RISK ANALYSIS

AND
MANAGEMENT

LECTURE 3
TOPIC 4: TECHNOLOGY AND
OPERATIONAL RISK
 TECHNOLOGY

Technological innovation has been and will continue to be a major concern for financial
institutions. Since the 1980s, banks, insurance companies, and investment companies have sought
to improve operational efficiency with major investments in internal and external communications,
computers, and an expanded technological infrastructure.

These technologies are means of providing financial services to institutions’

customers/clients.

Operational risk is partly related to technology risk and can arise when existing technology
malfunctions or back-office support systems break down (POS systems, Invoice processing
etc). Further, back-office support systems combine labor and technology to provide clearance,
settlement, and other services to back FIs’ underlying on- and off-balance-sheet transactions.
 T E C H N O L O G IC A L IN N O VAT IO N A N D P R O F ITA B IL IT Y

• Efficiency in technology for FI results in:

I. Lower costs, by combining labour and capital in a more efficient mix.

II. Increased revenues, by allowing a wider array of financial services to be produced or innovated and sold to customers.

• Technology is important because well-chosen technological investments have the potential to increase income and reduce costs in
several ways:

i. Interest income can increase if the FI sells a broader array of financial services because of technological developments. By
expanding their range of services, including cross-selling products and telemarketing services to customers. This investment
boosts innovation and service quality, and many FIs use high-tech efforts to reach more customers and develop new
product ideas.

ii. Interest expense can be reduced by a FI’s technological capability. By enabling banks to access lower-cost of funds that
are available directly from reserve banks through computers and screen-based trading (NEAT+ for the NSE, NDE from the
Reserve Bank of India)

iii. Noninterest income increases when fees for FI services, especially those from off-balance sheet activities, are linked to the
quality of the FI’s technology. By making more non-loan products available to customers through the computers to
customers such as letters of credit and commercial paper and derivatives.

iv. Noninterest expenses can be reduced if the processing and settlement fees are computer based and not paper
based. An area that has changed drastically for most FIs, especially in trading activities and in the use of
automated teller machines (ATMs).
 T H E IMPA C T O F T E C H N O L O G Y O N WH O L E S A L E A N D
R E TA IL FIN A N C IA L SE RV IC E S PR O D U C T IO N

The wholesale efforts have centered on the banks’ ability to improve cash management or working capital services for the bank and for
large corporate customers. Some of the services FIs sought to improve the efficiency with which corporate clients manage their
financial positions are the following:

• Facilitation of business-to-business e-commerce - FIs are automating the entire information flow related to procurement and
distribution of goods and services among businesses.

• Treasury management software - Allows efficient management of multiple currency and security portfolios for trading and
investment purposes

• Cheque deposit services - Encoding, endorsing, microfilming, and handling customers’ checks.

• Controlled disbursement accounts - The account feature allows corporations to monitor their net cash positions by setting up
payments for customers in the morning, informs the corporate client of the total funds it needs to meet disbursements, enabling
early wire transfers and informed financial management.

• Wholesale and electronic lockbox - A centralized or online collection service for corporate payments used to reduce the delay in
check clearing, or the float (the time it takes a cheque to clear).

• .
 THE IMPACT OF TECHNOLOGY ON
WHOLESALE AND RETAIL FINANCIAL
SERVICES PRODUCTION

For retail banking primarily has been to make it easier for individuals to obtain banking services as exemplified by ATMs
and home banking products.

• Automated Teller Machines (ATMs) - Allows customers 24-hour access to their deposit accounts
• Point-of-sale (POS) Debit Cards - Customers who prefer not to use cash, cheques, or credit cards can purchase
merchandise using debit card/point-of-sale (POS) terminals.

