Transcript 5-_chap017.ppt

CHAPTER 17
Technology and Other Operational Risks
Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved
Overview
 Factors affecting operational returns
and risks
 Importance of optimal management
and control of labor, capital, and other
input sources and their costs
 Technology and its impact on risk and
return
 Examples: Risks resulting from
innovations in IT and effects of terrorist
attacks on key technologies
Ch 17-2
Sources of Operational Risk
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Technology
Employees
Customer relationships
Capital assets
External
Ch 17-3
Technology & Profitability
 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
Ch 17-4
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
Ch 17-5
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
Ch 17-6
Impact on Wholesale Banking
Improvements to cash management:
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Controlled disbursement accounts
Account reconciliation
Wholesale lockbox
Electronic lockbox
Funds concentration
Electronic funds transfer
Check deposit services
Electronic initiation of letters of credit
Ch 17-7
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 ecommerce
 Online customer-facing technologies
 Cloud computing
Ch 17-8
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Impact on Retail Banking
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Automated teller machines
Point-of-sale debit cards
Tablet banking
Preauthorized debits/credits
Mobile banking
Online banking
Ch 17-9
Impact on Retail Banking
 Smart cards
 FI social media sites
 Integration of online, offline, and
mobile channels
 Financial planning services
 Instant ‘micro mobile loans’
 Loyalty programs
Ch 17-10
Effects of Technology on Revenues & Costs
 Investments in technology are risky
– Potentially negative NPV projects due to
uncertainty and potential competitive
responses
– Service quality and convenience
 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
Ch 17-11
Effects of Technology on Revenues & Costs
 Evidence shows the impact of
regulation on the 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
Ch 17-12
Effects of Technology on Revenues & Costs
 Revenue effects:
– Facilitates cross-marketing
 Mixed success
∙ Example: Citigroup and insurance
– Increases innovation
Ch 17-13
Technology and Costs
 For larger FIs the scale and array of
potential technology investments is
greater
– Potential average cost advantage for
larger FIs
 Economies of scale
 Potential elimination of smaller banks?
– Technological investments are risky
 Potential diseconomies of scale
Ch 17-14
Economies of Scale in FIs
Ch 17-15
Effects of Technological Improvement
Ch 17-16
Effects on Costs (continued)
 Economies of scope
– Multiple outputs may provide synergies in
production
– FI size may affect potential gains and
losses from IT investment
 Diseconomies of scope
– Specialization may have cost benefits in
production and delivery of some FI
services
Ch 17-17
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)
Ch 17-18
Empirical Findings
 Evidence of 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
 Potential long term gains from innovation
– Cashless payments system?
Ch 17-19
Technology and Evolution of the Payments System
 Use of electronic transactions higher in
other countries
– Usage of checks rapidly becoming
obsolete
– Checks cleared using electronic funds
transfer
– E-money virtually non-existent in the US
 Facilitates foreign currency transactions on the
internet
 Not FDIC insured
Ch 17-20
U.S. Payments System
– U.S. reluctance to abandon the use of
checks
– U.S. payments system
– FedWire
– Clearing House Interbank Payments
System (CHIPS)
– Combined value of transactions often
more than $5 trillion per day
Ch 17-21
Web Resources
 For more information on the Clearing
House Interbank Payments System,
visit:
CHIPS www.chips.org
Ch 17-22
Wire Transfer System Risks
 Daylight overdraft risk
– FedWire settlement at 6:30 EST
– Banks commonly ran daylight overdrafts
 50 basis point interest rate introduced for
daylight overdrafts
– Regulation J guarantees payment finality
of wire transfer messages by the Fed
 Fed bears the risk
– Regulation F sets exposure limits to
individual correspondent banks
Ch 17-23
Risks (continued)
 International Technology Transfer Risk
 Crime and Fraud Risk
– Fraud risk, especially from FI employees
– Riggs National Bank transactions with Saudis
– Costs of complying with Patriot Act
Ch 17-24
Risks (continued)
 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
Ch 17-25
Risks (continued)
 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
– Industrial loan corporations (ILCs)
 Technology allows locating in Utah where regulation is
more favorable
 Requirement to register ILCs as bank holding
companies, 2009
Ch 17-26
Other Operational Risks
 Employees
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Turnover
Key personnel
Fraud
Errors
Rogue trading
Money laundering
Confidentiality breach
 Example: Theft of code by ex-Goldman programmer
– Revelation of ethical problems via email
exchanges
Ch 17-27
Technology Risks
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Programming error
Model risk
Mark-to-market error
Management information
IT/Telecommunications systems outage
Technology provider failure
Contingency planning
Ch 17-28
Customer Relationship Risks
 Contractual disagreement
 Dissatisfaction from poorly performing
technology
 Default
Ch 17-29
Capital Asset Risk
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Safety
Security
Operating costs
Fire/flood
Ch 17-30
External Risks
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External fraud
Taxation risk
Legal risk
War
Market collapse
Reputation risk
Relationship risk
Ch 17-31
Controlling Operational Risk
 Loss prevention:
– Training, development, review of
employees
 Loss control:
– Planning, organization, back-up
 Loss financing:
– External insurance
 Loss insulation:
– FI capital
Ch 17-32
Regulatory Issues
 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
Ch 17-33
Other Concerns
 Efforts to expand consumer
acceptance of web-based services
frustrated by scams
– Identity theft concerns
 Vulnerability of online credit card
usage
Ch 17-34
Pertinent Websites
BIS
The Clearing House
FDIC
International Swap and
Derivatives Association
The Wall Street Journal
www.bis.org
www.chips.org
www.fdic.gov
www.isda.org
www.wsj.com
Ch 17-35