Managing Operational Risk (Euromoney books)

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9781855648913: Managing Operational Risk (Euromoney books)

Recent collapses of financial institutions show how operational risk should take an equal place alongside credit and market risk in the risk management strategy of all financial institutions.

This new book is an invaluable guide to operational risks and their mitigation. Divided into four sections it begins by identifying 12 factors which characterise operational risk. The first section examines operational risk in the contexts of merchant, corporate, investment and private banking and the insurance industry. The second demonstrates how operational risk can be managed and controlled and examines cases of operational failure, including Credit Lyonnais and NatWest Markets. The third identifies legal risk including cross-border conflicts of law, compliance and taxation issues and environmental factors. The final section assesses the risk in payments and settlements including dematerialisation, the role of IT solutions, handling intraday exposure and delivery vs payment issues.

Every financial institution should understand and protect against these risks and this unique and timely guide will ensure you establish an effective strategy for managing operational risk.

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From the Author:

PREFACE Classically in the finance industry, operational risk has taken the back seat to credit risk and market risk, but since the late 1990s this has been changing. Prompted by the 1999 New Capital Adequacy Framework issued by the Basle Committee on Banking Supervision, financial institutions are reviewing regulatory guidelines and best practice prevailing in the banking industry, and aiming to help themselves develop solutions for operational risk management. A fundamental understanding of both the type and quantity of operational risk taken by credit institutions and brokerage firms, and of the methods of controlling it, is essential as the industry faces up to increasingly demanding challenges. The fact is that the extent of operational risk exposure being taken may go unnoticed and unchecked until it reaches a level that represents an unacceptable threat to an institution's company's operations. This book is written for investment bankers, commercial bankers, loans officers, traders, treasurers and other practitioners in the financial industry, and also for members of the board and senior managers who want to take a proactive stance towards the control of operational risk. In Part 1, Chapter 1 provides factual and documented evidence of how financial institutions define and manage operational risk. The definition of operational risk outlined addresses today's interconnected environment in which all sorts of business risks are multiplying at an alarming rate. Barings in the United Kingdom and the Bank of New England in the United States, like a number of other institutions, crashed due to failures in the management of market risk and operational risk. A similar synergy exists between credit risk and operational risk. While no two banks have the same notion of what constitutes operational risk, or even the same terminology, there is a convergence of opinions, most pronounced at senior management level. The main elements are a lack of professional skills, organisational weaknesses and execution risk, the origin of which may be either internal or external. Based on the research responses, the following 12 factors demonstrate the range of operational risk: 1.

Management inadequacy at all levels. 2.

Quality and skills of personnel. 3.

Organisational issues, including separation between front and back office activities. 4.

Execution risk, including the handling of transactions, debit/credit and confirmation. 5.

Fiduciary and trust activities. 6.

Legal risk under all jurisdictions in which the bank operates, and compliance with regulations. 7.

Documentation (a hybrid between other operational risks and legal risk). 8.

Payments and settlements, including services provided by clearing agents, custody agents and major counterparties. 9.

Information technology risks, comprising software, computer platforms, databases and networks. 10.

Security and fraud, including rogue traders, internal or external. 11.

Infrastructure services, like power and telecoms. 12.

Present and future risk associated with innovation and globalisation. Because each bank has its own approach to operational risk, Chapter 2 takes a closer look at what is happening in merchant, corporate and investment banking. This is approached from the dual viewpoint of business opportunity and operational exposure. Operational failures often start with poor prognostication, including weak hypotheses about the future course of financial events and inability to anticipate the trends reshaping the banking industry. Chapter 3 focuses on private banking. It starts with practical examples demonstrating the synergy that exists between investment banking and personal banking, particularly from the perspective of institutional investors and high net worth individuals. Operational risk is encountered in many areas of personal banking, starting with the choice of assets and their allocation. Studies have shown around 90 per cent of pension plan investment performance as attributable to asset allocation, with the balance credited to other factors such as securities selection and market timing. The first part of the book concludes with Chapter 4, which examines operational risks characterising the insurance industry, with particular emphasis on what might be expected as insurance companies enter retail banking. The text emphasises operational risks specific to insurance, and elaborates on the likely impact of new trends in insurance practices. It also addresses certain regulatory issues and assesses the growing interest in obtaining catastrophe reinsurance through the capital markets. Part 2 aims to identify ways and means for managing and controlling operational risks. Chapter 5 makes the point that there is no way of avoiding operational risk in a service economy, but there are sound strategies for damage control. Credit institutions that are admired for their caution and their ability to control exposure have in place a rigorous system of internal control. However, not all banks are this careful, and there are large variations in the implementation of internal control systems among US, UK, Scandinavian and Continental European institutions. In the United Kingdom, Germany, Switzerland and the United States, external auditors are now responsible for providing a written report to regulators containing the results of their examination of the audited bank's internal control system. The dangers of uncontrolled operational risk are examined in Chapter 6, principally via practical, real-life examples. For instance, CrŽdit Lyonnais, where top management had lost the ability to say 'No!', and also NatWest Bank, where the lack of operational control resulted in losses totalling a rumoured £90 million (US$150 million) and eventually to the dismantling and selling of NatWest Markets. Other examples discussed include Daewoo of South Korea, Metallgesellschaft of Germany, and the Schneider affair involving Deutsche Bank. What these and many other cases of operational risk have in common is that top management failed to place sufficient emphasis on detailed and disciplined controls in the operation of the business. Chapter 7 presses the point that better organisation and structure often proves to be instrumental in controlling operational risk. To start with, good management always rests on solid organisational fundamentals, one of which is a firewall between front desk and back office. Transparency is another positive organisational trait because it gives senior executives a better chance to analyse projects and processes depending on them, and to ask some critical queries: ¥