• Online Banking - Allows customers to conduct retail banking and investment services offered via the Internet
• Mobile Banking - Allows customers to acquire banking apps through Apple and Android marketplaces and/or by
scanning promotional QR codes.
• Financial Planning Services - Allow customers to manage their finances and monitor spending through online,
mobile, and tablet services.
 THE EFFECT OF TECHNOLOGY ON REVENUES AND COSTS:
TECHNOLOGY AND REVENUES

• Technology product innovation can possibly fail because of either lack of acceptance by the customers
of the bank or problems with the design and delivery of the product ie. negative net present value
projects (the bank is earning less than expected).
• If the innovation is successful, the product can easily be mimicked without incurring similar
development cost of the original innovator.
• Agency conflicts, in which management may decide to push for new products or some kind of
expansion which are not in the best interests of stockholders’ value-maximizing objectives. As a
result, losses on technological innovations and new technology can weaken a FI because scarce capital
resources are invested in value-decreasing products.
 THE EFFECT OF TECHNOLOGY ON REVENUES AND
C O ST S

Standard capital budgeting techniques can be applied to technological innovations and new FI products.
Let:
I! = Initial capital outlay for developing an innovation or product at time 0
R " = Expected net revenues or cash flows from product sales in future years i, i= 1 . . . N
d= FI’s discount rate reflecting its risk-adjusted cost of capital
Thus, a negative net present value (NPV) project would result if:
𝑅# 𝑅$
𝐼! > +⋯ +
(1 + 𝑑) (1 + 𝑑)$
 TECHNOLOGY AND REVENUES

Benefits of technology in generating revenue for FIs:

ü Efficiency through cross-marketing of new and old products

ü Encourages an increase in the rate of innovation of new products

ü Lowering operating costs through service quality and convenience.

High-tech efforts by FIs aim to expand customer reach with diverse products, leading to the development
of new marketing lines and enhanced product usefulness.
The development of the AI in CIBC of recently.
 TECHNOLOGY AND COSTS

Technology may favourably affect a FI’s cost structure by allowing it to exploit either economies of scale or economies of
scope.

The idea of technology is to reduce long-term operating costs.

Economies of scale
The reduction of the average cost of production as output of a firm increases. Improved technology can lower financial
service production costs, giving larger financial institutions an economy of scale advantage over smaller firms. This leads
to decreased noninterest expense per dollar of assets and increased return on assets.

The average cost of producing a FI’s output of financial services is measured as:
𝑇𝐶!
𝐴𝐶! =
𝑆!
𝐴𝐶"# < 𝑇𝐴𝐶
AC = Average costs of the FI
TC = Total costs of the FI

S= Size of the FI measured by on and off-balance-sheet assets, deposits, or loans

TAC = total average cost
 T E C H N O L O G Y A N D C O S T S : E C O N O MIE S O F S C A L E
IN F IS

The largest FI 𝑆' has a lower

average cost of producing financial
services than do smaller firms B Average
and A. This means that at any cost
given price for financial service 𝐴𝐶%
firm products, firm C can make a
bigger profit than either B or A.
Alternatively, firm C can undercut 𝐴𝐶&
B and A in price and potentially
gain a larger market share. AC( Average cost function
of financial firms

0 𝑆% 𝑆& 𝑆' Size

 T E C H N O L O G Y A N D C O S T S :E F F E C T S O F
T E C H N O L O G IC A L
IMP R O V E ME N T

Average
Cost 𝐴𝐶$ is the AC curve prior to cost-reducing technological innovations.
𝐴𝐶% reflects the cost-lowering effects of technology on FIs of all sizes
but with the greatest benefit accruing to those of the largest size.

𝐴𝐶#

𝐴𝐶)

0 Size
 TECHNOLOGY AND COSTS

Diseconomies of Scale
ü Diseconomies of scale occur when the average cost of production increases as the amount of
production increases.
ü Large-scale investments may result in excess capacity problems and integration problems as well as
cost overruns and cost control problems.
ü Small FIs will have an average cost advantage, they are simple and have manageable computer
systems which do not need high levels of maintenance and installation.
ü Small FIs are willing to outsource production to gain the benefits of lower production expenses that
may be unattainable through their own technology upgrades.
ü Therefore, diseconomies of scale imply that small FIs are more cost-efficient than large FIs and that in
a freely competitive environment for financial services, small FIs prosper.
 TECHNOLOGY AND COSTS

Economies of Scope
ü Technology effects (positive/negative) may differ across FI, due to size etc, however, technology is
applied more in some product areas.
ü FIs are multiproduct firms that need different technologies.
ü Synergistic benefits can be achieved through technological improvements in one financial service
area, such as lending, which can lower the costs of producing financial services in other areas. For eg.
computerization allows the storage and joint use of important information on customers and their
needs.
ü Economies of scope refer to the average cost of production falling using joint inputs producing
multiple products, and thus reflect the benefits of a single-product firm becoming a multi-product
firm.
 TECHNOLOGY AND COSTS

Technology may allow two FIs to jointly use their input resources, such as capital and labor, to produce a
set of financial services at a lower cost than if financial service products were produced independently of
one another.

