India: Operational Risk

Last Updated: 17 February 2004

By N Raja Venkateswar and Raghu Ganapathy

The Context

Barings, Daiwa, Natwest, Sumitomo – a common thread runs through the high profile catastrophic losses suffered by these companies – all the losses arose in the area of Operational Risks (OR). These events have forced the regulators and banks world over to refocus on OR.

As businesses become more and more competitive, as the pace of change inside and outside the organization continues to increase exponentially, as the market place becomes more and more complex due to technological advancement and innovations, the management of operational change and the risks has become a critical success factor. Business operations will need to be as efficient as possible to deliver seamless service to the customer. Risk management structure and practices will need to mature to satisfy all stakeholders viz. shareholders, employees, Government, regulators and the society as a whole.

As the new millennium unfolds, the challenge, for business leaders and decision makers, is to adopt an integrated approach to strategy, value proposition, customer service, capital management, finance, operations, risk management and corporate culture.

What is Operational Risk ?

Operational Risks are enterprise wide and inherent in any business. It is more pronounced in industries like nuclear power plants, chemical industries and as has been seen lately, in the banking industry.

An acceptable and recognized definition for OR is yet to evolve. However, the description of OR ranges from narrow definition of covering operational breakdowns in processes to broad definitions which capture all risks that are not credit or market risks.

Historically, OR was associated with only operations and technology. The Financial Services authority, (FSA), UK, describes OR as the "risk of loss, resulting from inadequate or failed internal processes, people and systems, or from external events". Significant operational losses in recent years in the Banking industry have highlighted that OR can arise from internal and external fraud, failure to comply with employments laws or meet workplace safety standards, policy breaches, compliance breaches, key personnel risks, damage to physical assets, business disruptions and system failures, transaction processing failures, information security breaches and the like. With increasing attention being paid to social, ethical and environmental issues, the scope of OR Management has extended to monitoring and managing these risks as well. The Basel Committee on Banking supervision has recognized that managing OR is becoming an important feature of sound risk management practice in modern financial markets. The Committee has noted that the most important types of operational risk involve breakdowns in internal controls and corporate governance. Such breakdowns can lead to financial losses through error, fraud or failure to perform within accepted time-lines or cause the interests of the bank to be compromised in some other way, for example by its dealers, lending officers or other staff exceeding their authority or conducting business in an unethical or risky manner. Other aspects of operational risk include major failure of information technology systems or events such as major fires or other disasters.

Operational Risk – the Drivers

The Banking industry is by far the most advanced than any other, in attempting to manage the credit, market and operational risks in an integrated manner. Regulatory pressure has helped and goaded the banks to adopt a strategic approach to operational continuity and risk management. It is being realized that by managing risks on the operational side, banks can maximize returns through more efficient use of capital, thereby increasing shareholders’ wealth.

Globalization, consolidation, outsourcing, nearshoring and offshoring, breaking of geographical barriers by use of new technology, consolidation, growth of e-commerce, competition etc. have significantly increased the profit-making opportunities of the banking industry. At the same time, increased regulatory focus, increased awareness of ‘uninsurable’ risks, greater focus on corporate governance areas, renewed emphasis on corporate accountability and Director’s liability, public expectations etc. have become the key drivers compelling organizations to focus on management of operational risks. The industry’s risk-control structure has more often than not, not kept pace with the hectic changes taking place at the operational level functionality of the bank.

The Basel II norms

The Basel committee, saying that operational risk has become too important to ignore, decided that banks must take a disciplined and proactive approach to managing it. Though the final guidelines are still not very clearly defined, it is required for banks to apply an explicit capital charge to cover losses arising from operational risks. Ultimately, this would require two measurement models:

- Measuring operational risk and

- Measuring to determine how much capital must be allocated.

These models are currently in their formative stages, with multiple ideas and proposals being discussed. In the meantime, many "best practices" banks have created reserves for operational risk losses by substituting non-interest expense for the data that the models would otherwise provide. A few banks have made a fair degree of progress in developing more advanced techniques for allocating capital with regard to operational risk. To determine their capital allocation, they simply use a percentage of non-interest expense. These banks have allocated 8% of non-interest expense to sometimes as much as 20%. If the top 100 banks — which have a combined $500 billion of non-interest expense — set aside 30%, the allocation would total $150 billion. As with buying insurance, the banks would have to take an annual charge — using current interest rates of about 5% — of $7 billion to $8 billion to buy access to this reserve.

On a microeconomic level, a commercial bank with say $1.0 billion of non-interest expense would have to take an annual charge of about $40 million to finance a $250 million of allocation by similar calculations. Thus this would severely limit the bank’s risk taking and consequent profit making abilities. In absence of good models or best of breed operational risk management scenarios, banks could rely on this percentage calculation of averaged historical data or another data substitute to establish the required capital cushion. The illogical aspect of this plan is that, regardless of operational risk performance, all banks would be treated alike, and better performers would be penalized as they would have access to correct and accurate data increasing the need for minimum capital allocation calculated on standard derivative functions.

On the other hand, banks that can define, design, develop and follow best practices models to accurately measure their operational risk can allocate just enough capital to cover their exposure by using the newer and more accurate derivative functions. As a result, banks that manage their risk efficiently, measure it effectively, and allocate capital effectively would be rewarded with a smaller regulatory burden and more capital to support innovation and expansion. At the same time, their customers would be protected not by unnecessary amounts of external insurance but by solid operational risk management.

