Why managing operational risk is so important

By Stanley Epstein

Banks, like any other firm or individual, are exposed to many different forms of risk. So one would not expect it, but the term “risk” still remains one of the most misunderstood terms in the banking industry.

This short article will explain what risk is and some of the different types of risk that banks and other financial institutions are exposed to in their everyday business activities.
The definition of “Risk” as “exposure to the chance of injury or loss” is a typical one (with thanks to Dictionary.com).

There may be other variations on this theme, but what we have is good enough. The key elements of “RISK” are EXPOSURE to the CHANCE of LOSS. Put another way; the possibility that something will cause a financial or other loss. This is the basis for understanding the different types of risks that banks face.

In its basic form, banks take in deposits and lend these deposits out in the form of loans. Should the borrower not repay his loan the bank is faced with what is called “credit risk”. Credit risk is the possibility that a borrower will be unable to make payment of the amount of the loan when it falls due. Credit risk is absolute. It’s the chance that the borrower will never be able to repay the loan. Credit risk and bankruptcy are closely linked.

Liquidity risk is on the other hand not absolute. Liquidity risk is the possibility that a borrower will be unable to make payment of the amount due at the time that it is due. However the reason for this could be cash flow issues. It does not imply that the borrower is insolvent as he may be waiting for funds due to him to arrive. In terms of Liquidity risk the borrower may still be able to repay the loan at a later time.

Between them, Credit risk and Liquidity risk are the major business risks that banks face because they are the major part of the business of banking.

Over the last few years there has been a growing awareness that Operational risk is another source of danger to a bank. This was given “official” voice and form in the Basel Accords, where Operational Risk has been defined as “the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events”. Take note of this definition – it is very important.

Operational risk in terms of the Basel Accords has been subdivided into seven separate categories. We examine each of these categories and briefly explain what types of risks they cover.

• Internal Fraud. By and large this covers fraud by bank staff such as the stealing of assets, theft of client information, covering up errors, intentional mismarking of positions, bribery etc.
• External Fraud. This occurs where non-bank staff is involved such as in computer hacking, third-party theft, forgery.
• Employment Practices and Workplace Safety. Inequitable staff policies, workers compensation claims, employee health and safety issues.
• Clients, Products and Business Practice. This is a very wide field and generally covers market manipulation, antitrust issues, improper trading activities, bank product defects, fiduciary breaches, account churning. The sub-prime Mortgage debacle is a clear example of a product defect. The huge LIBOR rate rigging scandal which has dominated the news these past few years falls into this category as well.
• Damage to Physical Assets. This covers things like natural disasters, terrorism and vandalism – anything that results in actual damage or destruction of the bank’s physical assets. These actions may be deliberate or purely accidental.
• Business Disruption and Systems Failures. Power failures, computer software and hardware failures. A hurricane or a flood that results in banking services being disrupted also falls into this category.
• Execution, Delivery and Process Management. This covers things like data capture errors, accounting errors, failure to meet legal reporting requirement, negligent loss of client assets.

There are other risks too, such as legal, reputational, market – the list goes on. But that is another story.

The Connection between Big Banks and Systemic Risk

From GARP -

“Earlier this year, the European Central Bank published an interesting study on “bank bias.” This is the theory that the real economy is especially dependent on bank loans for their funding needs – as opposed to equity-based funding from capital markets.

European politicians, however, are trying to change this perceived over-reliance on bank funding with the upcoming Capital Markets Union.

The authors of the ECB study argue that bank bias increases systemic risk and decreases economic growth. The thinking behind this runs as follows: during a downturn in the economic cycle, asset prices and collateral values decline; consequently, banks need to adjust their balance sheets and deal with a heavier credit crunch – especially if they are highly leveraged. In this way, highly-leveraged banks amplify cyclical downturns.”

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Bloomberg outage highlights another bank weakness

From Reuters –
“Bloomberg’s global outage on Friday highlights yet another banking sector weakness. The financial data network’s downtime may have been a problem only for the richest fraction of the top 1 percent. But it prompted enough worry for the Bank of England to remind banks that it’s there as a lender of last resort, raising questions about traders’ heavy reliance on a few fallible systems.

There’s a frivolous side to the woes of Bloomberg LP, the private company whose terminals not only provide financial information and analytics to many in the financial sector but also function as the trading world’s most entrenched social network. The Wall Street Journal noted that bankers suddenly had to use telephones in the absence of Bloomberg’s messaging system, making trading floors noisier than usual. And Twitter revealed that denizens of the City of London, in the time zone most affected, were flocking to the enclave’s pubs.”

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Data Agency Warns of Next Potential Systemic Shock

From American Banker –

“The U.S. financial system may be on the verge of another systemic crash, according to a provocative new report issued this week by the Office of Financial Research.

The report posited that certain stock market conditions resemble the climate just before crises hit in 1929, 2000 and 2007. While some metrics like price-to-earnings ratio are within normal bounds, other indicators suggest that markets are overvalued and headed for a correction for which the financial system may not be adequately prepared.”

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Bank of England will provide a back-stop if a CCP collapses

From FTSE Global Markets

“In a speech given by David Bailey, director, Financial Market Infrastructure, Bank of England at the Deutsche Börse Group and Eurex Exchange of Ideas conference in London on Monday this week, he warns against the possibility that CCPs may accrue too much risk. However, he provides them with a ‘get out’ clause should a CCP collapse, saying that the central bank should offer a “final backstop; and to provide continuity to the CCP’s critical economic functions, whilst providing an orderly wind-down for any non-systemic operations”.

Bailey acknowledges that “the international community has made very significant and tangible progress to ensure that CCPs are being held to higher risk standards and regulatory expectations,” but argues that more must be done. In particular, he says that further progress is needed to ensure that recovery and resolution regimes are robust, “credible and well understood so that they can be used to successfully minimise the impact of a failing CCP on financial stability.”

Robust risk standards, implemented consistently across jurisdictions are “clearly essential to ensure that CCPs deliver the outcome that we, and the G20, expect of them. That is to safeguard the financial system through the effective management of counterparty credit risk. Internationally, the 2012 CPMI-IOSCO Principles for Financial Market Infrastructure, as implemented within the EU by EMIR, have represented a significant step forward, resulting in more rigorous expectations of CCPs across their business and including important areas such as counterparty, liquidity and operational risk management”.

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The pros and cons of a SWIFT response

From The Economist 


“Blocking rogue states’ access to the world’s financial-messaging network is a potent measure, but it carries long-term risks.

In 1973 global finance saw a back-room revolution when a group of banks formed a co-operative to offer those moving money across borders a slick alternative to the clunky old telex. Today the electronic financial-messaging system of the Society for Worldwide Interbank Financial Telecommunication (SWIFT) transmits more than 5 billion bank-to-bank messages each year. In 2013 it oiled the transfer of trillions of dollars globally by the 10,500 banks, asset managers and firms that are its members. SWIFT does not initiate transfers, hold customers’ money, or clear or settle payments. Rather, it provides a template that helps international transfers flow smoothly and be tracked.

Without SWIFT, global trade and investment would be slower, costlier and less reliable. But the network’s very usefulness means it is increasingly being cast in a new role, as a tool of international sanctions. In 2012 it was obliged, under European law, to cut off access for Iranian banks that had been subjected to sanctions by the European Union. Now there are calls for Russian banks to be banned from SWIFT in response to Russia’s invasion of Ukraine.”

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