drake drake university fin 129 operational risk fin 129

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Drake DRAKE UNIVERSITY Fin 129 Operational Risk Fin 129

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Page 1: Drake DRAKE UNIVERSITY Fin 129 Operational Risk Fin 129

DrakeDRAKE UNIVERSITY

Fin 129

Operational Risk

Fin 129

Page 2: Drake DRAKE UNIVERSITY Fin 129 Operational Risk Fin 129

DrakeDrake University

Fin 129Operational Risk

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.

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This and the next few Slide from Operational Risk , Carol Alexander

DrakeDrake University

Fin 129

BCBS Definitions of Operational Risk

1. Internal Fraud2. External Fraud3. Employment Practices and Workplace

Safety4. Clients, Products and Business Practices5. Damage to Physical assets6. Business Disruption and system failures7. Execution Delivery and Process

Management

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DrakeDrake University

Fin 129Internal Fraud

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

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DrakeDrake University

Fin 129External Fraud

Losses due to acts of a type intended to defraud, misappropriate property or circumvent the law, by a third partyTheft and Fraud – Forgery, Robbery, check kitingSystems Security –

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Employment Practices and Workplace Safety

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

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Clients, Products and Business Practices

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 –

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Clients, Products and Business Practices

Improper Business Practices – Antitrust market manipulation unlicensed activity, money launderingProduct Flaws – model errorsSelection, sponsorship, and exposure – failure to investigate per client guidelines exceeding client exposure limitsAdvisory activities

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DrakeDrake University

Fin 129Damage to Physical assets

Losses arising from loss or damage to physical assets from natural disaster or other events

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Fin 129

Business Disruption and system failures

Losses arising from disruption of business or system failuresHardware failuresSoftware failuresTelecommunications problemsUtility Outage / disruptions

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Execution Delivery and Process Management

Losses from failed transaction processing or process management, from relations with trade counterparties and vendorsTransaction capture – Miscommunication, data entry error, missed deadlinesMonitoring and reporting – failed mandatory reportCustomer intake and documentation – client disclaimers/ permissions missing

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Execution Delivery and Process Management

Customer client account management – unapproved access given to accounts negligent loss or damage of assetsTrade counterparties – nonclient counterparty misperformanceVendors and Suppliers

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DrakeDrake University

Fin 129Total Loss by Risk Type

5%

71%

10%

7%

2%

3%2%Internal Fraud

External Fraud

Employment Practicesand Workplace Safety

Clients, Products, andBusiness PracticesDamage to Physicalassets

Business Disruption andSystem FailuresExecution Delivery andProcess Management

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DrakeDrake University

Fin 129Basle

Requires measurement of the operational risk capital requirement resulting from each source in each of 8 business lines

1. Corporate Finance2. Trading and Sales3. Retail Banking4. Commercial Banking5. Payment and Settlement6. Agency and Custody7. Asset Management8. Retail Brokerage

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DrakeDrake University

Fin 129Frequency and Risk (F/R)

Internal Fraud

External Fraud

Employ Practices

Clients Damage to Phys

Bus Disruption

Execution delivery

Corp Fin L/H L/M L/L L/H L/L L/L L/L

Trading L/H L/L L/L M/M L/L L/L H/L

Retail Bank

L/M H/L L/L M/M M/L L/L H/L

Com Bank

L/H M/M L/L M/M L/L L/L M/L

Pay & Sett

L/M L/L L/L L/L L/L L/L H/L

Agency & Cust

L/M L/L L/L L/M L/L L/L M/L

Asset Mgmt

L/H L/L L/L L/H L/L L/L M/L

Retail Brok

L/M L/M L/L L/M L/L M/L M/L

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DrakeDrake University

Fin 129Importance of Technology

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

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DrakeDrake University

Fin 129Technology and NIM

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

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DrakeDrake University

Fin 129Impact of Technology

Interest income can be increased

Interest expense can be decreased

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DrakeDrake University

Fin 129Impact of Technology

Other income can be increased

Noninterest expenses can be reduced

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DrakeDrake University

Fin 129Impact on Wholesale Banking

Wholesale Banking – corporate customer servicesImprovements 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

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DrakeDrake University

Fin 129Impact on Wholesale Banking

Improvements to cash management continued

Wholesale lockbox – centralized collection service designed to reduce float. FI serves receives payments directly instead of through the clientElectronic lockbox – same as above except on lineFunds concentration –

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Impact on Wholesale Banking (continued)

Electronic funds transfer – CHIPS, Fedwire, automated payrolls etc..Check deposit servicesElectronic initiation of letters of credit – allows customers to initiate letters of creditTreasury management softwareElectronic data interchange –

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Impact on Wholesale Banking (continued)

Facilitating B2B e-commerceElectronic billingVerifying identities

Issue of law enforcement access to encrypted data since September 11, 2001

Assisting small business entry into e-commerce

assistance for small business to establish electronic capabilities that work in conjunction with the FI.

