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Operational Risk Management


Title: Operational Risk Management Author: vedpurav Keywords Last modified by: Admin Created Date: 7/10/2009 3:42:15 AM Document presentation format – PowerPoint PPT presentation

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Title: Operational Risk Management

Operational Risk Management
By A V Vedpuriswar
October 4, 2009
  • Globalization and deregulation of financial
    markets,combined with increased sophistication in
    financial technology, have made banking
    activities very complex.
  • Events such as the September 11 terrorist
    attacks, rogue trading losses at Barings and the
    Y2K scare serve to highlight the importance of
    operational risk management.
  • Operational risks faced by banks today include
    fraud, system failures, terrorism and employee
    compensation claims.

Typical Bank Org Structure
Front Office
  • The more client-facing side of the business is
    known as the front office.
  • These personnel typically include
  • sales people who act as the main contact point
    between the bank and its clients.
  • traders/market makers, who are responsible for
    executing trades with various counterparties.

Middle Office
Middle Office functions
  • Initial trade verification
  • The input of trades into relevant trading systems
  • Investigation of any discrepancies in trade
  • Daily PL reporting
  • Reconciliation and updating of trading positions
  • Monitoring risk limits

Middle Office functions
  • The middle office function attempts to bridge the
    gap between
  • the front office
  • the back office
  • The middle office typically gets involved in
  • risk management
  • control aspects of trading.
  • The middle office personnel are capable of
  • valuing portfolios
  • analyzing risk positions.

Back Office
  • In performing its role, the operations area has a
    major responsibility to control operations risk.
  • The back office should quickly detect errors and
    bring to the attention of dealers and management.
  • Some key responsibilities of back office
    employees include
  • capturing trade details in the settlement system
  • validating trade details
  • issuing settlement instructions
  • ensuring that the trades settle on the value date
  • making payments by electronic transfer mechanisms
  • ensuring timely delivery of securities

More about the Back Office
  • The term operations or back office describe
    those operational areas within the bank that
    deal with the result of trading by the front
  • Following the execution of a trade and recording
    of the trade within the system, trade details are
    typically fed through an interface between the
    trading system and settlement system.
  • The starting point for the settlement of trades
    and all subsequent activities is the capture of
    the trade details within the settlement system.
  • The moment the details of a trade are captured
    within the settlement system, the trading
    position for both securities and cash, at a
    trading book level, must be updated.

The Trade Lifecycle
Trade Execution
Trade Capture (Front office)
Trade Capture (Back Office)
Operational Activities
Trade Enrichment
Trade Validation
Trade Agreement
Transaction Reporting
Settlement Instructions
The Role of the Custodian
Pre Value Date Settlement Instruction Status
Settlement Failure
Trade Settlement
Reflecting Trade Settlement Internally
Trade skeleton
  • The typical trade information fed by a trading
    system and captured by the settlement system
    could be described as the trade skeleton.
  • These are the minimum details a trader or market
    maker must provide as these items are variable
    and cannot be guessed by the settlement

Recording details
  • Though the basic details of a trade may appear
    very clear-cut, the inaccurate recording of the
    details can lead to unnecessary costs being
    incurred and risks being taken by the STO.
  • In an attempt to prevent inaccurate information
    being sent to the outside world, the process of
    validating trade information is adopted by many

Trade agreement/validation
  • Failure of the bank and its counterparty to agree
    about the details of the trade, can result in
    monetary losses if the discrepancy remains
    unresolved at the value date.
  • Consequently, it has become standard practice in
    many markets to strive for trade agreement as
    soon as possible after trade execution.
  • In many securities marketplaces, individual
    trade details must be sent to the regulator by a
    specified deadline.

Settlement Exchanging Securities and Cash
  • The exchange of securities and cash is known as
    settlement with the securities industry.
  • The most efficient and risk-free method of
    settlement is known as Delivery versus Payment
  • DvP involves simultaneous exchange of securities
    and cash between buyer and seller (through their
  • The seller is not required to deliver securities
    until the buyer pays the cash.
  • The buyer is not required to pay cash until the
    seller delivers the securities.

