

Total Loss by Risk Type Drake University Fin 129

Basle Drake University Fin 129 Requires measurement of the operational risk capital requirement resulting from each source in each of 8 business lines 1. 2. 3. 4. 5. 6. 7. 8. Corporate Finance Trading and Sales Retail Banking Commercial Banking Payment and Settlement Agency and Custody Asset Management Retail Brokerage

Drake Frequency and Risk (F/R) Internal Fraud External Fraud Employ Practices Corp Fin L/H L/M L/L Trading L/H L/L Retail Bank L/M Com Bank Clients Drake University Fin 129 Damage to Phys Bus Disruption Execution delivery L/H L/L L/L M/M L/L H/L L/L M/M M/L L/L H/L L/H M/M L/L L/L M/L Pay & Sett L/M L/L L/L L/L H/L Agency & Cust L/M L/L L/L M/L Asset Mgmt L/H L/L L/L M/L Retail Brok L/M L/L M/L

Importance of Technology Drake University Fin 129 Efficient technological base can result in: Lower costs Increased revenues Earnings before taxes = (Interest income Interest expense) + (Other income Noninterest expense) - Provision for loan losses

Technology and NIM Drake University Fin 129 Well chosen Technology can increase net interest margin, by decreasing interest expense and increasing interest income. It also impacts non interest income and non interest expense

Impact of Technology Interest income can be increased Interest expense can be decreased Drake University Fin 129

Impact of Technology Other income can be increased Noninterest expenses can be reduced Drake University Fin 129

Impact on Wholesale Banking Drake University Fin 129 Wholesale Banking – corporate customer services Improvements to cash management Controlled disbursement accounts – establishes in morning all payments that need to be made by the customer that day. The Fi then receive a wire transfer in that amount form the client. Account reconciliation

Impact on Wholesale Banking Drake University Fin 129 Improvements to cash management continued Wholesale lockbox – centralized collection service designed to reduce float. FI serves receives payments directly instead of through the client Electronic lockbox – same as above except on line Funds concentration –

Impact on Wholesale Banking (continued) Electronic funds transfer – CHIPS, Fedwire, automated payrolls etc. . Check deposit services Electronic initiation of letters of credit – allows customers to initiate letters of credit Treasury management software Electronic data interchange – Drake University Fin 129

Impact on Wholesale Banking (continued) Drake University Fin 129 Facilitating B 2 B e-commerce Electronic billing Verifying identities Issue of law enforcement access to encrypted data since September 11, 2001 Assisting small business entry into ecommerce assistance for small business to establish electronic capabilities that work in conjunction with the FI.

Impact on Retail Banking Automated teller machines Point-of-sale debit cards Home banking Preauthorized debits/credits Pay-by-phone E-mail billing Online banking Smart cards Drake University Fin 129

Effects of Technology on Revenues and Costs Investments in technology are risky Potentially negative NPV projects due to uncertainty and potential competitive responses Potential agency conflicts: Drake University Fin 129

Effects of Technology on Revenues and Costs Drake University Fin 129 Evidence shows the impact of regulation on value of technological innovations. Branching restrictions in U. S. affect the value of cash management services, for example. Less valuable in Europe where comparable restrictions are absent

Effects of Technology on Revenues and Costs Drake University Fin 129 Revenue effects: Facilitates cross-marketing Increases innovation Service quality effects Survival of small banks and value of “human touch” Cost effects: Technological improvements Shift in cost curve.

Economies of Scale Drake University Fin 129 On impact is the ability to take advantage of economies of scale. Economies of scale exist when the FI can lower its average cost per unit by increasing its size.

Effects on Costs (continued) Drake University Fin 129 Economies of scale Optimal size depends on shape of average cost curve. AC AC Size

Effects on Costs (continued) Drake University Fin 129 Economies of scope Multiple outputs may provide synergies in production. Diseconomies of scope Specialization may have cost benefits in production and delivery of some FI services

Testing for Economies of Scale and Scope Drake University Fin 129 Production approach: Views FI as producing output of services using inputs of labor and capital. C = f(y, w, r) Intermediation Approach: Includes funds used to produce intermediated services among the inputs (k). C = f(y, w, r, k)

Empirical Findings Drake University Fin 129 Evidence economies of scale for banks up to the $10 billion to $25 billion range. X-inefficiencies may be more important. Inconclusive evidence on scope. Recent studies using a profit-based approach find that large FIs tend to be more efficient in revenue generation.

Technology and Evolution of the Payments System Drake University Fin 129 Use of electronic transactions higher in other countries. (E. g. , TARGET). U. S. Payments system: Fed. Wire Clearing House Interbank Payments System (CHIPS) Combined value of transactions often more than $2. 7 trillion per day.

Wire Transfer System Risks Drake University Fin 129 Daylight overdraft risk Fed. Wire settlement at 6: 30 EST Example of magnitude of daylight overdraft risk: Bank of New York (BONY)

Risks (continued) Drake University Fin 129 International Technology Transfer Risk Crime and Fraud Risk Regulatory Risk Technology facilitates avoidance of regulation by locating in least regulated state or country. Tax Avoidance Competition Risk

Controlling Operational Risk Drake University Fin 129 Loss prevention: Training, development, review of employees Loss control: Planning, organization, back-up Loss financing: External insurance Loss insulation: FI capital

Regulatory Issues Drake University Fin 129 1999 Basel Committee on Banking Supervision noted the importance of operational risks Required capital: Basic Indicator Approach Standardized Approach Internal Measurement Approach Consumer protection issues

Basic Indicator Approach Drake University Fin 129 The default option under Basle KBIA=a. GI KBIA = capital charge a= predetermined scaling factor. 15 GI = gross income = the sum of net interest income, net non-interest income, net trading income, and other income gross of provisions exclusive of irregular items.

Why Net Income? Drake University Fin 129 Consist and comparable across jurisdictions Easily confirmed by independent auditors Measure of size of activity (but not operational risk) Readily available

Problems Associated with the Basic Indicator Approach Drake University Fin 129 Should be related to an indicator of operational risk. Would operating expense be a better benchmark than gross income? Better relationship to operational risk Currently there is a incentive to decrease gross income to lessen capital requirement Why should there be a linear relationship with a volume (size) indicator? May impose different burden based upon business lines – advisory services, agency services and asset management – high operational risk – trading low operational risk given standard.

The Standardized Approach Drake University Fin 129 There is a capital charge for each of the 8 business lines. All activity must be mapped into one of the business lines The total capital charge is the sum of the individual capital charges in each of the business lines KSTA =Sbi. GIi

Drake Beta Factors Business Line Drake University Fin 129 Beta Factor Corporate Finance 18% Trading and Sales 18% Retail Banking 12% Commercial Banking 15% Payment and Settlement 18% Agency Services 15% Asset Management 12% Retail Brokerage 12%

Benefits of Standardized Approach Drake University Fin 129 Better reflection of the size, scope and culture of the organization Ability to assess risk from different activities and identify which business units contribute to the operational risk picture.

Issues with the Standardized Approach Drake University Fin 129 Still tied to gross income. No clear empirical evidence hat different business lines should have different sensitivities. May create a moral hazard problem if banks decide to self insure through the capital requirement instead of though the insurance industry.

Advanced Methods Drake University Fin 129 Based upon past loss experience Monitor loss experience based on the frequency and risk matrix. The risk measure (99. 9% confidence) must be based upon loss data Combinations of expected loss and unexpected loss Regular validation of the model.

Some possible methods Loss modeling Simulation Bayesian Estimation Scorecard Approach Drake University Fin 129