Managing Operational Risk Within Your Treasury Environment

Managing Operational Risk Within Your Treasury Environment

AGENDA

• General points• Impact of modern risk transfer • Proven techniques to control and assess

operational risk• Objective approach to managing operational

risk• Exploiting operational VaR

Why is Operational Risk a hot topic?

It is still the risk responsible for the most spectacular bank failures

• Barings – Index futures

• Natwest – Incorrect volatilities used to value cap portfolio

• AIB – Forex trading

What do they have in common?

• Treasury activities

• Failure is mostly due to operational risk

“Operational risk is the risk of direct or indirect loss resulting

from inadequate or failed internal processes, people and

systems or from external events”

Operational Risk – What is it?

Basel Definition

Where does Operational Risk occur?

Derivatives Desk Transaction

BeforeIdentify client

need

RiskIntellectual Capital

Key People

DuringStructure

Transaction

RiskModel Risk

Disclosure

Legal

AfterDeliver Product

RiskModel Risk

Business Continuity

Reputational Fraud, Processes

People, Technology

AGENDA

• General points• Impact of modern risk transfer • Proven techniques to control and assess



The Trend

.

• Moving from prevention to active management

• Tools and technology exist to transfer unwanted risks to other counterparties– Interest rate derivatives– Credit derivatives– Innovative insurance products using derivatives

Implications

.

Risks are intertwined

If the primary objective is to take and manage market risk

• Incur credit risk (counterparty risk)

• Incur operational risk (model risk, fraud etc.)

Why does the use of derivatives or structured products increase the operational risk of my business?

.

• Characteristics of these OTC products are described legal documents/contracts

• Pay-off may be linked to external events– Share prices, Bond Prices– Default of a third party

• Complex mathematical models are needed to value these instruments

• Skilled people for Administration and Risk management• Appropriate IT solutions end-to-end is scarce

AGENDA

• General points• Impact of modern risk transfer techniques• Proven techniques to control and assess



Proven techniques for control and assess Operational Risk – Within the Company

.

• Internal audit– Ensures the quality of risk processes

– Ensures compliance with internal policies & procedures

• Compliance– Ensures compliance of risk processes with external stakeholders such

as regulators

• Straight -Through – Processing

• Adequately skilled staff

Proven techniques for control and assess Operational Risk - External

.

• Securities Exchanges– Custody systems– Electronic trading systems

• Settlement Systems

AGENDA




Objective measures for all risks

To understand what a business’ most significant risks are, all exposures must be expressed in common terms, e.g., in Rands.

What’s my largestexposure?

Fraud

Legal Risk

Model Risk

Concept of Value-at-Risk

An estimate of the level of loss on a portfolio, which is expected to be equalled or exceeded with a given, small probability.

– Measured in monetary terms

– Specific Time horizon

– Given level of confidence (99%)

.

What is Operational VaR?

ILLUSTRATIVE

Mean

Distribution of losses for the bank

UnexpectedLosses(VaR)

ExpectedLosses

(included in costs)

Annual aggregate loss (R)

Operational Value at Risk (VaR) is the difference between the annual aggregate loss at a selected confidence level and the expected annual loss.

Measure losses from operational risk events in terms of six components, which include first and second order losses.

Regulatory

Legal Total Operational

Loss

Business Interruption

Reputation

Business

Replacement Cost

directlosses

forgoneincome

Categorisation of Operational Risk

Overview of the Statistical/Actuarial Approach

The statistical/actuarial approach is based on the theory that historical data can be used to measure the full range of potential exposures each business faces.

Frequency of events Mapping

quality of control

environment to peer group

Adjusting for insurance programs

Mapping products / service to generic

business units

Severity of loss +5

-5

100

0

0 1 2 3 4 5

Insurancecontract

Operational VaR = f (Exposure, Relevance, Quality, Transfers)

Internal Loss Data

• Significant commercial benefits• Quantification of operational risk• Development of management processes.

• How do I transform the raw data to make it useable?• Convert to the bank’s currency,• Adjust for inflation

Loss Data Matrix

The loss data are placed in a matrix which is used to calculate the risk profile of each business, i.e., the inherent exposure of each business to each type of risk.

CriminalTransactionProcessing

Technology

Retail BankingNo. of lossesMeanSTD.

CommercialBanking

Trading

No. of lossesMeanSTD.

No. of lossesMeanSTD.

5423

Loss DataMatrix

ILLUSTRATIVE

2136

11 1.5

4

210.40.3

312.22.6

111.20.6

180.20.4

702.44.1

111.23.6

Severity

Severity is initially assumed to follow a Log-normal distribution (based on best-fit analysis of existing loss data). In order to calculate the severity distribution for a cell we need to know the mean and standard deviation (the parameters of the Log-normal distribution) of the losses in each cell.

ILLUSTRATIVE

Pro

bab

ilit

y

Size of Loss

Size of Loss

Pro

bab

ilit

y

Severity

In most cases internal data is incomplete. One can therefore use “anchor cells” - internal data cells that appear to have a sufficient number of small, medium and large losses and external data relationships to populate cells that do not have sufficient data.

ILLUSTRATIVE

Anchor cell

CriminalTransactionProcessing

Technology

Retail BankingNo. of lossMeanSTD.

