Operational Risk

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2 Operational Risk Management
🠶 “Operational risk is the risk of loss resulting from inadequate or
failed internal processes, people, and systems or from external
events.”

Causes of Operational Risk

• Internal fraud
• External fraud
• Employment practices and workplace safety
• Clients, products and business practices.
• Damage to physical assets.
• Business disruption and system failures
• Execution, delivery and process management
• Highly Automated Technology
• Emergence of E- Commerce
• Emergence of banks acting as very large volume service providers
• Outsourcing
• Large-scale acquisitions, mergers, demergers and consolidations
• Engagement in risk mitigation techniques giving rise to legal risk
 Contributors to Operational Risk
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🠶 People Risk
🠶 Process Risk
🠶 – Transaction Risk
🠶 – Documentation/contract risk.
🠶 – Operational Control Risk
🠶 – Model Risk Systems Risk
🠶 – Technology Risk
🠶 – MIS Risk.
🠶 Legal and Regulatory Risk
🠶 Event Risk
 Operational Risk Management Process
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🠶 Appropriate policies and procedures

🠶 Efforts to identify and measure operational risk
🠶 Effective monitoring and reporting
🠶 A sound system of internal controls
🠶 Appropriate testing and verification of the Operational
Risk Framework
5 Operational Risk Approaches

Minimum for all banks for leadings

Minimum for large banks Target

Basic Indicator Standardized Advanced

Based upon an Based upon Based upon Loss

institutional Business Line Distribution
Gross Income Gross Income Beta Approach. Scenarios or
Risk Drivers &
Alpha
Controls

But also requires adherence to a set of “Sound

Practices”
6 Operational Risk Approaches
7 Operational Risk Approaches
8 Recognizing/Assessing Risk Events
🠶 Experience - The event has occurred in the past
🠶 Judgment - Business logic suggests that it is a risk
🠶 Intuition - Events where appropriate measures saved the institution in the nick of
time
🠶 Linked Events - This event resulted in a loss resulting from other risk type (credit,
market etc.)
🠶 Regulatory requirement

Assessment
🠶 Self assessment
🠶 Risk mapping
🠶 Key Risk indicators
 Managing Operational Risk
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RCSA (Risk & Control Self Assessment) – Workflow
10 Assessing Potential Risk Areas

🠶 Staff related factors such as productivity, expertise, turnover

🠶 Extent of activity outsourced
🠶 Process clarity, complexity, changes
🠶 IT Indices
🠶 Audit Scores
🠶 Expected changes or spurts in volumes
11 Risk Management: Basis

🠶 Total number of risk events

🠶 Total financial reversals
🠶 Net financial impact
🠶 Exposure: Based on expected increase in volumes
🠶 Total number of customer claims paid out
🠶 IT indices: Uptime etc.
🠶 Office Accounts Status: such as changes in balances
12 Monitoring Operational Risk Management Issues
🠶 Operational loss events
🠶 Identification of appropriate indicators
🠶 Frequency of monitoring and reporting MIS

Business line identification

🠶 Corporate finance
🠶 Trading and sales
🠶 Retail banking
🠶 Commercial banking
🠶 Payment and settlement
🠶 Agency services
🠶 Asset management
🠶 Retail brokerage.
13 Operational Risk Management Data Needs

Data Collected
Data Types
🠶 Transactional
🠶 Loss Event Data
🠶 Operational/CRM
Analytical 🠶 Causal Data Loss Effect
🠶 Key Risk Indicators (KRIs)
🠶 Risk management
🠶 Proxies Risk Inventories
🠶 Economy/Industry
🠶 Structured Self Assessment Data
14 Operational Risk Management: Management Tasks

🠶 Decision whether control for risk minimization or bear Risk

mitigation tools as complementary to control Investment in
technology and Information security
🠶 Outsourcing policy-- development and adoption
🠶 Impact of operational break downs and loss--- intra and outside
bank
🠶 Business Continuity plans and testing
🠶 Review of Business Continuity plans
15 Organizational Set up

