technology and other operational risks chapter 16 © 2008 the mcgraw-hill companies, inc., all...
TRANSCRIPT
Technology and Technology and Other Operational Other Operational
RisksRisks
Chapter 16
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.McGraw-Hill/Irwin
16-2
Overview
This chapter discusses the factors affecting operational returns and risks, and the importance of optimal management and control of labor, capital, and other input sources and their costs. The emphasis is on technology and its impact on risk and return.
Examples: Risks resulting from innovations in IT, and effects of terrorist attacks on key technologies.
16-3
Sources of Operational Risk
Technology Employees Customer relationships Capital assets External
16-4
Importance of Technology
Efficient technological base can result in: Lower costs
Through improved allocation of inputs. Increased revenues
Through wider range of outputs. Earnings before taxes = (Interest income -
Interest expense) + (Other income - Noninterest expense) - Provision for loan losses
16-5
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
liabilities Fedwire, CHIPS
16-6
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 technology.
Especially true for securities-related activities.
16-7
Impact on Wholesale Banking
Improvements 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
16-8
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
16-9
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
16-10
Effects of Technology on Revenues & Costs
Investments in technology are risky Potentially negative NPV projects due to
uncertainty and potential competitive responses Potential agency conflicts:
Growth-oriented investments may not maximize shareholder’s value
Losses on technological investments can weaken an FI
16-11
Effects of Technology on Revenues & 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
16-12
Effects of Technology on Revenues and Costs
Revenue effects: Facilitates cross-marketing Increases innovation Service quality effects
Survival of small banks and value of “human touch” Consumer reluctance to apply for mortgage on the
web Cost effects:
Technological improvements Shift in cost curve.
16-13
Effects on Costs (continued)
Economies of scale Optimal size depends on shape of average cost
curve.
AC
Size Size
AC AC
Size
16-14
Effects on Costs (continued)
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
16-15
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)
16-16
Empirical 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.
16-17Technology and Evolution of the Payments System
Use of electronic transactions higher in other countries. Usage of checks obsolete (or rapidly becoming
obsolete) outside U.S. U.S. Payments system:
FedWire Clearing House Interbank Payments System
(CHIPS) Combined value of transactions often more than
$3.5 trillion per day.
16-18
Web Resources
For information on the Clearing House Interbank Payments System, visit:
CHIPS: www.chips.org
16-19
Wire Transfer System Risks
Daylight overdraft risk FedWire settlement at 6:30 EST Regulation J guarantees payment finality of wire
transfer messages by the Fed Regulation F sets exposure limits to individual
correspondent banks.
16-20
Risks (continued)
International Technology Transfer Risk Crime and Fraud Risk
Fraud risk, especially from FI employees increased
ABN Amro $80 million fine Costs of complying with Patriot Act
Regulatory Risk Technology facilitates avoidance of regulation
by locating in least regulated state or country. Tax Avoidance Competition Risk from nonfinancial firms
16-21
Other Operational Risks
Employees Turnover Key personnel Fraud Errors Rogue trading (Barings, Allied Irish/Allfirst) Money laundering Confidentiality breach
Revelation of ethical problems via email exchanges
16-22
Technology Risks
Programming error Model risk Mark-to-market error Management information IT/Telecomm systems outage Technology provider failure Contingency planning
16-23
Customer Relationship Risks
Contractual disagreement Dissatisfaction from poorly performing
technology Default
16-25
External risks
External fraud Taxation risk Legal risk War Market collapse Reputation risk Relationship risk
16-26
Controlling Operational Risk
Loss prevention: Training, development, review of employees
Loss control: Planning, organization, back-up
Loss financing: External insurance
Loss insulation: FI capital
16-28
Regulatory Issues
1999 Basel Committee on Banking Supervision noted the importance of operational risks
Follow up report
Required capital: Basic Indicator Approach Standardized Approach Internal Measurement Approach
Consumer protection issues
16-29
Other Concerns
Efforts to expand consumer acceptance of web-based services frustrated by scams Phishing “Spoofing” messages purported to be from FIs Identity theft concerns
Vulnerability of online credit card usage