Diseconomies of scope
Diseconomies of scope occur when the average cost of production is higher from the joint production of
services than the average costs from the previous independent production of the services.
It occurs if the technology used in the production of a portion of the services is not sufficiently efficient
to produce the remaining services.
 TESTING FOR ECONOMIES OF SCALE AND ECONOMIES OF
SCOPE

To test for economies of scale and economies of scope, FIs must clearly specify both the inputs to their
production process and the cost of those inputs. The two (2) approaches are :
ü The production approach views FIs’ utilizes labor and capital (input) to produce outputs (deposits and
loans).
ü The intermediation approach the FI function is to intermediate between borrowers and lenders, the
inputs are capital, labor, and deposits. deposit costs would be an input in the banking and thrift
industries, while premiums or reserves would be inputs in the insurance industry.
T E C H N O L O G Y A N D T H E E VO L U T IO N O F T H E
PAY ME N T S S Y S T E M

U.S. Cashless Payments System: Volume,

Value, and Average Transaction Amount
TECHNOLOGY AND THE EVOLUTION OF
THE PAYMENTS SYSTEM

Worldwide Cashless Payment Systems: Volume, Value, and

Average Transaction Amount
 RISKS THAT ARISE IN AN ELECTRONIC
TRANSFER PAYMENT SYSTEM

Wire transfer systems have presented a few risks along the way.

Daylight Overdraft Risk - Some analysts and regulators view settlement, or daylight, overdraft risk as one of the greatest potential sources of
instability in the financial markets today. A daylight overdraft occurs at the Federal Reserve Bank when a bank, in the continuing process of
transferring in money and transferring out money from its account, has transferred out more money than currently is in the account. This is similar
to the retail transaction of depositing a check and withdrawing cash before the funds from the initial check have cleared into the account.

Crime And Fraud Risk - The increased replacement of checks and cash by wire transfers as methods of payment or exchange has resulted in an
increase in the efficiency of the execution of transactions, but it has also resulted in new problems regarding theft, data snooping, and white-collar
crime.

Regulatory Risk - Improved computer and telecommunications networks in financial institutions (FIs) enhance their power over regulators, aiding
regulatory avoidance. Regulation can impact the profitability of technological innovations and can either encourage or hinder the rate and types of
innovation. Regulations, like usury ceilings, can also influence innovation rates.

Tax Avoidance International wire and financial service firm networks enable FIs to use internal pricing mechanisms to shift funds and profits,
minimizing U.S. tax burden and maximizing foreign tax credits.

Competition Risk - As financial services become more technologically based, they are increasingly competing with non-traditional financial
service suppliers

International Technology Transfer Risk - U.S. financial service firms struggle to profitably transfer domestic technological innovations to
international markets, while foreign firms gain direct access to U.S. technology-based products at low costs.
 D E FIN IT IO N

ü Operational risk is defined as “The risk of loss resulting from the inadequacy or failure of internal
processes or deliberate external events, whether accidental or natural”
ü This definition applies to the internal processes of all business lines and of their support functions, as
well as to all internal processes of all group and general management functions
ü The external events mentioned in this definition include those of human or natural origin. External
events include neither the defaults of borrowers or counterparties (see credit risk), nor variations of the
financial markets (see market risk)
ü Management of operational risk means and includes identification, assessment, monitoring and
control/mitigation of this risk
 R E G U L ATO RY ISSU E S A N D T E C H N O L O G Y A N D
O PE R AT IO N A L R ISK S

