Measuring operational risk

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Measuring operational risk

  1. 1. MEASURING OPERATIONAL RISK CHAPTER 11
  2. 2. Learning Objectives  Operational Risk Data     Measuring Operational Risk      Loss Events Key Risk Indicators Subjective Risk Assessments Top Down Approaches Bottom-up Approaches Managing Operational Risk Developing an appropriate risk management environment Risk identification, assessment, monitoring and control Management of Financial Institutions by Dr. Meera Sharma
  3. 3. OPERATIONAL RISK  DEFINITION A wide definition of operational risk is that it encompasses all risks that a bank faces other than credit and market risks. A narrow definition, on the other hand, is that operational risk is the risk associated with the operations department of the bank. Management of Financial Institutions by Dr. Meera Sharma
  4. 4. OPERATIONAL RISK  Incidents of Losses Owing to Operational Risk    In May 2001, a dealer at Lehman Brothers in London traded a £300 million lot instead of an intended £3 million. (Patel 2002). In 1995 Daiwa Bank reported a $1.1 Billion loss as a result of an internal fraud in its securities trading department. Subsequent punishment by US regulators and loss of reputation led to Daiwa bank having to quit the US market. In 1995 Barings Bank, UK’s oldest merchant bank, was purchased by Dutch bank ING for just 1 Pound Sterling after sustaining $1 billion of unauthorized trading losses owing to internal fraud by its trader Nick Leeson. Management of Financial Institutions by Dr. Meera Sharma
  5. 5. OPERATIONAL RISK  Incidents of Losses Owing to Operational Risk In 1998 LTCM (Long Term Capital Management) had to be rescued by the Federal Reserve to prevent a systemic crisis. One of the reasons for its failure was inadequate stress testing of its valuation models. Banker’s Trust, one of the leading banks in the business of offering innovative financial products was sued by 4 of its large clients in 1994 for having misled them about the true risk profiles of its new products. The lawsuits were settled at a loss to Banker’s Trust of $ 171 million. Management of Financial Institutions by Dr. Meera Sharma
  6. 6. OPERATIONAL RISK  The New Basel Capital Accord (2003) defines operational risk as  The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.  This definition includes legal risk but excludes strategic and reputational risk. Management of Financial Institutions by Dr. Meera Sharma
  7. 7. OPERATIONAL RISK BANKING RISKS OPERATIONAL MARKET CONSEQUENTIAL RISKS CREDIT CHOSEN RISKS BUSINESS MANAGEMENT RISKS Management of Financial Institutions by Dr. Meera Sharma
  8. 8. OPERATIONAL RISK  DRIVERS OF INCREASING OPERATIONAL RISK  CHANGING MARKETS; CHANGING PRODUCTS AND SERVICES; CHANGING TECHNOLOGIES, CHANGING TECHNIQUES AND UNEXPECTED EVENTS.     Management of Financial Institutions by Dr. Meera Sharma
  9. 9. OPERATIONAL RISK  GOALS OF INVESTING IN OPERATIONAL RISK MANAGEMENT AVOIDANCE OF LARGE UNEXPECTED LOSSES - SEVERITY  AVOIDANCE OF SMALL BUT LARGE NUMBER OF LOSSES - FREQUENCY  IMPROVED OPERATIONAL EFFICIENCY AND RETURN ON CAPITAL  Management of Financial Institutions by Dr. Meera Sharma
  10. 10. OPERATIONAL RISK SEVERITY SECONDARY CHALLENGE NOT RELEVANT •NOT FIRM THREATENING •CAN BE MANAGED WITH EXPERIENCE •CAN BE INCORPORATED INTO PRICING •GENERATE EFFICIENCY SAVINGS DON’T MATTER PRIMARY CHALLENGE •CAN PUT BANKS OUT OF BUSINESS •DIFFICULT TO PREDICT AND MANAGE •SIMILAR TO RISKS IN OTHER INDUSTRIES SUCH AS CHEMICAL, AVIATION, HEALTHCARE Management of Financial Institutions by Dr. Meera Sharma FREQUENCY
  11. 11. OPERATIONAL RISK  OPERATIONAL RISK DATA  Loss Events An operational loss event is an occurrence that results in a loss owing to operational reasons.    Key Risk Indicators Operational risk indicators are measures that can signal the potential of loss owing to operational risk Management of Financial Institutions by Dr. Meera Sharma
  12. 12. OPERATIONAL RISK Operational Loss Events Types Identified by the Basel Committee  Internal Fraud: Theft, position mis-reporting and insider trading.  External Fraud: Robbery, forgery, hacking.  Employment Practices: Worker compensation claims, fines for employee health and safety violation. Management of Financial Institutions by Dr. Meera Sharma
  13. 13. OPERATIONAL RISK Operational Loss Events Types Identified by the Basel Committee     Clients, Products and Business Practices: Fiduciary breaches, money laundering, unlawful operations. Damage to Physical Assets: Terrorism, vandalism, natural disasters. Systems Failure: Hardware and software failures. Execution, Delivery and Process Management: Data entry errors, incomplete documentation, collateral management failure Management of Financial Institutions by Dr. Meera Sharma
  14. 14. OPERATIONAL RISK KEY RISK INDICATORS  Employee sick days,  Staff Turnover,  Aggregate grading of employee reviews,  Failed background checks on employees,  Above market returns,  Transaction volumes, Management of Financial Institutions by Dr. Meera Sharma
  15. 15. OPERATIONAL RISK KEY RISK INDICATORS  Amount of overtime worked,  Investments in technology,  System downtime,  Age of hardware,  Capacity to usage ratio,  Margin on a product,  Level of training required by internal staff. Management of Financial Institutions by Dr. Meera Sharma
  16. 16. OPERATIONAL RISK CATEGORIES OF OPERATIONAL RISK  Technology Risk  Human risk  Risk from external events  Model risk  Risk of failed processes  Legal risk Management of Financial Institutions by Dr. Meera Sharma
  17. 17. OPERATIONAL RISK CATEGORIES OF OPERATIONAL RISK Technology Risk: The risk that banks face owing to advances in technology arises from system breakdowns. Failure of technology, hardware, software or telecommunication systems is a major cause of operational risk. Management of Financial Institutions by Dr. Meera Sharma
