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By: A V Vedpuriswar
October 4, 2009
Introduction
Globalization and deregulation of financial markets,combined with increased sophistication in financial technology, have made banking activities very complex. Events such as the September 11 terrorist attacks, rogue trading losses at Barings and the Y2K scare serve to highlight the importance of operational risk management. Operational risks faced by banks today include fraud, system failures, terrorism and employee compensation claims.
Front Office
The more client-facing side of the business is known as the front office. These personnel typically include: sales people who act as the main contact point between the bank and its clients. traders/market makers, who are responsible for executing trades with various counterparties.
Middle Office
Back Office
In performing its role, the operations area has a major responsibility to control operations risk.
The back office should quickly detect errors and bring to the attention of dealers and management. Some key responsibilities of back office employees include: capturing trade details in the settlement system validating trade details issuing settlement instructions ensuring that the trades settle on the value date making payments by electronic transfer mechanisms
The moment the details of a trade are captured within the settlement system, the trading position for both securities and cash, at a trading book level, must be updated.
Trade skeleton
The typical trade information fed by a trading system and captured by the settlement system could be described as the trade skeleton.
These are the minimum details a trader or market maker must provide as these items are variable and cannot be guessed by the settlement department.
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Recording details
Though the basic details of a trade may appear very clear-cut, the inaccurate recording of the details can lead to unnecessary costs being incurred and risks being taken by the STO. In an attempt to prevent inaccurate information being sent to the outside world, the process of validating trade information is adopted by many banks.
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Trade agreement/validation
Failure of the bank and its counterparty to agree about the details of the trade, can result in monetary losses if the discrepancy remains unresolved at the value date.
Consequently, it has become standard practice in many markets to strive for trade agreement as soon as possible after trade execution.
In many securities marketplaces, individual trade details must be sent to the regulator by a specified deadline.
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The buyer is not required to pay cash until the seller delivers the securities.
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Free of Payment
The alternative to settling a DvP basis is to settle on a Free of Payment (FoP) basis. Parties will need to arrange delivery of securities or payment of cash prior to taking possession of the other asset. Due to the risks involved, most STOs avoid settling in this manner, whenever possible.
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Settlement Department
The STO must issue a settlement instruction to its custodian in order for settlement to occur. All pending incomes against securities must be carefully monitored. The first step in collection of the benefit is to become aware that the issuer is making a specific income payment. The bank must calculate whether it is in fact entitled to the income. If so, it must assess who will remit the income and monitor the receivable amount until full payment is received.
Where it offers a safe custody service to clients, the STO is expected to collect income on behalf of its clients.
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Static data
Static data (sometimes referred to as standing data) describes data that changes occasionally, or not at all. The two principal components are: Securities static data Counterparty static data. The data must be carefully maintained. If for instance, the coupon rate on a bond is not set up correctly, incorrect trade cash values will result.
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Static Data
Likewise, the setting up of an incorrect counterparty postal address could result in a client failing to receive a trade confirmation.
Books and records must be accurate, up-to-date, complete and reflect reality.
Reconciliation is achieved through the comparison of specific pieces of information within the banks books and records, and between the banks books and records and the outside world.
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Compliance
The compliance officers within a bank are responsible for ensuring conformity to the various rules and regulations, as laid down by the local regulatory authority.
reporting of trade and positional information to the regulatory authorities is complete and effected within the stated deadlines;
methods of investigating trade disputes between the STO and its counterparties are carried out in a thorough and correct manner;
measures are taken to prevent unlawful activities within the STO, such as insider trading
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Settlement failures
Insufficient securities Insufficient cash
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Definition
The Basel Committee defines operational risk as: "The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events." This definition includes legal risk, but excludes strategic and reputational risk.
Banks can adopt their own definitions of operational risk, if the minimum elements in the Committee's definition are included.