When technology increases, so does operational risk. There are two areas arise with the increase in
operational risk; Operational Risk and FI Insolvency and Consumer Protection.
Operational Risk and FI Insolvency
The Basel Committee said that operational risks “are sufficiently important for banks to devote necessary
resources to quantify the level of such risks and to incorporate them (along with market and credit risk)
into their assessment of their overall capital adequacy.”
The Basel Committee proposed three (3) methods in which depositories can calculate the required
minimum capital to protect themselves against operational risk. The Basic Indicator Approach, The
Standardised Approach and the Advanced Measurement Approach.
As banks develop their operational measurement systems they are to move along the available
approaches.
Banks that are more exposed to significant operational risk should take a more complex approach than
that of the Basic Indicator Approach which is more appropriate for its risk profile.
 R E G U L ATO RY ISSU E S A N D T E C H N O L O G Y A N D
O PE R AT IO N A L R ISK S

Consumer Protection
• Consumers have concerns about their financial information on the web.
ü They are worried about who has access to this information and how it will be used.

ü They worry that credit card or account details will be stolen or used fraudulently

These are all valid concerns.

• Electronic banking is making consumer protection an increasingly important responsibility for regulators of FIs.
• In 1999 Financial Services Modernization Act allows FI customers to opt out of any private information sharing a FI
may want to pursue. Thus, FI customers have some control over who will see and have access to their private
information.

• The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 authorized the Consumer Financial
Protection Bureau (CFPB) to supervise nonbanks in residential mortgage, private education lending markets, and
supervise larger consumer reporting agencies.

• Because these technologies are available does not ensure that FIs will use them, their costs may be too high.
Consequently, regulators may need to oversee (or even mandate) the implementation of these technologies if FIs are
slow to use them operationally.
 C A U SE S O F O PE R AT IO N A L R ISK

• There are three (3) layers of segmentation of operational risk sources

ü Level 1 and level 2 segmentation: proposed by the Basel Committee on Banking Supervision
ü Level 3: more detailed segmentation, defined by your bank
• The Basel Committee segmentation… (regulatory segmentation)
ü Internal fraud
ü External fraud
ü Employment practices and workplace safety
ü Clients, products and business practices.
ü Damage to physical assets.
ü Business disruption and system failures
ü Execution, delivery and process management
ü Other (e.g. Highly Automated Technology, Emergence of E-Commerce , Outsourcing, Large-scale
acquisitions, mergers, de-mergers and consolidations, …)
Sources Definition L2 Segmentation
INTERNAL FRAUD

Losses due to acts intended to defraud, embezzle assets or avoid regulations, legislation or the company •Unauthorised activity
policy, involving at least one internal party of the company. •Theft and Fraud (internal)

EXTERNAL FRAUD

Losses due to actions intended to defraud, misappropriate assets or circumvent the legislation by a third party. •Theft and Fraud (external)
•Systems Security

EMPLOYMENT PRACTICES / WORKPLACE SAFETY

Losses due to actions that do not comply with the legislation or agreements relative to employment, health •Employee relations
and safety, compensation requests relative to personal injury or undermining of equal rights / acts of •Safe environment
discrimination. •Rights and discriminations

CLIENTS, PRODUCTS / BUSINESS PRACTICES

Losses resulting from a failure to meet a professional obligation (including requirements in fiduciary and •Suitability, fiduciary and disclosure
suitability matters) to one or more given customer(s) or resulting from a product's nature or design •Improper business or market practices
•Services or products flaws
•Selection, sponsorship and exposure
•Advisory activities

S O U R C E S O F O P E R AT IO N A L R IS K
DAMAGE TO PHYSICAL ASSETS

Damage to buildings, movable property and persons resulting from natural • Disasters and other events
disaster or other events

BUSINESS DISRUPTIONS AND SYSTEM FAILURES

Losses resulting from business disruptions or malfunctions of systems). •Systems

•Other disruptions

EXECUTION, DELIVERY AND PROCESS

MANAGEMENT
Losses resulting from a pending transaction or problem in the •Transaction capture, execution and maintenance
management of the processes or losses suffered as part of the relations •Financial surveillance and notification
with trade counterparties and suppliers. •Customer intake / documentation
•Customer / client account Management
•Trade Counterparties
•Vendors and Suppliers

S O U R C E S O F O P E R AT IO N A L R IS K
 MA P P IN G O F R IS K S

Likelihood

•A risk is often specified in terms of

an event or circumstance and the
consequences that may flow from it
•Risk is measured in terms of a
combination of the consequences of
an event and their likelihood