Is this project a logical or necessary one considered as a commercial venture? ¥

Has it been properly developed technically, financially and operationally? ¥

What's its relative value to the institution as compared to other projects under consideration? The key area of technology is examined in Chapter 8. This chapter starts by providing some practical examples of institutions that are technology innovators, then it focuses on others that are less so. Lloyds Bank might have saved the £32 million (US$50 million) it lost in the early 1970s in runaway forex trading by its subsidiary in Switzerland if its internal controls, organisation and technology had been in better shape. Following a review of this case, the discussion then centres on mathematical risk analysis and using technology as a tool in developing an approach to risk governance. Part 3 addresses legal risk in its different forms, including compliance and taxation. Legal exposure can teach senior management about the need for organised cooperation between every division and department of the institution and its legal advisers. Chapter 9 explains why the majority of credit institutions think legal risk is a complex issue, particularly in the context of a deregulated, globalised economy where diversity in laws and regulations is the norm rather than the exception. Shareholder activism increases legal risk, and turns the spotlight on the board. In the final analysis there is no alternative to rethinking our policies and practices from a legal perspective, clarifying events that might lead to legal problems before they become a torrent. Master agreements can help reduce legal risk, but they don't handle the different facets of political risk, some of which lead to significant weakening of judicial and law enforcement systems. Nor are all board members and CEOs fully aware that there is latent legal risk in insurance contracts. The message of Chapter 10 is that an institution's management has a much wider role to play than that of just solving financial problems. Every manager has a personal responsibility for the different aspects of legal risk. Discovery, for instance, is an analytical process that helps in the management of legal problems by making it possible to learn what past events can tell us about current and future levels of legal exposure. Chapter 11 concentrates on taxation rules and legal risk. Countries like the United States, the United Kingdom and Holland, which have modernised their fiscal service, divide taxpayers into two large classes. Those who pay regularly and whose fiscal declarations don't contain errors; and those who have had problems in the past. Tax incidents clearly impact on the cost of tax inspection, and they condition the associated penalties. Of the total cost of tax inspection, only 20 per cent relate to the majority of people and entities who file without problems. The focal point of Chapter 12 is environmental risk, and it divides into two parts. The first concerns liability and compensation because of physical damage, and the case of asbestos claims is taken as a practical example. The second is environmental risk in the context of the economic environment, and here the example is the euro and what it has taught the financial markets. Operational risk in payments and settlements is the subject of Part 4 of the book. A key point is that the schooling credit institutions have received over the years in settlements risk should be used to cross-fertilise other, newer domains. Chapter 13 discusses the characteristics, goals and functions of the new generation of payments and settlements solutions. To make the point about the role technology can play in the settlements area, the case is made that a bank's business architecture represents the home of its payments system, and an explanation follows on why only real-time applications can help in controlling operational risk resulting from payments and settlements. A key area of concern in the current environment is the development of efficient ways in which to handle intraday exposure, and this is the subject matter of Chapter 14. Topics discussed include protecting the position of our institution in the local and global payments system, the ability to monitor intraday payments in real-time and the answer to the question who would (or should) guarantee major defaults in intraday payments. Chapter 15 is devoted to studying the development of national and cross-border electronic payments. Part and parcel of this is the transition from T+5 to T+3, which has already taken place, and from there to T+1 and T+0, which means real-time settlements. Organisational, procedural and technological challenges associated with real-time settlements are examined, but it is also suggested that a practical solution is possible on both a national and cross-border basis. In the latter case, implementation of the EU's real-time gross settlement (RTGS) system is reviewed, and the chapter also examines the background to RTGS and the work the European Central Bank had to do to make it work. The book concludes with Chapter 16, which concentrates on operational issues associated with dematerialisation, delivery versus payment (DVP) and the problems with securities lending. Key points in this discussion are the need for risk analysis of dematerialisation operational controls; the synergy (but also possible conflicts) between DVP, custody and the management of settlements risk; and an examination of the limitations of DVP and why it may not be the answer to all our operational risk problems. The text pays particular attention to prudential regulation and the impact of securities lending on operational risk, as well as the conflicts of interest that might result from such lending. Senior managers of credit institutions are urged to ask themselves a number of critical questions as part of risk analysis: What is the likelihood of each type of incident occurring? What can go wrong? What is the impact of each operational risk? How can it be prevented or minimised? Who would be accountable if it takes place? The answers to these questions help us decide about what we really should do as contrasted with what we are trying to do. They also make it possible to come to a view on what is an acceptable level of operational risk. Once we have identified all the potential risks of running our business, we can get busy testing for each potential vulnerability, providing cost/effective solutions based on our findings. *


* I am indebted to 161 knowledgeable people and 84 organisations, for their contribution to the research that made this book feasible. Also to several senior executives and experts for constructive criticism during the preparation of the manuscript. The complete list of people and organisations who participated to the research is shown in the Acknowledgements. Let me take this opportunity to thank Jacqueline Grosch Lobo, David Rathborne of Euromoney Books for suggesting this project and guiding it all the way to publication, and Kim Gross for her work in managing the production. To Eva-Maria Binder goes the credit for compiling the research results, typing the text and drawing the exhibits. Dimitris N. Chorafas Valmer and Vitznau December 2000


"...another tour de force on the part of Dr. Chorafas.......the true nature and ramifications of operational risk are superbly illustrated." -- Gunnar T. Andersen, Managing Director & Member of the Executive Board, International Banking & Treasury, Landsbanki êslands h.f.

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