Technology and Other Operational Risks Chapter 16 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin

16-2 Overview  This chapter discusses the factors affecting operational returns and risks, and the importance of optimal management and control of labor, capital, and other input sources and their costs. The emphasis is on technology and its impact on risk and return.  Examples: Risks resulting from innovations in IT, and effects of terrorist attacks on key technologies.

16-3 Sources of Operational Risk  Technology  Employees  Customer relationships  Capital assets  External

16-4 Importance of Technology  Efficient technological base can result in: Lower costs  Through improved allocation of inputs. Increased revenues  Through wider range of outputs. Earnings before taxes = (Interest income - Interest expense) + (Other income - Noninterest expense) - Provision for loan losses

16-5 Impact of Technology  Interest income can be increased Through wider array of outputs or cross selling.  Interest expense can be decreased Through improved access to markets for liabilities  Fedwire, CHIPS

16-6 Impact of Technology  Other income can be increased Through electronic handling of fee generating OBS activities such as LCs and derivatives  Noninterest expenses can be reduced Through improved efficiency of back office operations using technology.  Especially true for securities-related activities.

16-7 Impact on Wholesale Banking Improvements to cash management:  Controlled disbursement accounts  Account reconciliation  Wholesale lockbox  Electronic lockbox  Funds concentration  Electronic funds transfer  Check deposit services  Electronic initiation of letters of credit

16-8 Impact on Wholesale Banking (continued)  Treasury management software  Electronic data interchange  Facilitating B2B e-commerce  Electronic billing  Verifying identities Issue of law enforcement access to encrypted data since September 11, 2001  Assisting small business entry into e- commerce

16-9 Impact on Retail Banking  Automated teller machines  Point-of-sale debit cards  Home banking  Preauthorized debits/credits  Pay-by-phone  billing  Online banking  Smart cards

16-10 Effects of Technology on Revenues & Costs  Investments in technology are risky Potentially negative NPV projects due to uncertainty and potential competitive responses Potential agency conflicts:  Growth-oriented investments may not maximize shareholder’s value  Losses on technological investments can weaken an FI

16-11 Effects of Technology on Revenues & Costs  Evidence shows the impact of regulation on value of technological innovations. Branching restrictions in U.S. affect the value of cash management services, for example. Less valuable in Europe where comparable restrictions are absent

16-12 Effects of Technology on Revenues and Costs  Revenue effects: Facilitates cross-marketing Increases innovation Service quality effects  Survival of small banks and value of “human touch”  Consumer reluctance to apply for mortgage on the web  Cost effects: Technological improvements  Shift in cost curve.

16-13 Effects on Costs (continued)  Economies of scale Optimal size depends on shape of average cost curve. AC Size AC Size

16-14 Effects on Costs (continued)  Economies of scope Multiple outputs may provide synergies in production.  Diseconomies of scope Specialization may have cost benefits in production and delivery of some FI services

16-15 Testing for Economies of Scale and Scope  Production approach: Views FI as producing output of services using inputs of labor and capital. C = f(y,w,r)  Intermediation Approach: Includes funds used to produce intermediated services among the inputs. C = f(y,w,r, k)

16-16 Empirical Findings  Evidence economies of scale for banks up to the $10 billion to $25 billion range.  X-inefficiencies may be more important.  Inconclusive evidence on scope.  Recent studies using a profit-based approach find that large FIs tend to be more efficient in revenue generation.

16-17 Technology and Evolution of the Payments System  Use of electronic transactions higher in other countries. Usage of checks obsolete (or rapidly becoming obsolete) outside U.S.  U.S. Payments system: FedWire Clearing House Interbank Payments System (CHIPS) Combined value of transactions often more than $3.5 trillion per day.

16-18 Web Resources  For information on the Clearing House Interbank Payments System, visit:  CHIPS:

16-19 Wire Transfer System Risks  Daylight overdraft risk FedWire settlement at 6:30 EST Regulation J guarantees payment finality of wire transfer messages by the Fed Regulation F sets exposure limits to individual correspondent banks.

16-20 Risks (continued)  International Technology Transfer Risk  Crime and Fraud Risk Fraud risk, especially from FI employees increased ABN Amro $80 million fine Costs of complying with Patriot Act  Regulatory Risk Technology facilitates avoidance of regulation by locating in least regulated state or country.  Tax Avoidance  Competition Risk from nonfinancial firms

16-21 Other Operational Risks  Employees Turnover Key personnel Fraud Errors Rogue trading (Barings, Allied Irish/Allfirst) Money laundering Confidentiality breach  Revelation of ethical problems via exchanges

16-22 Technology Risks  Programming error  Model risk  Mark-to-market error  Management information  IT/Telecomm systems outage  Technology provider failure  Contingency planning

16-23 Customer Relationship Risks  Contractual disagreement  Dissatisfaction from poorly performing technology  Default

16-24 Capital Asset Risk  Safety  Security  Operating costs  Fire/flood

16-25 External risks  External fraud  Taxation risk  Legal risk  War  Market collapse  Reputation risk  Relationship risk

16-26 Controlling Operational Risk  Loss prevention: Training, development, review of employees  Loss control: Planning, organization, back-up  Loss financing: External insurance  Loss insulation: FI capital

16-27 Optimal Risk Management Cost RME Cost of problems Cost of risk management Total cost

16-28 Regulatory Issues  1999 Basel Committee on Banking Supervision noted the importance of operational risks  Follow up report Required capital: Basic Indicator Approach Standardized Approach Internal Measurement Approach  Consumer protection issues

16-29 Other Concerns  Efforts to expand consumer acceptance of web-based services frustrated by scams Phishing “Spoofing” messages purported to be from FIs Identity theft concerns  Vulnerability of online credit card usage

16-30 Pertinent Websites American Banker BIS CHIPS FDIC International Swap and Derivatives Association The Wall Street Journal