CHAPTER 17Technology and Other Operational Risks

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Overview Factors affecting operational returns

and risks Importance of optimal management

and control of labor, capital, and other input sources and their costs

Technology and its impact on risk and return

Examples: Risks resulting from innovations in IT and effects of terrorist attacks on key technologies

Ch 17-2

Sources of Operational Risk

Technology Employees Customer relationships Capital assets External

Ch 17-3

Technology & Profitability Efficient technological base can

result in:– Lower costs

Through improved allocation of inputs

– Increased revenuesThrough wider range of outputs

– Earnings before taxes = (Interest income - Interest expense) + (Other income - Noninterest expense) - Provision for loan losses

Ch 17-4

Impact of Technology

Interest income can be increased – Through wider array of outputs or cross

selling Interest expense can be decreased

– Through improved access to markets for liabilitiesFedwire, CHIPS

Ch 17-5

Impact of Technology

Other income can be increased– Through electronic handling of fee

generating OBS activities such as LCs and derivatives

Noninterest expenses can be reduced– Through improved efficiency of back

office operations using technologyEspecially true for securities-related activities

Ch 17-6

Impact on Wholesale BankingImprovements to cash management: Controlled disbursement accounts Account reconciliation Wholesale lockbox Electronic lockbox Funds concentration Electronic funds transfer Check deposit services Electronic initiation of letters of credit

Ch 17-7

Impact on Wholesale Banking (continued)

Treasury management software Electronic data interchange 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 e-commerce

Online customer-facing technologies Cloud computing

Ch 17-8

Impact on Retail Banking

Automated teller machines Point-of-sale debit cards Tablet banking Preauthorized debits/credits Mobile banking Online banking

Ch 17-9

Impact on Retail Banking

Smart cards FI social media sites Integration of online, offline, and

mobile channels Financial planning services Instant ‘micro mobile loans’ Loyalty programs

Ch 17-10

Effects of Technology on Revenues & Costs

Investments in technology are risky– Potentially negative NPV projects due to

uncertainty and potential competitive responses

– Service quality and convenience Inability of ATMs to interact with customers

as humans canExample: Customers compare mortgage

rates online, but only 2% close onlineVirtual FIs operating branch offices

∙ Example: ING DirectCh 17-11

Effects of Technology on Revenues & Costs

Evidence shows the impact of regulation on the 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

Ch 17-12

Revenue effects:– Facilitates cross-marketing

Mixed success∙ Example: Citigroup and insurance

– Increases innovation

Ch 17-13

Effects of Technology on Revenues & Costs

Technology and Costs

For larger FIs the scale and array of potential technology investments is greater– Potential average cost advantage for

larger FIsEconomies of scalePotential elimination of smaller banks?

– Technological investments are riskyPotential diseconomies of scale

Ch 17-14

Economies of Scale in FIs

Ch 17-15

Effects of Technological Improvement

Ch 17-16

Effects on Costs (continued)

Economies of scope– Multiple outputs may provide synergies

in production– FI size may affect potential gains and

losses from IT investment Diseconomies of scope

– Specialization may have cost benefits in production and delivery of some FI services

Ch 17-17

Testing 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

– C = f(y,w,r, k)

Ch 17-18

Empirical Findings Evidence of 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

Potential long term gains from innovation– Cashless payments system?

Ch 17-19

Technology and Evolution of the Payments System

Use of electronic transactions higher in other countries– Usage of checks rapidly becoming

obsolete– Checks cleared using electronic funds

transfer– E-money virtually non-existent in the US

Facilitates foreign currency transactions on the internet

Not FDIC insuredCh 17-20

U.S. Payments System

– U.S. reluctance to abandon the use of checks

– U.S. payments system– FedWire– Clearing House Interbank Payments

System (CHIPS)– Combined value of transactions often

more than $5 trillion per day

Ch 17-21

Web Resources

For more information on the Clearing House Interbank Payments System, visit: CHIPS www.chips.org

Ch 17-22

Wire Transfer System Risks

Daylight overdraft risk– FedWire settlement at 6:30 EST– Banks commonly ran daylight overdrafts

50 basis point interest rate introduced for daylight overdrafts

– Regulation J guarantees payment finality of wire transfer messages by the FedFed bears the risk

– Regulation F sets exposure limits to individual correspondent banks

Ch 17-23

Risks (continued)

International Technology Transfer Risk Crime and Fraud Risk

– Fraud risk, especially from FI employees– Riggs National Bank transactions with Saudis– Costs of complying with Patriot Act

Ch 17-24

Risks (continued)

Regulatory Risk– Technology facilitates avoidance of

regulation by locating in least regulated state or countryCitigroup credit card operations in South

DakotaSouth Dakota and Delaware liberal in terms

of usury ceilings and other regulatory controls

Cayman Islands

Ch 17-25

Risks (continued) Tax Avoidance

– Internal pricing mechanisms to shift profits to low tax regimes

– UBS AG: the Hong Kong connection Competition Risk: nonfinancial firms

– GMs credit card operation– AT&T– Industrial loan corporations (ILCs)

Technology allows locating in Utah where regulation is more favorable

Requirement to register ILCs as bank holding companies, 2009

Ch 17-26

Other Operational Risks Employees

– Turnover – Key personnel– Fraud– Errors– Rogue trading– Money laundering– Confidentiality breach

Example: Theft of code by ex-Goldman programmer

– Revelation of ethical problems via email exchanges

Ch 17-27

Technology Risks

Programming error Model risk Mark-to-market error Management information IT/Telecommunications systems

outage Technology provider failure Contingency planning

Ch 17-28

Customer Relationship Risks

Contractual disagreement Dissatisfaction from poorly

performing technology Default

Ch 17-29

Capital Asset Risk

Safety Security Operating costs Fire/flood

Ch 17-30

External Risks

External fraud Taxation risk Legal risk War Market collapse Reputation risk Relationship risk

Ch 17-31

Controlling Operational Risk Loss prevention:

– Training, development, review of employees Loss control:

– Planning, organization, back-up Loss financing:

– External insurance Loss insulation:

– FI capital

Ch 17-32

Regulatory Issues

1999 Basel Committee on Banking Supervision noted the importance of operational risks

Follow up reportRequired capital:

– Basic Indicator Approach– Standardized Approach– Advanced Measurement Approach

Consumer protection issuesCh 17-33

Other Concerns

Efforts to expand consumer acceptance of web-based services frustrated by scams– Identity theft concerns

Vulnerability of online credit card usage

Ch 17-34

Pertinent WebsitesBIS

www.bis.org The Clearing House

www.chips.orgFDIC www.fdic.govInternational Swap and

www.isda.orgDerivatives Association

The Wall Street Journal www.wsj.com

Ch 17-35