More importantly, true competitive advantages arise from developing an organizational culture that proactively manages day-to-day risk, identifies new risks progressively, shares best practices in the organization and beyond and systematically tracks risk exposures. Building the right culture for that begins with instituting a disciplined approach to operational risk management, starting with the board and filtering down through every level and business unit and across every major process in the organization using a software framework customized to peculiar needs for each bank and country of operation. Once the infrastructure is in place, banks must learn to assess the quality of their risk risk-management programs continuously and assign monetary values to the risks they confront, understand the same and take effective measures to mitigate the same. This is the starting point for building a model that banks can use instead of the standard percentage rate that regulators will probably assign across the industry making the better banks enjoy less leverage.

Measuring Operational Risk

Operational risk is more difficult to measure than market or credit risk due to the non-availability of objective data, redundant data, lack of knowledge of what to measure etc.

The data requirements for measuring market risk are pretty straight forward - prices, volatility, and other external data, packaged with significant history in large data bases easily accessible and measurable. Similarly, credit risk relies on the assessment and analysis of historic and factual data, which is easily available in most core banking systems.

Operational risk, however, is an ill-defined "inside measurement," related to the measures of internal performance, such as internal audit ratings, volume, turnover, error rates and income volatility, interaction of people, processes, methodologies, technology systems, business terminology and culture. Uncertainty about which factors are important arises from the absence of a direct relationship between the risk factors usually identified and the size and frequency of losses.

Capturing operational loss experience also raises measurement questions. Further the costs of investigating and correcting the problems underlying a loss event could be significant and in some cases exceed the direct costs of operational losses. Measuring operational risk requires both estimating the probability of an operational loss event and the potential size of the loss.

Thus any mathematical approach to operational risk struggles with lack of objective data. Operational risk could cost the 100 biggest banks $14-15 billion a year given the evolving nature of operations and a single enterprise-wide historical view of operational risk may not be the right approach.

Instead, banks should develop suitable internal measures of operational risk to substitute or add to available historical risk data. This means identifying categories and classes of risk and gathering all readily available information, which together can support a reliable measure of operational risk in each area of activity and for each category or sub-category. Information can be data on risk experience, inherent risk on risk-scoring mechanisms, and subjectively based measurements of risk impact and likelihood. Better operation risk management means that banks are less likely to have major losses through error, fraud, or failure to deliver quality service.

Along with protecting a company from potential damage, proactive risk management contributes to the bottom line. The benefits include protection of assets by preventing major losses, protection of shareholder value, avoidance of regulatory censure, the ability to render services without interruption, and the maintenance of a good reputation and public confidence. In the long run, the new Basel II guidelines will motivate better control of operational risk, leading to greater efficiencies in pricing and, ultimately, lower costs for lending money. Institutions with enterprise wide operational risk awareness and ownership and clear processes to monitor and manage it will be best equipped to embrace change and profit from it.

Risk Management Tools

A robust operational risk management process consists of clearly defined steps which involve identification of the risk events, analysis, assessment of the impact, treatment and reporting.

While sophisticated tools for measuring and managing operational risks are still to evolve, the current practices in this area are based on self-assessment. The starting point is the development of enterprise-wise generic standards for OR which includes Corporate Governance standards. It is extremely important for a robust risk management framework that the operational risks are managed where they originate. Risk management and compliance monitoring is a line management function and the risk culture has to be driven by the line Manager. It is, therefore, the line manager’s responsibility to develop the generic operational risk standards applicable to his line of business. The purpose of this tool is to set minimum operational risk standards for all business and functional units to establish controls and monitor risks through Control Standards and Risk Indicators.

Once the standards are set, the line manager has to undertake a periodic operational risk self assessment to identify key areas of risk so that necessary risk based controls and checks can be developed to monitor and mitigate the risks.

Control Standards set minimum controls and minimum requirements for self-assessment of effectiveness of controls for the key processes.

The Risk indicators identify operational risks and control weaknesses through statistical trend analysis. The Risk Indicators are reviewed periodically to ensure that they are constantly updated.

Reporting is a very important tool in the management of operational risks since it ensures timely escalation and senior management overview. Reporting should include significant operational risk exceptions, corporate governance exceptions, minutes of meetings of Operations Risk Committee and real time incident reports.

Conclusion

Operational Risk management is one of the most complex and fastest growing areas in financial services industry. The methods to quantify the risk are evolving rapidly though they are not likely in the near future, to attain the sophistication with which market and credit risks are measured. Nevertheless, it is extremely important that the significance and impact of this risk area on the overall viability of a banking enterprise is given due recognition so that there are strong incentives for banks to continue to work towards developing models to measure operational risks and to hold the required capital buffers for this risk.

N Raja Venkateswar
Vice President
Telesis Technologies

Raghu Ganapathy
Consultant
Telesis Technologies

Raja heads worldwide sales and marketing and the Risk Management Practice for Telesis Technologies, a business consultancy and software solutions and services provider for banks and financial institutions worldwide.

Raghu consultants with the Telesis’ Risk Management practice and previously headed the Country Operation Risk Group for one of the top MNC banks in the world.

Telesis is a US and India based Software Services & Products and Business Consultancy organization and provides cutting edge solutions to Banks and other Financial Institutions in the field of Business Intelligence, Risk Management, Regulatory Compliance, Core Banking and Operations including Employee welfare solutions. Telesis is presently operational in the Americas, Middle East, Africa and South Asia.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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