Impact
 R ISK MIT IG AT IO N

Frequency
of 2 options
occurrence
Priority 1
•Reduce likelihood of
Priority 2 occurrence
Priority 1 •Reduce financial impact

Priority 2

Financial impact
 O PE R AT IO N A L R ISK IN B A SE L 2

The Basel Committee defined operational risk as “The risk of direct or indirect loss resulting from inadequate or failed
internal processes, people and systems or from external events.”
Operational risks relating to internal processes include events such as:
ü Inadequate procedures and controls for reporting, monitoring and decision-making.
ü Inadequate procedures on processing information, such as errors in booking transactions and failure to scrutinize
legal documentation.
ü Organizational deficiencies.
ü Risk surveillance and excess limits: management deficiencies in risk monitoring, such as not providing the right
incentives to report risks, or not abiding by the procedures and policies in force.
ü Errors in the recording process of transactions.
ü The technical deficiencies of the information system or the risk measures.
B A SE L II – A MO R E R E F IN E D F R A ME WO R K : P IL L A R I
MIN . C A P ITA L R E Q U IR E ME N T S MIN . C A P ITA L
R E Q U IR E ME N T

Credit risk Operational Market risk

risk
This is dependent on how
active the bank is in the
financial market and how
Standardised Approach Basic Indicator Approach much of their financial
statements (balance sheet)
are exposed to market
price fluctuations.

Internal Rating Based

Approach
üFoundation
üAdvanced Standardised Approach

Advanced Measurement
Approach
 O PE R AT IO N A L R ISK IN B A SE L 2

• Operational risk presents challenges in data and methodology. Modelling involves classifying risk
events and assessing their frequency and monetary impacts. Historical data on incidents and their
costs, serve for measuring the number of incidents and the direct losses attached to such incidents.
Beyond statistics, expert judgments, local managers' questions, pooled data from similar institutions,
and insurance costs are essential sources.
• Basel proposes a range of three approaches to capital requirements for operational risk and are ranked
based on their degree of sophistication:
ü Basic indicator Approach
ü Standardized Approach
ü Advanced Measurement Approach
 O PE R AT IO N A L R ISK IN B A SE L 2

• The “basic indicator approach” this approach considers a bank’s gross income. The capital required is to be
maintained at a certain percentage of gross income earned by the Bank. Gross income is used as a proxy for operational
risk. The capital charge for operational risk by multiplying by the “alpha factor” ∝ determined by the Basel
Committee and originally set at 15% of average annual gross income over the 3 previous years
• The “standardized approach” builds on the basic indicator approach by dividing a bank’s activities into several
standardized business lines (eg. corporate finance, retail banking, commercial banking etc). Within each business line,
the capital charge is a selected indicator of operational risk times a fixed percentage “beta factor” (𝛽). Both the
indicator and the beta factor may differ across business lines. For the capital charge, weightings range from 12% to
18%, depending on the business line
• The “advanced measurement approach” on internal models of the bank is; most complex approach, requiring the use
of historical observations and calculation of operational risk VaR ie. Statistical approach and mathematical modelling.
It is only used by the largest and advanced financial institutions (regulators usually push for this approach).
• The technique requires three inputs for a specified set of business lines and risk types:
ü An indicator of exposure to operational risk;

ü The probability that a loss event occurs;

ü The losses given such events.

 C A PITA L A D E Q U A C Y R AT IO

𝑇𝑜𝑡𝑎𝑙 𝑂𝑤𝑛 𝐹𝑢𝑛𝑑𝑠 (𝑇𝑖𝑒𝑟 1 + 𝑇𝑖𝑒𝑟 2 + 𝑇𝑖𝑒𝑟 3)

𝐶𝐴𝑅 = ≥ 8%
𝐶𝑟𝑒𝑑𝑖𝑡 𝑅𝑖𝑠𝑘!"# + 𝑀𝑎𝑟𝑘𝑒𝑡 𝑅𝑖𝑠𝑘!"# + 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝑅𝑖𝑠𝑘!"#

ü Tier 3 capital consists of short-term subordinated debt. A bank may only use this capital for covering
market risk.
TECHNOLOGY AND OPERATIONAL RISK

THE END