  18. 18. OPERATIONAL RISK CATEGORIES OF OPERATIONAL RISK Human Risk: The Basel committee (Working Paper on the Regulatory Treatment of Operational Risk, 2001) defines internal fraud as, “losses due to acts of a type intended to defraud, misappropriate property or circumvent regulations, the law or company policy,…”. Management of Financial Institutions by Dr. Meera Sharma
  19. 19. OPERATIONAL RISK CATEGORIES OF OPERATIONAL RISK Risk from External Events: This category includes risk owing to external fraud defined by the Basel committee as, “Losses due to acts of a type intended to defraud, misappropriate property or circumvent the law, by a third party.” It also includes loss arising from damage to physical property arising from natural or manmade disasters. Management of Financial Institutions by Dr. Meera Sharma
  20. 20. OPERATIONAL RISK CATEGORIES OF OPERATIONAL RISK Model Risk: This risk arises from the breakdown of assumptions underlying models of valuation or risk calculation. It also includes losses from faulty design of products. Management of Financial Institutions by Dr. Meera Sharma
  21. 21. OPERATIONAL RISK CATEGORIES OF OPERATIONAL RISK Process Failure Risk: This risk category includes the risk of inadequate or failed processes of execution of transactions, maintenance of transactions or delivery of products. Management of Financial Institutions by Dr. Meera Sharma
  22. 22. OPERATIONAL RISK CATEGORIES OF OPERATIONAL RISK Legal Risk Legal risk can arise when the bank breaches contracts it has entered into. Apart from situations where the bank breaches a contract, legal risk can also arise when a contract entered into by a bank cannot be legally enforced. Management of Financial Institutions by Dr. Meera Sharma
  23. 23. OPERATIONAL RISK MEASURING OPERATIONAL RISK -the top down approach -the bottom up approach. Management of Financial Institutions by Dr. Meera Sharma
  24. 24. OPERATIONAL RISK MEASURING OPERATIONAL RISK Top-Down Approaches  The top down approach involves first estimating the risk and the capital required for the bank as a whole  The basic indicator approach  The standardized approach in the New Basel Capital Accord. Management of Financial Institutions by Dr. Meera Sharma
  25. 25. OPERATIONAL RISK The Basic Indicator Approach calculates the operational risk capital charge as 15% of the bank’s average annual gross income over past three years Management of Financial Institutions by Dr. Meera Sharma
  26. 26. OPERATIONAL RISK Gross income is defined as Gross income = Net profit + provisions and contingencies + operating expenses –         reversal during the year in respect of provisions and write-offs made during the previous year(s); income recognised from the disposal of items of movable and immovable property; realised profits/losses from the sale of securities in the “held to maturity” category; income from legal settlements in favour of the bank; other extraordinary or irregular items of income and expenditure; and income derived from insurance activities (i.e. income derived by writing insurance policies) and insurance claims in favour of the bank. Management of Financial Institutions by Dr. Meera Sharma
  27. 27. OPERATIONAL RISK The standardized approach involves dividing the bank’s activities into eight business lines The total capital charge is calculated by summing the capital charge for each business line. The capital charge for each business line is calculated by multiplying the gross income of that business line by a factor ranging from 12 to 18%. Management of Financial Institutions by Dr. Meera Sharma
  28. 28. OPERATIONAL RISK Business Lines Multiplication Factors 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% Management of Financial Institutions by Dr. Meera Sharma
  29. 29. Management of Financial Institutions by Dr. Meera Sharma
  30. 30. OPERATIONAL RISK MEASURING OPERATIONAL RISK Bottom-Up Approaches – CHALLENGES Lack of position equivalence; Incompleteness of portfolio; Context dependence and Irrelevance of past data; and Validation difficulties. Management of Financial Institutions by Dr. Meera Sharma
  31. 31. Ca De usal y M pe nd od enc el y al nc u s de Ca pen l D e od e M Historical Database Loss Event Frequencies Historical Database of Loss Event Impact Historical Database of Key Risk Indicators Causal Dependency Model Estimates of Loss Event frequencies over a future Horizon Forecasting Model Estimates of Key Risk Indicators over a future Horizon Aggregate Loss Data over a future Time Horizon Management of Financial Institutions by Dr. Meera Sharma Causal Dependency Model Estimates of Loss Event Impact over a Future Horizon
  32. 32. OPERATIONAL RISK MEASURING OPERATIONAL RISK Bottom-Up Approaches Guidelines from Basel Committee – New Accord It allows banks to use an internal operational risk measurement system provided some qualitative and quantitative criteria are met. One of these is that the bank should be able to demonstrate that its model captures potentially severe “tail” loss events. Management of Financial Institutions by Dr. Meera Sharma
  33. 33. OPERATIONAL RISK MEASURING OPERATIONAL RISK Bottom-Up Approaches Guidelines from Basel Committee – New Accord It should be able to capture loss comparable to a oneyear horizon and 99.9% confidence interval. Its historical loss database should be at least three years long, extendable to five years. In addition to loss data banks should also capture key business environment and internal control factors that can change its operational risk profile to make risk assessments forward looking. Management of Financial Institutions by Dr. Meera Sharma

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