Free of Payment
  • The alternative to settling a DvP basis is to
    settle on a Free of Payment (FoP) basis.
  • Parties will need to arrange delivery of
    securities or payment of cash prior to taking
    possession of the other asset.
  • Due to the risks involved, most STOs avoid
    settling in this manner, whenever possible.

Settlement Department
  • The STO must issue a settlement instruction to
    its custodian in order for settlement to occur.
  • All pending incomes against securities must be
    carefully monitored.
  • The first step in collection of the benefit is to
    become aware that the issuer is making a specific
    income payment.
  • The bank must calculate whether it is in fact
    entitled to the income.
  • If so, it must assess who will remit the income
    and monitor the receivable amount until full
    payment is received.
  • Where it offers a safe custody service to
    clients, the STO is expected to collect income on
    behalf of its clients.

Static data
  • Static data (sometimes referred to as standing
    data) describes data that changes occasionally,
    or not at all.
  • The two principal components are
  • Securities static data
  • Counterparty static data.
  • The data must be carefully maintained.
  • If for instance, the coupon rate on a bond is
    not set up correctly, incorrect trade cash values
    will result.

Static Data
  • Likewise, the setting up of an incorrect
    counterparty postal address could result in a
    client failing to receive a trade confirmation.
  • Books and records must be accurate, up-to-date,
    complete and reflect reality.
  • Reconciliation is achieved through the
    comparison of specific pieces of information
    within the banks books and records, and between
    the banks books and records and the outside

  • The compliance officers within a bank are
    responsible for ensuring conformity to the
    various rules and regulations, as laid down by
    the local regulatory authority.
  • This includes ensuring that
  • only qualified personnel execute trades on the
    banks behalf
  • reporting of trade and positional information to
    the regulatory authorities is complete and
    effected within the stated deadlines
  • methods of investigating trade disputes between
    the STO and its counterparties are carried out in
    a thorough and correct manner
  • measures are taken to prevent unlawful
    activities within the STO, such as insider trading

Settlement failures
  • Insufficient securities
  • Insufficient cash
  • Unmatched settlement instructions

  • The Basel Committee 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.
  • Banks can adopt their own definitions of
    operational risk, if the minimum elements in the
    Committee's definition are included.

Types of Operational Risk
  • Internal fraud
  • External fraud
  • Employment practices and workplace safety
  • Clients, products and business practices
  • Damage to physical assets
  • Business disruption and system failures
  • Execution, delivery and process management

Internal Fraud
  • Intentional misreporting of positions
  • Unauthorized undertaking of transactions
  • Deliberate mismarking of positions
  • Insider trading (on an employee's own account)
  • Malicious destruction of assets
  • Theft/robbery/extortion/embezzlement
  • Bribes/kickbacks
  • Forgery
  • Willful tax evasion

External Fraud
  • Theft/robbery
  • Forgery
  • Computer hacking damage
  • Theft of information
  • Check kiting

Employment practices and workplace safety
  • Employee compensation claims
  • Wrongful termination
  • Violation of health and safety rules
  • Discrimination claims
  • Harassment
  • General liability

Clients, products and business practices
  • Breaches of fiduciary duties
  • Suitability/disclosure issues (KYC, and so on)
  • Account churning
  • Misuse of confidential client information
  • Antitrust
  • Money laundering
  • Product defects
  • Exceeding client exposure limits

Damage to physical assets
  • Natural disasters (earthquakes, fires, floods,
    and so on)
  • Terrorism
  • Vandalism

Business disruption and system failures
  • Hardware and software failures
  • Telecommunication problems
  • Utility outages/disruptions

Execution, delivery and process management
  • Miscommunication
  • Data entry errors
  • Missed deadline or responsibility
  • Model/system misoperation
  • Accounting errors
  • Mandatory reporting failures
  • Missing or incomplete legal documentation
  • Unapproved access given to client accounts
  • Non-client counterparty disputes
  • Vendor disputes
  • Outsourcing

Qualitative assessment
  • Environment
  • Activities
  • Supervision
  • Disclosure

Risk Assessment
  • Checklists
  • Questionnaires
  • Workshops
  • Scorecards

Operational Risk Indicators
  • Operational risk indicators attempt to identify
    potential losses before they happen.
  • Some indicators are applicable to specific
    organizational units (for example, transaction
    volumes and processing errors).
  • Others can be applied across the entire bank (for
    example, employee turnover, new hires and number
    of sick days).
  • In practice, the most common risk indicators are
    lagging or ex-post measures.
  • They provide information on events that have
    already taken place (eg, failed trades,
    settlement errors, and so on).

