Transcript 5-_chap016-edited03.ppt

CHAPTER 16
Technology and Other Operational Risks
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All Rights Reserved.
1. Introduction
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Financial risk is only one part of a modern FI’s risk profile.
FI’s have a real/production side to their operations that results in additional
costs and revenues.
This chapter discusses the factors
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–
That impact operational returns and risks, and also
the importance of optimal management and control of labor, capital, and other
input sources and their costs.
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The emphasis is on technology and its impact on risk and return.
Technology is not just a new distribution channel but a different way of
providing financial services.
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Examples:
Risks resulting from innovations in IT and effects of terrorist attacks on key
technologies.
Technology effects our operations. So there are operational dimentions.
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Hitachi Data Systems indicates that back office system failures occur 4 times per year
in a average firm. Recovery takes 12 hours.
After 9/11 it took a week for Bank of New York to handle all the problems.
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2. Sources of Operational Risk
At least five categories are available
1. Technology
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2.
Employees
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3.
(human error and internal fraud like case of Jerome Kerviel in Feb2008 at Societe
Generale) (same example is also involves market risk and off balance sheet risk as
well
Customer relationships
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4.
(contractual disputes)
Capital assets
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5.
(destruction by fire or other catastrophes)
External
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(Failure and declining systems)
(external fraud)
1 to 4 are internally controllable while item 5 is not.
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3. Technological Innovation and
Profitability
The US banks alone spend 20 billion USD per year in technology
related expenditures
 Efficient technological base can result in:
– Lower costs
 Through improved allocation of inputs/sources.
– Increased revenues
 Through wider range of outputs
– Importance of operating cost and the efficient use of IT is
demonstrated with the following profit function:
Earnings before taxes =
(Interest income - Interest expense) +
(Other income - Noninterest expense) –
Provision for loan losses
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Technological Innovation and
Profitability
 Technological investments have the potential to
increase both the FI’s net interest margin or the
difference between interest income and interest
expense.
Earnings before taxes =
(Interest income
↑ - Interest expense↓) +
↑
(Other income
- Noninterest expense
Provision for loan losses
↓) –
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Technological Innovation and
Profitability
(Interest income
↑ - Interest expense↓) +
 Interest income can be increased
– Through wider array of outputs or cross selling as a result of
technological developments.
 Interest expense can be decreased
– If access to markets for liabilities is directly dependent on
the FI’s technological capability.
 Fedwire, CHIPS link the domestic and international interbank
lending markets.
 Ability to originate and sell commercial paper is increasingly
computer driven.
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Technological Innovation and
Profitability
↑
↓
 (Other income
- Noninterest expense ) –
Provision for loan losses
 Other income can be increased
– Through electronic handling of fee generating OBS
activities such as LCs and derivatives, many trade finance
products are now on line.
– These are linked to the quality of the FI’s technology.
 Noninterest expenses can be reduced
– Through improved efficiency of back office operations
using technology
 Especially true for securities-related activities
 Collection, storage, processing and settlement of customer
information are computer based.
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4. Impact of IT on Wholesale & Retail
Banking
Improvements to cash management: (services designed to collect, disburse and transfer funds on a local,
regional, national, international basis)
These services required by corporates
a)
b)
1.
2.
3.
4.
5.
7.
8.
9.
10.
11.
12.
13.
14.
Excess cash balances result in a significant opportunity cost
Need to know working capital or cash position real time.
Controlled disbursement accounts
Account reconciliation (by a feature which checks have been paid)
Wholesale lockbox – regarding check payments
Electronic lockbox – for online payments
Funds concentration – from several accounts to one FI
Electronic funds transfer – including SWIFTCheck deposit services Electronic initiation of letters of credit
Treasury management software-allows efficienty for multiple currency-security
transactions.
Electronic data interchange-EDI
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 of IT on Wholesale & Retail
Banking
Retail customers also want efficiency and flexibility in
their financial transactions.
With a single click Merrill Lynch customers can obtain
information on all research (conducted by Merrill
Lynch) on a company. Another click gives the
customer information on the best terms available on
a trade, an a final click executes a customer’s trade.
A typical customer transaction through a branch or
phone call costs a customer about $1, while a similar
online transaction costs just $0.02.
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1.
2.
3.
4.
5.
6.
7.
8.
Impact of IT on Wholesale & Retail
Banking
Automated teller machines (ATMs)
Point-of-sale debit cards (POS)
Home banking
Preauthorized debits/credits
Pay-by-phone
Online banking
Smart cards
+++
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5. Effects of Technology on
Revenues & Costs-1
 Investment in technology is risky
– Innovations may fail to attract sufficient business,
it is risky !
– Innovations may turn out to be negative net
present value projects. (because of uncertainty
over revenue and cost)
– Potential competitive responses from the rivals
may be another problem (mimicing the
successfull project)
– Manager’s growth oriented investment vs.
stockholder’s value maximizing objective can be
in conflict.
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Effects of Technology on
Revenues & Costs-2
 Profitabilty of product innovation negatively related with initial
setup and development cost and positively related with
expected cash flows
 You should consider whether direct or indirect evidence shows
if IT invesment to increase revenue or decrease cost !!!
