CHAPTER 16

Technology and Other Operational Risks

Copyright © 2011 by The McGraw-Hill Companies, Inc. All Rights Reserved.McGraw-Hill/Irwin

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1. Introduction1. Introduction 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

– 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. 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.

Examples:Risks resulting from innovations in IT and effects of terrorist attacks on key technologies. Technology effects our operations. So there are operational dimentions.

– 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. 2. Sources of Operational RiskSources of Operational Risk

At least five categories are available1.Technology

– (Failure and declining systems)

2.Employees– (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

3.Customer relationships– (contractual disputes)

4.Capital assets– (destruction by fire or other catastrophes)

5.External– (external fraud)

1 to 4 are internally controllable while item 5 is not.

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3. 3. TechnologTechnological Innovation and ical Innovation and ProfitabilityProfitability

The US banks alone spend 20 billion USD per year in The US banks alone spend 20 billion USD per year in technology related expenditurestechnology related expenditures

Efficient technological base 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. 4. Impact Impact of IT of IT on on WholesaleWholesale & Retail & Retail BankingBanking

Improvements to cash management: (services designed to collect, disburse and transfer funds on a local, regional, national, international basis)

These services required by corporatesa) Excess cash balances result in a significant opportunity cost b) Need to know working capital or cash position real time.

1. Controlled disbursement accounts2. Account reconciliation (by a feature which checks have been paid)3. Wholesale lockbox – regarding check payments4. Electronic lockbox – for online payments5. Funds concentration – from several accounts to one FI7. Electronic funds transfer – including SWIFTCheck deposit services - 8. Electronic initiation of letters of credit9. Treasury management software-allows efficienty for multiple currency-security

transactions.10. Electronic data interchange-EDI11. Facilitating B2B e-commerce12. Electronic billing13. Verifying identities

Issue of law enforcement access to encrypted data since September 11, 200114. Assisting small business entry into e-commerce

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Impact Impact of IT of IT on Wholesale on Wholesale & & RetailRetail BankingBanking

Retail customers also want efficiency and flexibility Retail customers also want efficiency and flexibility in their financial transactions.in their financial transactions.

With With a single click a single click Merrill Lynch customers can Merrill Lynch customers can obtain information on all research (conducted by obtain information on all research (conducted by Merrill Lynch) on a company. Merrill Lynch) on a company. Another click Another click gives gives the customer information on the best terms the customer information on the best terms available on a trade, an a available on a trade, an a final click final click executes a executes a customer’s trade.customer’s trade.

A typical customer transaction A typical customer transaction through a branch through a branch or phone call or phone call costs a customer about $1costs a customer about $1, while , while a similar a similar online transaction costs just $0.02.online transaction costs just $0.02.

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Impact Impact of IT of IT on Wholesale on Wholesale & & RetailRetail BankingBanking

1. Automated teller machines (ATMs)2. Point-of-sale debit cards (POS)3. Home banking4. Preauthorized debits/credits5. Pay-by-phone6. Online banking7. Smart cards8. +++

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5. 5. Effects of Technology on Effects of Technology on Revenues & CostsRevenues & Costs-1-1

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 growth oriented investment vs. stockholder’s value maximizing objective stockholder’s value maximizing objective can be in conflict. can be in conflict.

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Effects of Technology on Effects of Technology on Revenues & CostsRevenues & Costs-2-2

Profitabilty of product innovation negatively related with initial setup and development cost initial setup and development cost and positively related with expected cash flowsexpected cash flows

You should consider whether direct or indirect evidence shows You should consider whether direct or indirect evidence shows if IT invesment to increase revenue or decrease cost !!!if IT invesment to increase revenue or decrease cost !!!

& Innovation cannot be evaluated independently from regulation&regulatory changes. regulation&regulatory changes. Evidence shows the impact of regulation on the value of technological innovations– for example, BranchingBranching restrictions in U.S. affect the

value of cash management servicesvalue 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 Effects of Technology on RevenuesRevenues & Costs & Costs-3-3

Revenue effects:– Facilitates cross-marketingFacilitates cross-marketing

Mixed success∙ Example: Citigroup and insurance

– Technology iTechnology increases innovationncreases innovation (new products) (new products)– Service quality and convenienceService quality and convenience is another is another

dimentiondimention Inability of ATMs to interact with customers as humans Inability of ATMs to interact with customers as humans

cancan Example: Customers compare mortgage rates online, Example: Customers compare mortgage rates online,

but only 2% close onlinebut only 2% close online Virtual FIs operating branch officesVirtual FIs operating branch offices

∙ Example: ING DirectExample: ING Direct

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Effects of Technology on Effects of Technology on Revenues & Revenues & CostsCosts-4-4

The benefitsbenefits are considered more on the costs side costs side rather then revenue siderevenue 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 scalediseconomies 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 ImprovementThe 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 Effects of Technology on Revenues & Revenues & CostsCosts-5-5

Economies of ScopeEconomies of Scope: : The ability of FIs to generate synergistic cost savings The ability of FIs to generate synergistic cost savings

through joint use of inputs in producing multiple products. through joint use of inputs in producing multiple products. Diseconomies of Diseconomies of SScopecope: Instead of joint production : Instead of joint production

specializationspecialization may have cost benefits in production and may have cost benefits in production and delivery of some FI servicesdelivery 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 capitalCost function = f(y,w,r) (output of services,

wage, rent)

Intermediation approach:– Includes funds used to produce intermediated

services among the inputsCost 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. 8. Technology and Evolution of the Technology and Evolution of the Payments SystemPayments 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

For more information on the Clearing House Interbank Payments System, visit: CHIPS www.chips.org

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Risks that arise in an Electronic Transfer Payment System :Daylight

Overdraft Risk 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 RiskInternational 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 RiskCrime and Fraud Risk– 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

Regulatory Risk– Technology facilitates avoidance of regulation 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 AvoidanceTax 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. 9. Other Operational RisksOther 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. 10. Regulatory IssuesRegulatory 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 reportRequired 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.