Commercial Banking

Trading

No. of lossMeanSTD.

No. of lossMeanSTD.

111.23.6

111.20.6

0 210.40.3

10.20.4

11 1.5

4

32.22.6

0

5423

Internal Loss Data Matrix

To be populated byanchor cell(s) and

external data

Why use external loss data ?

SMALL LOSSES - MANY INTERNAL DATAPOINTS

MEDIUM LOSSES - SOME INTERNAL MEDIUM LOSSES - SOME INTERNAL DATAPOINTSDATAPOINTS

LARGE LOSSES - VERY FEW LARGE LOSSES - VERY FEW INTERNAL DATAPOINTSINTERNAL DATAPOINTS

Size of loss

Num

ber

of e

vent

s

External data is necessary here

ILLUSTRATIVE

Frequency

Frequency is assumed to follow a Poisson distribution. Mean frequency for each cell is calculated using a weighted average of internal and external data.

Internal business unit event countExternal business unit event countExternal all financial data event countExternal all data event count

Weighted (annual) average frequency

Criminal

14123422

1216

3.2

TransactionProcessing

11109312835

2.4

Technology

21214614

2327

5.2

Unauthorized Activities

23213424

1123

3.1

Sales Practices

21102211612

1.5

ILLUSTRATIVE

Retail Banking

The end result is a customized set of frequency and severity distributions for each business unit, for each risk category.

Pro

babili

ty

Retail BankingCriminalSeverity

Distribution

ILLUSTRATIVE

0 1 2 3 4 5

Size of loss (R)Number of events

Pro

babili

ty

Retail BankingCriminal

Frequency Distribution

Frequency

AGENDA




Operational VaR – Value Proposition

• Create objective measure – Expected Losses (Cost of operational failure)– Unexpected losses (Largest exposures)

• Provide framework for cost-benefit analysis• Link controls to performance measurement

– Quantifying Operational Risk Capital– Link to shareholder value

• Rationalise Insurance Programs

Trading & SalesTrading & SalesTrading & SalesTrading & SalesInvestment Banking

Asset ManagementRetail Banking

Private Banking

82%

18%Percent of

Firm CapitalRisk

Capital

FirstSecondThirdFourth

FirstSecondThirdFourth

UnauthorizedActivities

168161153145

UnauthorizedActivities

50607590

Sales Practices

168161153145

SalesPractices

50607590

Technology

33323029

Technology

50607590

Criminal

33323029

Criminal

50607590

ManagementProcesses

33323029

ManagementProcesses

50607590


33323029


50607590

Disasters106101

9691

Disasters

50607590

ILLUSTRATIVE

Unit NameVaR (‘000 $)

Unit NameQuality Score

0

100

200

300

400

500

600

700

800

1st Qtr 2nd Qtr 3rd Qtr 4th Qtr

Disasters

Ext. Environ.

Technology

Human

Sample Operational Risk Report

VaR ComparisonVaR is primarily driven by low frequency, high severity risks. Thus, some businesses which experience high annual losses may have a relatively low VaR.

Probability

Mean A Mean B

99th percentile B

99th percentile A

Distribution of losses for Business Unit A

Distribution of losses for Business Unit B

Annual aggregate loss ($)

VaR A

VaR B

ILLUSTRATIVE

Calculate the operational risk capital needed in RAROC processes.

Risk Adjusted Returns

Operational VaR

Pro

bab

ilit

y

Low

Medium

$10m R1billion

Capital for Unexpected LossesCredit RiskMarket RiskInsurance RiskOperational Risk

RAROC =

RAROC

Tool to help a business cost justify investments or risk transfers that will reduce operational risks.

VaR savings R36M

Hurdle Rate 15%

Annual benefit R5.4M

VaR cost savings Cost of New System over 5

years R27M > R18M

ILLUSTRATIVE

Trading and Sales Department considers purchasing a new state-of-the-art computer system for transaction processing.Cost = R18.0 million

Cost Benefit Analysis

Issue

Quality Score CurrentNew

EstimateNet

Change

Unauthorized Act. 62 67 5Sales Practices 64 66 2Human Resources 36 38 2Criminal 88 88 -Management Prs. 54 55 1Trans. Processing 44 53 9Disasters 67 68 1Technology 68 74 8External 75 75 -

Total Change = +28

Capital

VaR Estimate R378 R342 -R36

Cost Benefit Analysis

Cost Benefit AnalysisVaR savings R6.0M

Hurdle Rate 15%

Annual Benefit R 0.9M

VaR cost savings Cost of Insurance R0.9M > R 0.8M

Potential Loss

Pro

bab

ilit

y

Low

Medium

1billion

Potential Loss

Pro

bab

ilit

y

Low

Medium

R50m

Without Insurance

With Insurance

Whether to purchase a rogue trader insurance policy with excess of R50 million. Cost = R0.8million

Issue

ILLUSTRATIVE

R 1billion

50m 200m

Capital

VaR Estimate R80 R74 -R6

Insurance Analysis

The Challenge

Hazard

Compliance & Prevention

Operating Performance

Strategic Initiatives

Opportunity

Uncertainty /

Variance

A B C

pwc

Managing Operational Risk Within Your Treasury Environment

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Managing Operational Risk Within Your Treasury Environment