CHAPTER 17 Technology and Other Operational Risks Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved

Overview  Factors affecting operational returns and risks  Importance of optimal management and control of labor, capital, and other input sources and their costs  Technology and its impact on risk and return  Examples: Risks resulting from innovations in IT and effects of terrorist attacks on key technologies Ch 17-2

Sources of Operational Risk  Technology  Employees  Customer relationships  Capital assets  External Ch 17-3

Technology & Profitability  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 Ch 17-4

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 Ch 17-5

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 Ch 17-6

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 Ch 17-7

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  Online customer-facing technologies  Cloud computing Ch 17-8

Impact on Retail Banking  Automated teller machines  Point-of-sale debit cards  Tablet banking  Preauthorized debits/credits  Mobile banking  Online banking Ch 17-9

Impact on Retail Banking  Smart cards  FI social media sites  Integration of online, offline, and mobile channels  Financial planning services  Instant ‘micro mobile loans’  Loyalty programs Ch 17-10

Effects of Technology on Revenues & Costs  Investments in technology are risky –Potentially negative NPV projects due to uncertainty and potential competitive responses –Service quality and convenience  Inability of ATMs to interact with customers as humans can  Example: Customers compare mortgage rates online, but only 2% close online  Virtual FIs operating branch offices ∙ Example: ING Direct Ch 17-11

Effects of Technology on Revenues & Costs  Evidence shows the impact of regulation on the 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 Ch 17-12

 Revenue effects: –Facilitates cross-marketing  Mixed success ∙ Example: Citigroup and insurance –Increases innovation Ch Effects of Technology on Revenues & Costs

Technology and Costs  For larger FIs the scale and array of potential technology investments is greater –Potential average cost advantage for larger FIs  Economies of scale  Potential elimination of smaller banks? –Technological investments are risky  Potential diseconomies of scale Ch 17-14

Economies of Scale in FIs Ch 17-15

Effects of Technological Improvement Ch 17-16

Effects on Costs (continued)  Economies of scope –Multiple outputs may provide synergies in production –FI size may affect potential gains and losses from IT investment  Diseconomies of scope –Specialization may have cost benefits in production and delivery of some FI services Ch 17-17

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) Ch 17-18

Empirical Findings  Evidence of 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  Potential long term gains from innovation –Cashless payments system? Ch 17-19

Technology and Evolution of the Payments System  Use of electronic transactions higher in other countries –Usage of checks rapidly becoming obsolete –Checks cleared using electronic funds transfer –E-money virtually non-existent in the US  Facilitates foreign currency transactions on the internet  Not FDIC insured Ch 17-20

U.S. Payments System –U.S. reluctance to abandon the use of checks –U.S. payments system –FedWire –Clearing House Interbank Payments System (CHIPS) –Combined value of transactions often more than $5 trillion per day Ch 17-21

Web Resources  For more information on the Clearing House Interbank Payments System, visit: CHIPS Ch 17-22

Wire Transfer System Risks  Daylight overdraft risk –FedWire settlement at 6:30 EST –Banks commonly ran daylight overdrafts  50 basis point interest rate introduced for daylight overdrafts –Regulation J guarantees payment finality of wire transfer messages by the Fed  Fed bears the risk –Regulation F sets exposure limits to individual correspondent banks Ch 17-23

Risks (continued)  International Technology Transfer Risk  Crime and Fraud Risk –Fraud risk, especially from FI employees –Riggs National Bank transactions with Saudis –Costs of complying with Patriot Act Ch 17-24

Risks (continued)  Regulatory Risk –Technology facilitates avoidance of regulation by locating in least regulated state or country  Citigroup credit card operations in South Dakota  South Dakota and Delaware liberal in terms of usury ceilings and other regulatory controls  Cayman Islands Ch 17-25

Risks (continued)  Tax Avoidance –Internal pricing mechanisms to shift profits to low tax regimes –UBS AG: the Hong Kong connection  Competition Risk: nonfinancial firms –GMs credit card operation –AT&T –Industrial loan corporations (ILCs)  Technology allows locating in Utah where regulation is more favorable  Requirement to register ILCs as bank holding companies, 2009 Ch 17-26

Other Operational Risks  Employees –Turnover –Key personnel –Fraud –Errors –Rogue trading –Money laundering –Confidentiality breach  Example: Theft of code by ex-Goldman programmer –Revelation of ethical problems via exchanges Ch 17-27

Technology Risks  Programming error  Model risk  Mark-to-market error  Management information  IT/Telecommunications systems outage  Technology provider failure  Contingency planning Ch 17-28

Customer Relationship Risks  Contractual disagreement  Dissatisfaction from poorly performing technology  Default Ch 17-29

Capital Asset Risk  Safety  Security  Operating costs  Fire/flood Ch 17-30

External Risks  External fraud  Taxation risk  Legal risk  War  Market collapse  Reputation risk  Relationship risk Ch 17-31

Controlling Operational Risk  Loss prevention: –Training, development, review of employees  Loss control: –Planning, organization, back-up  Loss financing: –External insurance  Loss insulation: –FI capital Ch 17-32

Regulatory Issues  1999 Basel Committee on Banking Supervision noted the importance of operational risks  Follow up report Required capital: –Basic Indicator Approach –Standardized Approach –Advanced Measurement Approach  Consumer protection issues Ch 17-33

Other Concerns  Efforts to expand consumer acceptance of web-based services frustrated by scams –Identity theft concerns  Vulnerability of online credit card usage Ch 17-34

Pertinent Websites BIS The Clearing House FDIC International Swap and Derivatives Association The Wall Street Journal Ch 17-35