From lagging into leading indicators
  • The challenge for risk managers is to transform
    lagging indicators into leading or predictive
  • This can be done by changing the focus of the
    indicators that are tracked or by adding new
    information to these indicators.
  • Thus the focus of the indicators could be
    changed to highlight issues that are still
    outstanding or remain open after a specified
    period of time (for example, 24 hours) has
  • In reality, however, it is not easy to transform
    lagging indicators into predictive indicators.

Statistical Approaches
  • Statistical approaches to operational risk
    measurement generally involve the use of
    methodologies to quantify operational risk .
  • The approaches involve the collection of actual
    loss data and the derivation of an empirical
    statistical distribution.
  • An unexpected loss amount, against which banks
    must hold a capital buffer, can then be
    calculated from the distribution.
  • In theory, the unexpected loss can be calculated
    to any desired target confidence level.
  • In practice, many banks are working towards
    measuring operational risk to a 99.9 confidence

Legal risk
  • The Basel Committee's definition of operational
    risk explicitly includes legal risk.
  • Legal risk is the risk of disruption or adverse
    impact on the operations or condition of a bank
    due to
  • unenforceable contracts
  • lawsuits
  • adverse judgments
  • other legal proceedings
  • It can arise due to a variety of issues, from
    broad legal or jurisdictional issues to something
    as simple as a missing provision in an otherwise
    valid agreement.

Master Agreements
  • There are now master agreement forms for many
    financial products.
  • These agreements
  • create a common legal framework that can be
    understood by all market participants.
  • cover most of the major legal points that should
    be agreed as part of documenting the
  • Individual transactions are tied to master
    agreements with confirmation documents containing
    specific terms of each transaction.

  • The master agreements should ideally be
    negotiated prior to any individual transaction
    being agreed.
  • But, in many cases, the master agreement is only
    negotiated as a consequence of the first
  • Master agreements cover how the parties will
    conduct themselves in case of the early
    termination of the contractual agreements due to
    credit default or other unforeseen events.
  • The agreements specify how the exposures for
    more than one transaction under the master
    agreement will be netted against each other.

Reputation risk
Reputation Risk
  • Negative public opinion regarding an
    institution's practices, whether true or not, may
    result in a decline in its customer base,
    expensive litigation and/or a fall in revenue.
  • Reputational risk may cause liquidity
    difficulties, fall in share price and a
    significant reduction in market capitalization.
  • In 1994, Bankers Trust was accused of having
    misled customers by selling them inappropriate
    derivatives positions.
  • Its reputation was so badly damaged that it was
    forced into acquisition.

Strategic Risk
Strategic(Business) Risk
  • It incorporates the risk arising from an adverse
    shift in the assumptions, goals and other
    features that underpin a strategy.
  • Business Risk is a function of
  • a bank's strategic goals
  • the business strategies developed to achieve
    these goals
  • the resources deployed in pursuit of these goals
  • the quality of implementation of these resources
  • Business risk, however, is difficult to assess in
  • It can be particularly difficult to separate from
    other forms of risk, such as market risk.

Model Risk
Model Risk
  • Model risk arises out of the failure of a model
    to sufficiently match reality, or to otherwise
    deliver the required results.
  • It can arise from a number of issues, including
  • mathematical errors (for example, in determining
    the formulas for valuing more complex financial
  • the lack of transparent market prices for some of
    the more illiquid market factors
  • invalid assumptions
  • inappropriate parameter specification
  • incorrect programming

Dealing with model risk
  • Companies must model the instruments and the
    portfolio carefully.
  • Very large and unexpected moves may occur in
    market factors sometimes in conjunction with each
  • Liquidity can suddenly vanish.
  • Being based on assumptions, models are always a
    simplified representation of what happens under
    real-life conditions.
  • If these assumptions break down, then the model
    is worthless.
  • Therefore, modeling for disaster as well as for
    normal market conditions is highly desirable.
  • This is why stress testing is important in
    addition to value at risk calculations.
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