 & Innovation cannot be evaluated independently from
regulation&regulatory changes. Evidence shows the
impact of regulation on the value of technological
innovations
– for example, Branching restrictions in U.S. affect the value
of cash management services,
– 2 dimentions of Technology we will discuss are
 Product revenue side / Operating cost side
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Effects of Technology on
Revenues & Costs-3
 Revenue effects:
– Facilitates cross-marketing
 Mixed success
∙ Example: Citigroup and insurance
– Technology increases innovation (new products)
– Service quality and convenience is another
dimention
 Inability of ATMs to interact with customers as humans
can
 Example: Customers compare mortgage rates online,
but only 2% close online
 Virtual FIs operating branch offices
∙ Example: ING Direct
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Effects of Technology on
Revenues & Costs-4
 The benefits are considered more on the costs side rather then
revenue side.
– Economies of Scale:
– Potential average cost advantage for larger FIs
 Economies of scale imply that the unit or average cost of
producing FI services in aggregate falls as the size of the FI
expand.
 Potential elimination of smaller banks?
– Technological investments are risky
 Potential diseconomies of scale (increase in the average
costs of production as the output of an FI increases)
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Economies of Scale in FIs
The unit or average cost of
producing FI services in aggregate
(or some specifics services) falls as
the size of the FI expands. (Sc)
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Effects of Technological Improvement
The effects of improving
technology over time is to shift
the AC curve downward but with a
larger downward shift for large FIs
If not (due to excess capacity, or
integration problems etc.) than small
FIs with simple and easily managed
computer systems without a huge
fixed cost will have advantage
causing diseconomies of scale.
Diseconomies of scale imply that small FIs are more cost efficient than
large FIs and that in a freely competitive environment for financial services.
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Effects of Technology on
Revenues & Costs-5
 Economies of Scope:
 The ability of FIs to generate synergistic cost savings through
joint use of inputs in producing multiple products.
 Diseconomies of Scope: Instead of joint production
specialization may have cost benefits in production and
delivery of some FI services.
 FIs are multiproduct firms producing services involving different
technological needs.
 Improving technology in one service may synergistic benefits
in lowering the costs of some other areas.
 Economies of scale ignores this interrelationship while
Economies of scope does not
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Calculation of Average Costs
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6. Testing for Economies of Scale and
Scope
 Production approach:
– Views FI as producing output of services using
inputs of labor and capital
Cost function = f(y,w,r) (output of services, wage,
rent)
 Intermediation approach:
– Includes funds used to produce intermediated
services among the inputs
Cost function = f(y,w,r, k) (and cost of funds)
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7. Empirical Findings on Cost Economies
of Scale and Scope
 Evidence of economies of scale for banks up to the
$10 billion to $25 billion size range.
 X-inefficiencies (managerial performance and other
hard-to-quantify factors) 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
 Potential long term gains from innovation
– Cashless payments system?
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8. Technology and Evolution of the
Payments System
 Use of electronic transactions higher in
other countries than the USA.
– Usage of checks rapidly becoming
obsolete (outdated)
– Checks cleared using electronic funds
transfer
– E-money virtually non-existent in the US
 Facilitates foreign currency transactions on the
internet
 Not FDIC insured
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Technology and Evolution of the
Payments System
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Technology and Evolution of the
Payments System
– U.S. reluctance to abandon the use of checks. Closing the
gap will take time.
– U.S. payments system
 FedWire
 Clearing House Interbank Payments System (CHIPS)
– Combined value of transactions often more than $4.5
trillion per day
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For more information on the Clearing House Interbank Payments System, visit:
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CHIPS www.chips.org
Risks that arise in an Electronic Transfer
Payment System :Daylight Overdraft Risk
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At the end of the banking day at 6.30 PM EST the bank should not
have a negative reserve position with FED, by rules. (Banks must
maintain cash reserves on deposit at the FED)
What is true at the end of the day is not true during the day.
Usually banks run daylight overdrafts on their reserve accounts at the
Fed as their payment outflow messages exceed their payment inflow
messages. (within day lending by Fed)
Fed bears the Fedwire credit risk of bank failures by granting
overdrafts without charging a market interest rate.
On CHIPS, privately owned payment system, operations are different
but similar.
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Risks that arise in an Electronic Transfer
Payment System
 International Technology Transfer Risk
– While US FIs were unable to transfer their tech. İt is just the
opposite for foreign FIs entering into US market.
 Crime and Fraud Risk
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Fraud risk, especially from FI employees
Riggs National Bank transactions with Saudis
Wachovia investigated in relation to money laundering
Costs of complying with Patriot Act
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Risks that arise in an Electronic Transfer
Payment System
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Regulatory Risk
– Technology facilitates avoidance of regulation by locating in least
regulated state or country
 Citigroup credit card operations in South Dakota
 South Dakota and Delaware liberal in terms of usury ceilings and other
regulatory controls
 Cayman Islands
Tax Avoidance
– Internal pricing mechanisms to shift profits to low tax regimes
– UBS AG: the Hong Kong connection
Competition Risk: nonfinancial firms
– GMs credit card operation
– AT&T has also a financial institution.
– Industrial loan corporations (ILCs)
 Technology allows locating in Utah where regulation is more
favorable
 Requirement to register ILCs as bank holding companies
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9. Other Operational Risks
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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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10. Regulatory Issues
 As FIs’ use of technology increases, operational risk increases
as well. (1980s-1990s lost over 200 billion Usd due to Op. Risk)
 1999 Basel Committee on Banking Supervision noted the
importance of operational risks
 Follow up report
Required capital:
– Basic Indicator Approach
– Standardized Approach
– Advanced 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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Thanks.
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