Chapter 13 Technology and Other Operational Risks

13-2 Overview This chapter explores how the complex nature of modern FIs creates operational risk. We identify the sources of operational risk. We learn about how technology has impacted on FIs’ profitability and their ability to deliver services. We learn how to determine the financial benefits and risks of new technologies. We discuss how bank regulation attempts to address operational risk issues in FIs. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-3 What are the Sources of Operational Risk? Technology Employees Customer relationships Capital assets External (e.g. external fraud). Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-4 Technological Innovation and Profitability Technology = Computers, audio and visual communication systems and other IT. Efficient technology base can result in: –Lower cost –Increased revenues. Profit before tax = (Interest income – Interest expense) + (Other income – Non-interest expense) – Provision for loan losses Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-5 Technological Innovation and Profitability Technology can directly improve profitability: –Increase in interest income through sales of a larger range of financial services due to technological developments. –Reduction in interest expenses through direct access to liquid markets due to technological developments. –Increase in other income if fees are linked to the quality of technology. –Reduction of non-interest expenses in case of computer-based rather than paper-based collection and storage of customer information. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-6 The Impact of Technology on Wholesale Financial Service Production Wholesale Financial Services: Cash management or working capital services. Largely resulted from: –Corporate recognition of costs associated with excess cash balances, –Corporate need to know cash capital position on a real- time basis. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-7 The Impact of Technology on Wholesale Financial Service Production Wholesale Financial Services provided by FIs: Controlled disbursement activities, Account reconciliation, Wholesale lockbox, Electronic lockbox, Funds concentration, Electronic funds transfer, Cheque deposit services, Electronic initiation of letters of credit, Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-8 The Impact of Technology on Wholesale Financial Service Production Wholesale Financial Services provided by FIs (cont): Treasury management software, Electronic data interchange, Facilitating business-to-business commerce, Electronic billing, Verifying identities, Assisting small business entries into e-commerce. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-9 The Impact of Technology on Retail Financial Service Production Demand for efficiency and flexibility. Retail Financial Services provided by FIs: Automated Teller Machines (ATMs), Electronic Funds Transfer at Point Of Sale (EFTPOS) debit cards, Home banking, Preauthorised debits/credits, Telephone banking, billing, Online banking, Smart cards (stored-value cards). Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-10 The Effect of Technology on Revenues and Costs Retail and wholesale financial services provide potential for higher revenues. Problem – product innovation may fail to attract sufficient business: –Risk of negative net present value projects. –Uncertain revenues and/or costs. –Copying of product innovation by competitors. –Agency conflicts. Losses on technology have the potential to weaken an FI’s financial position. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-11 Technology and Revenues Revenue effects: Facilitates cross-marketing, Increases innovation, Service quality and convenience effects, Survival of small banks and value of ‘human touch’. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-12 Technology and Costs Cost effects: Economies of Scale: optimal size depends on shape of average cost curve. Where: AC i = average costs of the ith FI, TC i = total costs of the ith FI, S i = size of the FI measured by assets, deposits or loans. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-13 Technology and Costs Cost effects – Economies of Scale: Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-14 Technology and Costs Cost effects – Diseconomies of Scale: An increase in an FI’s average costs of production as output increases. Implication: small FIs are more cost efficient than large FIs. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-15 Technology and Costs Economies of Scope: An FI’s ability to generate synergistic cost savings through joint use of inputs in producing multiple outputs. I.e.: Results in: Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-16 Technology and Costs Economies of Scope – Exercise: A commercial bank has total costs of producing lending services of $120,000 for a loan volume of $25,000,000. A specialised investment bank is selling commercial paper for the same customer, with total costs of $12,000 for a $1,500,000 issue. a. What is the average cost for the commercial bank? b. What is the average cost for the investment bank? c. What is the total average cost? Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-17 Technology and Costs Economies of Scope – Solution to Exercise: a. What is the average cost for the commercial bank? $120,000 / $25,000,000 = 0.48%. b. What is the average cost for the investment bank? $12,000 / $1,500,000 = 0.80%. c. What is the total average cost? ($120,000 + $12,000) / ($25,000,000 + $1,500,000) = $132,000 / $26,500,000 = 0.50%. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-18 Technology and Costs Economies of Scope – Expanded Exercise: Reconsider the example of the commercial and investment banks. Assume that the commercial bank is able to provide both services to the customer. This should enable the bank to reduce the total cost of both services to $125,000. We find that the new average costs are: $125,000 / $26,500,000 = 0.47% 0.47% < 0.50% Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-19 Technology and Costs Diseconomies of Scope: The costs of joint production of FI services exceed the costs of independent production. AC FS > TAC May occur if highly specialised technology in one area proves to be inefficient for other areas. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-20 Testing for Economies of Scale and Economies of Scope The Production Approach: C = f(y,w,r) Where: w = wage costs of labour, y = output of services, r = rental costs of capital, C = total cost function for the FI. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-21 Testing for Economies of Scale and Economies of Scope The Intermediation Approach: C = f(y,w,r,k) Where: w = wage costs of labour, y = output of services, r = rental costs of capital, k = cost of funds for the FI, C = total cost function for the FI. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-22 Empirical Findings on Cost Economies of Scale and Scope, X-inefficiencies and Implications There is evidence of economies of scale for banks up to the $10–$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. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-23 Technology and the Payments System Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-24 Technology and the Payments System Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-25 Technology and the Payments System Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-26 Technology and the Payments System Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-27 Risks that Arise in An Electronic Transfer Payment System RTGS and Daylight Overdraft Risk: Major risk: failure of banks to settle their obligations with other financial system participants. Risk minimised through: –Exchange settlement accounts (ESAs), –Real-time gross settlement (RTGS). ESAs and RTGS allow early identification of risks. Greatest source of instability arises from daylight overdraft risks. Daylight overdraft means that a bank’s reserve account at the RBA becomes negative within the banking day. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-28 Risks that Arise in An Electronic Transfer Payment System Other risks include: Crime and Fraud Risk: –Specialised knowledge of PINs, –Opportunities for white-collar crime. Regulatory Risk: –Usury ceilings place caps and controls on fees and interest rates that many FIs can charge on financial services. Competition Risk: –Increased competition with non-traditional financial service providers. –Examples: RAMS, Aussie Home Loans, AMEX, General Electric. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-29 Other Operational Risks Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-30 Other Operational Risks Efforts to prevent, control, finance and insulate FIs from losses caused by operational risks: Loss prevention: Training, development and review of employees. Loss control: Planning, organisation and back-up. Loss financing: External insurance. Loss insulation: Use of bank capital. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-31 Other Operational Risks Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-32 Regulatory Issues and Technology and Operational Risks Operational Risk and FI Solvency: Research estimates that FIs have lost over $200 billion due to operational risk since Call for regulatory reform initiated by the Basel Committee on Banking Supervision in Basel Committee’s consultative document issued in 2001 demands explicit capital charge against operational risk exposures in FIs. Three methods: –Basic Indicator Approach, –Standardised Approach, –Internal Measurement Approach. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-33 Regulatory Issues and Technology and Operational Risks For information on regulatory approaches to operational risk, see: APRA: BIS: (under heading: Basel Committee on Banking Supervision). Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

13-34 Regulatory Issues and Technology and Operational Risks Consumer Protection: According to KPMG (2000), consumers are uncomfortable with providing personal details on internet: –Worries about who has access to information, –Worries about how the information will be used. Internet transactions involve ‘open’ systems and are thus susceptible to interception and fraud. Cryptographic techniques ensure safety for consumer transactions. Regulators are yet to address consumer protection needs arising from increased use of technology. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher