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MODERN OPERATIONAL RISK MANAGEMENT PRESENTATION
GROUP MEMBERSb) SAIFULLAHMALIKc) RAHEEM ANSERSUBMITTED TOMISS SHAFAQ
WHAT IS RISK“Risk is a measure of adverse deviation from the expectation, expressed at a level of uncertainty (probability).”
BASEL II(OPERATIONAL RISK)"The risk of loss resulting from inadequate orfailed internal processes, people and systems orfrom external events."SCOPE EXCLUSIONf. Strategic Risk - the risk of a loss arising from a poor strategic business decision.h. Reputational Risk (damage to an organization through loss of its reputation or standing) can arise as a consequence (or impact) of operational failures
BASEL II EVENT TYPE CATEGORIESi. Internal Fraudii. External Fraudiii. Employment Practices and Workplace Safetyiv. Damage to Physical Assetsv. Business Disruption & Systems Failuresvi. Execution, Delivery, & Process Management
• FRONT OFFICE-Executing trades with various counterparties• MIDDLE OFFICE-Investigation of any discrepancy in trade details Reconciliation and updating of trading positions• BACK OFFICE-The operations area has a major responsibility to control operations risk. back office should quickly detect errors and bring to the attention of dealers and management capturing trade details in the settlement system validating trade details issuing settlement instructions
OPERATIONAL RISK (CHARACTERIZED)unconscious execution errors andprocessing are normal operational failuresOperational risk, by contrast, is drivenprimarily by “non-normal” operationalfailures, particularly conscious violationsof professional or moral standards andexcessive risk taking. Examples includesales practice violations and unauthorizedtrading activities
OPERATIONAL RISK (20 YEARS)Catastrophic financial institution lossiii. Barings Bankiv. Long Term Capital Managementv. Allied Irish Bank-All Firstvi. Société Généralevii. Bear Stearnsviii. Lehman Brothersix. American Insurance Group (AIG)
TRADITIONAL ORM (PROBLEM-Example) Walking along the train tracks Death by train crash. You assess the risk: Likelihood= 90%; impact = $10 million (a person’s value to society). So you estimate the risk at $9 million
THE MODERN ORM (PROBLEM- Example)suppose it costs $5 millionto build a fence around the train tracks,and you expect that will bring down thedeath rate to two per year (benefit = $80Million. Using the modern ORM approach,Comprehensive cost-benefit analysisReveals that the optimal solution is tobuild a fence around the tracks andtolerate an average loss of two deathsper year.
MODERN APPROACH TO ORMIts not just Measurementrobust and systematic process forincorporating risk reward and risk-controlinformation into business decisions.Specifically, it is a process for makingbusiness decisions where the level of riskto be assumed net of controls is alignedwith the risk and loss tolerance standardsof the stakeholders
MODERN ORM FRAMEWORK (RISK ASSESSMENT)i. Portfolio of risks using an “organizational unit-risk class” matrix.ii. Determining which businesses to invest in based on their risk-reward relationshipiii. Which risk mitigation strategies to employ by optimizing the risk-reward and risk control relationship across the full spectrum of exposures
TRADITIONAL VS MODERN OPERATIONAL RISKTraditional Moderninterpretation, maximum interpretation, highrisk exists where the risk is characterizedprobability of loss is by low probability (or100% — i.e., the loss is low frequency) andcertain high severity
TRADITIONAL VS MODERN OPERATIONAL RISKDifferent Schools Of Thoughtb. Traditional ORM “Risk is the possibility that an event will occur and adversely impact the achievement of the entity’s mission or business objectives.”Traditional Approach Measuring the probability of a loss (Risk = Probability X (Loss) Impact)
TRADITIONAL VS MODERN OPERATIONAL RISKa. Modern ORMRisk is a measure of exposure to loss at alevel of uncertainty. Probability x impact is referred to as the expected loss
TRADITIONAL VS MODERN OPERATIONAL RISK (GOALS)• TRADITIONAL ORM-Day-to-day management of current threats arising from imminent operational failures: loss prevention through tactical intervention One possible outcome (drawback)• MODERN ORM-Optimization of risk- reward, risk-control and risk-transfer in the context of cost-benefit analysis Multidimensional framework
MODERN ORM (TAXONOMY)Classification scheme (structured process)every operational failure has threedimensions: contributory factors, eventsand consequences
Traditional ORM, the terms likelihood and frequency are often used synonymously, but under Modern ORM these terms have very different meanings. Likelihood means probability and is generally used in the context of a single incident or scenario (e.g., the likelihood of getting into a car accident today is 5%). Likelihood is measured on a scale of 0 to 1 (or 0 to 100%)
Frequency describes the number of events (e.g., 10 losses per year). Frequency is measured on a scale of 0 to infinity. Mean frequency is the average number of events that have taken place or are expected to take place during a specified period of time.