Operational Risk
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Drake Fin 129
DRAKE UNIVERSITY
Operational Risk
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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.
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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
Internal Fraud
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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
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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
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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
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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
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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
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Losses arising from loss or damage to
physical assets from natural disaster or other
events
Business Disruption and system
failures
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Losses arising from disruption of business or
system failures
Hardware failures
Software failures
Telecommunications problems
Utility Outage / disruptions
Execution Delivery and Process
Management
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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
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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
2%
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Internal Fraud
3%
10%
5%
Drake
External Fraud
7%
2%
71%
Employment Practices
and Workplace Safety
Clients, Products, and
Business Practices
Damage to Physical
assets
Business Disruption and
System Failures
Execution Delivery and
Process Management
Basle
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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
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Damage to
Phys
Bus
Disruption
Execution
delivery
L/H
L/L
L/L
L/L
L/L
M/M
L/L
L/L
H/L
H/L
L/L
M/M
M/L
L/L
H/L
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
Importance of Technology
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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
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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
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Impact of Technology
Other income can be increased
Noninterest expenses can be reduced
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Impact on Wholesale Banking
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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
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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 –
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Impact on Wholesale Banking (continued)
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Facilitating B2B 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
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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:
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Effects of Technology
on Revenues and Costs
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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
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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
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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.
Total Cost
Average Cost 
Size
where Size is measure by assets, deposits or loans...
Effects on Costs (continued)
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Economies of scale
Optimal size depends on shape of average
cost curve.
AC
AC
Size
AC
Size
Size
Effects on Costs (continued)
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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
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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
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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
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Use of electronic transactions higher in other
countries. (E.g., TARGET).
U.S. Payments system:
FedWire
Clearing House Interbank Payments System
(CHIPS)
Combined value of transactions often more
than $2.7 trillion per day.
Wire Transfer System Risks
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Daylight overdraft risk
FedWire settlement at 6:30 EST
Example of magnitude of daylight overdraft
risk: Bank of New York (BONY)
Risks (continued)
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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
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Loss prevention:
Training, development, review of employees
Loss control:
Planning, organization, back-up
Loss financing:
External insurance
Loss insulation:
FI capital
Regulatory Issues
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
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Basic Indicator Approach
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The default option under Basle
KBIA=aGI
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?
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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
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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
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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 SbiGIi
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Beta Factors
Business Line
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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
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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
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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
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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
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