🠶 Board of Directors
🠶 Risk Management Committee of the Board
🠶 Operational Risk Management Committee
🠶 Operational Risk Management Department
🠶 Operational Risk Managers Support Group for operational risk
management
 Standard’s Based Approach to Operational
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Risk
◼ The COSO ERM Framework (Committee of Sponsoring Organizations)
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Problem
♦In an outpatient clinic, the number of cancellations is expected to
be 1.5 per day. What is the probability of 0, 1 and 2 cancellations
on a day?
♦λ = 1.5
In first case using the formula we have 1.5^0 * 2.71828^-1.5 / 0!
♦POISSON( 0,1.5,0) = .2231
♦POISSON( 1,1.5,0) = .3347
♦POISSON( 2,1.5,0) = .2510
18 Problem
♦A bank wants to expand its asset management operations.
The main concern in this business is operational risk.
The expected losses due to operational risk in one year
from the new venture are $ 2mn and the 99.7% VAR is $ 40
mn. The expected fees are $ 12 mn and the admin costs
are $ 3 mn per year. Estimate RAROC.
♦Expected loss = $ 2mn
♦Unexpected loss = $ (40 – 2) mn = $ 38 mn
♦Capital = $ 38 mn.

♦Return = (12 -3 – 2 )/38 = 7/38 = 0.184

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Problem

♦A bank with revenue of $ 1 bn incurs a loss of $ 100 mn due

to operational risk. What would be the loss for a bank with
revenue of $3 bn. Assume the scaling factor is .23.
♦Loss = 3.23 x 100 = $ 128.75 mn
 In Short
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21 BASEL Norms
What are Basel norms?
🠶 International banking regulations issued by the Basel Committee on Banking Supervision.
🠶 Goal of strengthening the international banking system.
🠶 Set of the agreement by the Basel committee of Banking Supervision

Basel Committee on Banking Supervision (BCBS)

🠶 Primary global standard setter for the prudential regulation of banks Established by the Central
Bank governors of the Group of Ten countries in 1974.
🠶 BCBS now has 45 members from 28 Jurisdictions.
🠶 Key objective: improve the quality of banking supervision worldwide.
 BASEL Norms
22 Why Basel norms?

🠶 Banks lend to different types of borrowers and each carries its own risk.
🠶 They lend the deposits of the public as well as money raised from the market i.e., equity and debt.
🠶 This exposes the bank to a variety of risks of default and as a result they fall at times.
🠶 Banks have to keep aside a certain percentage of capital as security against the risk of non – recovery.
🠶 The Basel committee has produced norms called Basel Norms for Banking to tackle this risk .
🠶 Recommended BASEL I, II, III norms

Why the name Basel?

🠶 Basel is a city in Switzerland.

🠶 It is the headquarters of the Bureau of International Settlement (BIS), which fosters cooperation among central banks
with a common goal of financial stability and common standards of banking regulations.
🠶 It was founded in 1930.
🠶 Basel Committee on Banking Supervision is housed in the BIS offices in Basel, Switzerland.
 BASEL Norms
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Basel -I

🠶 It was introduced in 1988.

🠶 It focused almost entirely on credit risk.
🠶 Credit risk is the possibility of a loss resulting from a borrower's failure to repay a loan or meet
contractual obligations.
🠶 Traditionally, it refers to the risk that a lender may not receive the owed principal and interest.
🠶 It defined capital and structure of risk weights for banks.
🠶 The minimum capital requirement was fixed at 8% of risk weighted assets (RWA).
🠶 RWA means assets with different risk profiles.
🠶 For example, an asset backed by collateral would carry lesser risks as compared to personal loans,
which have no collateral.
🠶 India adopted Basel-I guidelines in 1999.
 BASEL Norms
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Basel -II

🠶 In 2004, Basel II guidelines were published by BCBS.