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Internal Fraud
Intentional misreporting of positions Unauthorized undertaking of transactions Deliberate mismarking of positions Insider trading (on an employee's own account) Malicious destruction of assets
Theft/robbery/extortion/embezzlement
Bribes/kickbacks Forgery Willful tax evasion
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External Fraud
Theft/robbery Forgery
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General liability
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Antitrust
Money laundering Product defects
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Vandalism
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Utility outages/disruptions
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Model/system misoperation
Accounting errors Mandatory reporting failures Missing or incomplete legal documentation Unapproved access given to client accounts
Qualitative assessment
Environment Activities
Supervision
Disclosure
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Risk Assessment
Checklists Questionnaires
Workshops
Scorecards
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Some indicators are applicable to specific organizational units (for example, transaction volumes and processing errors).
Others can be applied across the entire bank (for example, employee turnover, new hires and number of sick days). In practice, the most common risk indicators are lagging or ex-post measures.
They provide information on events that have already taken place (eg, failed trades, settlement errors, and so on).
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In reality, however, it is not easy to transform lagging indicators into predictive indicators.
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Statistical Approaches
Statistical approaches to operational risk measurement generally involve the use of methodologies to quantify operational risk . The approaches involve the collection of actual loss data and the derivation of an empirical statistical distribution. An unexpected loss amount, against which banks must hold a capital buffer, can then be calculated from the distribution. In theory, the unexpected loss can be calculated to any desired target confidence level.
In practice, many banks are working towards measuring operational risk to a 99.9% confidence level.
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Legal risk
The Basel Committee's definition of operational risk explicitly includes legal risk. Legal risk is the risk of disruption or adverse impact on the operations or condition of a bank due to:
unenforceable contracts lawsuits
adverse judgments
other legal proceedings
It can arise due to a variety of issues, from broad legal or jurisdictional issues to something as simple as a missing provision in an otherwise valid agreement.
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Master Agreements
There are now master agreement forms for many financial products.
These agreements:
create a common legal framework that can be understood by all market participants. cover most of the major legal points that should be agreed as part of documenting the transactions.
Individual transactions are tied to master agreements with confirmation documents containing specific terms of each transaction.
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The master agreements should ideally be negotiated prior to any individual transaction being agreed.
But, in many cases, the master agreement is only negotiated as a consequence of the first transaction. Master agreements cover how the parties will conduct themselves in case of the early termination of the contractual agreements due to credit default or other unforeseen events.
The agreements specify how the exposures for more than one transaction under the master agreement will be netted against each other.
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Reputation risk
Reputation Risk
Negative public opinion regarding an institution's practices, whether true or not, may result in a decline in its customer base, expensive litigation and/or a fall in revenue. Reputational risk may cause liquidity difficulties, fall in share price and a significant reduction in market capitalization. In 1994, Bankers Trust was accused of having misled customers by selling them inappropriate derivatives positions. Its reputation was so badly damaged that it was forced into acquisition.
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Strategic Risk
Strategic(Business) Risk
It incorporates the risk arising from an adverse shift in the assumptions, goals and other features that underpin a strategy. Business Risk is a function of:
a bank's strategic goals the business strategies developed to achieve these goals the resources deployed in pursuit of these goals the quality of implementation of these resources
Business risk, however, is difficult to assess in practice. It can be particularly difficult to separate from other forms of risk, such as market risk.
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Model Risk
Model Risk
Model risk arises out of the failure of a model to sufficiently match reality, or to otherwise deliver the required results.
It can arise from a number of issues, including:
mathematical errors (for example, in determining the formulas for valuing more complex financial instruments) the lack of transparent market prices for some of the more illiquid market factors invalid assumptions inappropriate parameter specification incorrect programming
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Very large and unexpected moves may occur in market factors sometimes in conjunction with each other.
Liquidity can suddenly vanish.
Being based on assumptions, models are always a simplified representation of what happens under real-life conditions.
If these assumptions break down, then the model is worthless.
Therefore, modeling for disaster as well as for normal market conditions is highly desirable.
This is why stress testing is important in addition to value at risk calculations.
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