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DrakeDrake University

Fin 129Impact on Retail Banking

Automated teller machinesPoint-of-sale debit cardsHome bankingPreauthorized debits/creditsPay-by-phoneE-mail billingOnline bankingSmart cards

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Effects of Technology on Revenues and Costs

Investments in technology are riskyPotentially negative NPV projects due to uncertainty and potential competitive responsesPotential agency conflicts:

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Effects of Technology on Revenues and Costs

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

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Effects of Technology on Revenues and Costs

Revenue effects:Facilitates cross-marketingIncreases innovationService quality effects

Survival of small banks and value of “human touch”

Cost effects:Technological improvements

Shift in cost curve.

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Fin 129Economies of Scale

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.

loans...or deposits assets,by measure is Size where Size

Cost TotalCost Average

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Fin 129Effects on Costs (continued)

Economies of scaleOptimal size depends on shape of average cost curve.

AC

Size Size

AC AC

Size

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Fin 129Effects on Costs (continued)

Economies of scopeMultiple outputs may provide synergies in production.

Diseconomies of scopeSpecialization may have cost benefits in production and delivery of some FI services

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Fin 129Testing for Economies

of Scale and Scope

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)

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Fin 129Empirical Findings

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.

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Fin 129Technology and Evolution of the Payments System

Use of electronic transactions higher in other countries. (E.g., TARGET).U.S. Payments system:

FedWireClearing House Interbank Payments System (CHIPS)Combined value of transactions often more than $2.7 trillion per day.

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Fin 129Wire Transfer System Risks

Daylight overdraft riskFedWire settlement at 6:30 ESTExample of magnitude of daylight overdraft risk: Bank of New York (BONY)

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Fin 129Risks (continued)

International Technology Transfer RiskCrime and Fraud RiskRegulatory Risk

Technology facilitates avoidance of regulation by locating in least regulated state or country.

Tax AvoidanceCompetition Risk

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Fin 129Controlling Operational Risk

Loss prevention: Training, development, review of employees

Loss control: Planning, organization, back-up

Loss financing: External insurance

Loss insulation: FI capital

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DrakeDrake University

Fin 129Regulatory Issues

1999 Basel Committee on Banking Supervision noted the importance of operational risksRequired capital:

Basic Indicator ApproachStandardized ApproachInternal Measurement Approach

Consumer protection issues

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Fin 129Basic Indicator Approach

The default option under BasleKBIA=GI

KBIA = capital charge

predetermined scaling factorGI = 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.

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Fin 129Why Net Income?

Consist and comparable across jurisdictionsEasily confirmed by independent auditorsMeasure of size of activity (but not operational risk)Readily available

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Problems Associated with theBasic Indicator Approach

Should be related to an indicator of operational risk.Would operating expense be a better benchmark than gross income?

Better relationship to operational riskCurrently there is a incentive to decrease gross income to lessen capital requirementWhy 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.

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Fin 129The Standardized Approach

There is a capital charge for each of the 8 business lines.All activity must be mapped into one of the business linesThe total capital charge is the sum of the individual capital charges in each of the business linesKSTA iGIi

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Fin 129Beta Factors

Business Line 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%

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Benefits of Standardized Approach

Better reflection of the size, scope and culture of the organizationAbility to assess risk from different activities and identify which business units contribute to the operational risk picture.

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Issues with the Standardized Approach

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.

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Fin 129Advanced Methods

Based upon past loss experienceMonitor loss experience based on the frequency and risk matrix.The risk measure (99.9% confidence) must be based upon loss dataCombinations of expected loss and unexpected lossRegular validation of the model.

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Fin 129Some possible methods

Loss modelingSimulationBayesian EstimationScorecard Approach