🠶 These were the refined and reformed versions of Basel I accord.
🠶 The guidelines were based on three parameters, which the committee calls it as pillars.
🠶 Capital Adequacy Requirements: Banks should maintain a minimum capital adequacy requirement
of 8% of risk assets
🠶 Supervisory Review: According to this, banks were needed to develop and use better risk
management techniques in monitoring and managing all the three types of risks that a bank faces,
viz. credit, market and operational risks.
🠶 Market Discipline: This needs increased disclosure requirements. Banks need to mandatorily
disclose their CAR, risk exposure, etc. to the central bank.
🠶 Basel II norms in India and overseas are yet to be fully implemented though India follows these
norms
 BASEL Norms
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Basel –III

🠶 In 2010, Basel III guidelines were released.

🠶 These guidelines were introduced in response to the financial crisis of 2008.
🠶 A need was felt to further strengthen the system as banks in the developed economies were under-capitalized,
over-leveraged and had a greater reliance on short-term funding.
🠶 It was also felt that the quantity and quality of capital under Basel II were deemed insufficient to contain any
further risk.
🠶 Focus on four vital banking parameters viz. capital, leverage, funding and liquidity.

🠶 Capital: The capital adequacy ratio is to be maintained at 12.9%. The minimum Tier 1 capital ratio and the
minimum Tier 2 capital ratio have to be maintained at 10.5% and 2% of risk-weighted assets respectively.
🠶 In addition, banks have to maintain a capital conservation buffer of 2.5%. Counter-cyclical buffer is also to be
maintained at 0-2.5%.
🠶 Leverage: The leverage rate has to be at least 3 %. The leverage rate is the ratio of a bank’s tier-1 capital to
average total consolidated assets.
 BASEL Norms
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Tier I and Tier II Capital:

Banks have two main silos of capital that are qualitatively different from one another.
🠶 Tier 1: It refers to a bank's core capital, equity, and the disclosed reserves that appear on
the bank's financial statements.
🠶 In the event that a bank experiences significant losses, Tier 1 capital provides a cushion
that allows it to weather stress and maintain a continuity of operations.
🠶 Tier 2: It refers to a bank's supplementary capital, such as undisclosed reserves and
unsecured subordinated debt instruments that must have an original maturity of at least
five years.
🠶 Tier 2 capital is considered less reliable than Tier 1 capital because it is more difficult to
accurately calculate and more difficult to liquidate.
 BASEL Norms
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Funding & Liquidity
🠶 Basel-III created two liquidity ratios: LCR and NSFR.
🠶 The liquidity coverage ratio (LCR) will require banks to hold a buffer of high-quality
liquid assets sufficient to deal with the cash outflows encountered in an acute short term
stress scenario as specified by supervisors.
🠶 This is to prevent situations like “Bank Run”. The goal is to ensure that banks have
enough liquidity for a 30-days stress scenario if it were to happen.
🠶 The Net Stable Funds Rate (NSFR) requires banks to maintain a stable funding profile in
relation to their off-balance-sheet assets and activities. NSFR requires banks to fund their
activities with stable sources of finance (reliable over the one-year horizon).
🠶 The minimum NSFR requirement is 100%. Therefore, LCR measures short-term (30 days)
resilience, and NSFR measures medium-term (1 year) resilience.
🠶 The deadline for the implementation of Basel-III was March 2019 in India. It was
postponed to March 2020 and further to January 2023 due to corona virus pandemic
 BASEL Norms
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Bank Run & CCCB

🠶 Bank run
🠶 It occurs when a large number of customers of a bank or other financial institution withdraw their deposits
simultaneously over concerns of the bank's solvency.
🠶 As more people withdraw their funds, the probability of default increases, prompting more people to withdraw
their deposits.
🠶 Countercyclical capital buffer (CCCB)
🠶 Following Basel-III norms, central banks specify certain capital adequacy norms for banks in a country. The
CCCB is a part of such norms and is calculated as a fixed percentage of a bank’s risk-weighted loan book.
🠶 Helps a bank to counteract the effect of a downturn or distressed economic conditions.
🠶 With the CCCB, banks are required to set aside a higher portion of their capital during good times when loans are
growing rapidly, so that the capital can be released and used during bad times, when there’s distress in the
economy.
🠶 Although the RBI had proposed the CCCB for Indian banks in 2015 as part of its Basel-III requirements, it hasn’t
actually required the CCCB to be maintained, keeping the ratio at zero percent ever since.