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.

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Sources of Operational Risk

Technology Employees Customer relationships Capital assets External

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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

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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

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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.

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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

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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

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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 & 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

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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

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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.

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Effects on Costs (continued)

Economies of scale Optimal size depends on shape of average cost

curve.

AC

Size Size

AC AC

Size

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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

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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)

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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.

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Web Resources

For information on the Clearing House Interbank Payments System, visit:

CHIPS: www.chips.org

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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.

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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

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Technology Risks

Programming error Model risk Mark-to-market error Management information IT/Telecomm systems outage Technology provider failure Contingency planning

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Customer Relationship Risks

Contractual disagreement Dissatisfaction from poorly performing

technology Default

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Capital Asset Risk

Safety Security Operating costs Fire/flood

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External risks

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

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Controlling Operational Risk

Loss prevention: Training, development, review of employees

Loss control: Planning, organization, back-up

Loss financing: External insurance

Loss insulation: FI capital

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Optimal Risk Management

Cost

RME

Cost of problems

Cost of risk management

Total cost

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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

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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

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Pertinent Websites

American Banker www.americanbanker.com

BIS www.bis.org

CHIPS www.chips.org

FDIC www.fdic.gov

International Swap and Derivatives Association www.isda.org

The Wall Street Journal www.wsj.com