©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin Chapter Technology and Other Operational Risks

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 14-2 Overview u 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. u Examples: Risks resulting from innovations in IT, and effects of terrorist attacks on key technologies.

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 14-3 Sources of Operational Risk u Technology u Employees u Customer relationships u Capital assets u External

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 14-4 Importance of Technology u 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

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 14-5 Impact of Technology u Interest income can be increased Through wider array of outputs or cross selling. u Interest expense can be decreased Through improved access to markets for liabilities »Fedwire, CHIPS

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 14-6 Impact of Technology u Other income can be increased Through electronic handling of fee generating OBS activities such as LCs and derivatives u Noninterest expenses can be reduced Through improved efficiency of back office operations using technology. Especially true for securities-related activities.

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 14-7 Impact on Wholesale Banking u Improvements to cash management Controlled disbursement accounts Account reconciliation Wholesale lockbox Electronic lockbox Funds concentration

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 14-8 Impact on Wholesale Banking (continued) u Electronic funds transfer u Check deposit services u Electronic initiation of letters of credit u Treasury management software u Electronic data interchange u Facilitating B2B e-commerce u Electronic billing

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin 14-9 Impact on Wholesale Banking (continued) u Verifying identities Issue of law enforcement access to encrypted data since September 11, 2001 u Assisting small business entry into e-commerce

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin Impact on Retail Banking u Automated teller machines u Point-of-sale debit cards u Home banking u Preauthorized debits/credits u Pay-by-phone u billing u Online banking u Smart cards

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin Effects of Technology on Revenues and Costs u 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

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin Effects of Technology on Revenues and Costs u 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

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin Effects of Technology on Revenues and Costs u Revenue effects: Facilitates cross-marketing Increases innovation Service quality effects »Survival of small banks and value of “human touch” u Cost effects: Technological improvements »Shift in cost curve.

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin Effects on Costs (continued) u Economies of scale Optimal size depends on shape of average cost curve. AC Size AC Size

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin Effects on Costs (continued) u Economies of scope Multiple outputs may provide synergies in production. u Diseconomies of scope Specialization may have cost benefits in production and delivery of some FI services

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin Testing for Economies of Scale and Scope u Production approach: Views FI as producing output of services using inputs of labor and capital. C = f(y,w,r) u Intermediation Approach: Includes funds used to produce intermediated services among the inputs. C = f(y,w,r, k)

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin Empirical Findings u Evidence economies of scale for banks up to the $10 billion to $25 billion range. u X-inefficiencies may be more important. u Inconclusive evidence on scope. u Recent studies using a profit-based approach find that large FIs tend to be more efficient in revenue generation.

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin Technology and Evolution of the Payments System u Use of electronic transactions higher in other countries. (E.g., TARGET). u U.S. Payments system: FedWire Clearing House Interbank Payments System (CHIPS) Combined value of transactions often more than $2.7 trillion per day.

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin Web Resources u For information on the Clearing House Interbank Payments System, visit: CHIPS: Web Surf

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin Wire Transfer System Risks u Daylight overdraft risk FedWire settlement at 6:30 EST Example of magnitude of daylight overdraft risk: Bank of New York (BONY) Regulation J guarantees payment finality of wire transfer messages by the Fed Regulation F sets exposure limits to individual correspondent banks.

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin Risks (continued) u International Technology Transfer Risk u Crime and Fraud Risk u Regulatory Risk Technology facilitates avoidance of regulation by locating in least regulated state or country. u Tax Avoidance u Competition Risk

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin Other Operational Risks u Employees Turnover Key personnel Fraud Errors Rogue trading (Barings, Allied Irish/Allfirst) Money laundering Confidentiality breach

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin Technology Risks u Programming error u Model risk u Mark-to-market error u Management information u IT/Telecomm systems outage u Technology provider failure u Contingency planning

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin Customer Relationship Risks u Contractual disagreement u Dissatisfaction from poorly performing technology u Default

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin Capital Asset Risk u Safety u Security u Operating costs u Fire/flood

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin External risks u External fraud u Taxation risk u Legal risk u War u Market collapse u Reputation risk u Relationship risk

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin Controlling Operational Risk u Loss prevention: Training, development, review of employees u Loss control: Planning, organization, back-up u Loss financing: External insurance u Loss insulation: FI capital

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin Optimal Risk Management Cost RME

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin Regulatory Issues u 1999 Basel Committee on Banking Supervision noted the importance of operational risks u Required capital: Basic Indicator Approach Standardized Approach Internal Measurement Approach u Consumer protection issues

©2003 McGraw-Hill Companies Inc. All rights reserved Slides by Kenneth StantonMcGraw Hill / Irwin Pertinent Websites u For more information visit: American Banker BIS FDIC Mortgage Bankers Assoc. Federal Reserve Bank The Economist The Wall Street Journal CHIPS Web Surf