CHAPTER 16 Technology and Other Operational Risks Copyright © 2011 by The McGraw-Hill Companies, Inc. All Rights Reserved.McGraw-Hill/Irwin

Introduction  Financial risk is only one part of a modern FI’s risk profile.  FI’s have a real/production side to their operations that results in additional costs and revenues.  This chapter discusses the factors –That impact operational returns and risks, and also –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.  Technology is not just a new distribution channel but a different way of providing financial services.  Examples: Risks resulting from innovations in IT and effects of terrorist attacks on key technologies. Technology effects our operations. So there are operational dimentions. –Hitachi Data Systems indicates that back office system failures occur 4 times per year in a average firm. Recovery takes 12 hours. –After 9/11 it took a week for Bank of New York to handle all the problems.

Sources of Operational Risk At least five categories are available 1.Technology –(Failure and declining systems) 2.Employees –(human error and internal fraud like case of Jerome Kerviel in Feb2008 at Societe Generale) (same example is also involves market risk and off balance sheet risk as well 3.Customer relationships –(contractual disputes) 4.Capital assets –(destruction by fire or other catastrophes) 5.External –(external fraud)  1 to 4 are internally controllable while item 5 is not.

Technological Innovation and Profitability The US banks alone spend 20 billion USD per year in technology related expenditures  Efficient technological base  Efficient technological base can result in: – Lower costs  Through improved allocation of inputs/sources. – Increased revenues  Through wider range of outputs –Importance of operating cost and the efficient use of IT is demonstrated with the following profit function: Earnings before taxes = (Interest income - Interest expense) + (Other income - Noninterest expense) – Provision for loan losses

16-5 Technological Innovation and Profitability  Technological investments have the potential to increase both the FI’s net interest margin or the difference between interest income and interest expense. Earnings before taxes = (Interest income ↑ - Interest expense ↓ ) + (Other income ↑ - Noninterest expense ↓ ) – Provision for loan losses

16-6 Technological Innovation and Profitability (Interest income ↑ - Interest expense ↓ ) +  Interest income can be increased –Through wider array of outputs or cross selling as a result of technological developments.  Interest expense can be decreased –If access to markets for liabilities is directly dependent on the FI’s technological capability.  Fedwire, CHIPS link the domestic and international interbank lending markets.  Ability to originate and sell commercial paper is increasingly computer driven.

16-7 Technological Innovation and Profitability  (Other income ↑ - Noninterest expense ↓ ) – Provision for loan losses  Other income can be increased –Through electronic handling of fee generating OBS activities such as LCs and derivatives, many trade finance products are now on line. –These are linked to the quality of the FI’s technology.  Noninterest expenses can be reduced –Through improved efficiency of back office operations using technology  Especially true for securities-related activities  Collection, storage, processing and settlement of customer information are computer based.

Impact of IT on Wholesale & Retail Banking Improvements to cash management : (services designed to collect, disburse and transfer funds on a local, regional, national, international basis) These services required by corporates a)Excess cash balances result in a significant opportunity cost b)Need to know working capital or cash position real time. 1.Controlled disbursement accounts 2.Account reconciliation (by a feature which checks have been paid) 3.Wholesale lockbox – regarding check payments 4.Electronic lockbox – for online payments 5.Funds concentration – from several accounts to one FI 7.Electronic funds transfer – including SWIFTCheck deposit services - 8.Electronic initiation of letters of credit 9.Treasury management software-allows efficienty for multiple currency-security transactions. 10.Electronic data interchange-EDI 11.Facilitating B2B e-commerce 12.Electronic billing 13.Verifying identities Issue of law enforcement access to encrypted data since September 11, Assisting small business entry into e-commerce

16-9 Impact of IT on Wholesale & Retail Banking Retail customers also want efficiency and flexibility in their financial transactions. With a single click Merrill Lynch customers can obtain information on all research (conducted by Merrill Lynch) on a company. Another click gives the customer information on the best terms available on a trade, an a final click executes a customer’s trade. A typical customer transaction through a branch or phone call costs a customer about $1, while a similar online transaction costs just $0.02. A typical customer transaction through a branch or phone call costs a customer about $1, while a similar online transaction costs just $0.02.

16-10 Impact of IT on Wholesale & Retail Banking 1.Automated teller machines (ATMs) 2.Point-of-sale debit cards (POS) 3.Home banking 4.Preauthorized debits/credits 5.Pay-by-phone 6.Online banking 7.Smart cards 8.+++

Effects of Technology on Revenues & Costs-1  Investment in technology is risky –Innovations may fail to attract sufficient business, it is risky ! –Innovations may turn out to be negative net present value projects. (because of uncertainty over revenue and cost) – Potential competitive responses from the rivals may be another problem (mimicing the successfull project) growth oriented investment stockholder’s value maximizing objective can be in conflict. –Manager’s growth oriented investment vs. stockholder’s value maximizing objective can be in conflict.

16-12 Effects of Technology on Revenues & Costs-2 initial setup and development cost expected cash flows  Profitabilty of product innovation negatively related with initial setup and development cost and positively related with expected cash flows  You should consider whether direct or indirect evidence shows if IT invesment to increase revenue or decrease cost !!! regulation&regulatory changes.  & Innovation cannot be evaluated independently from regulation&regulatory changes. Evidence shows the impact of regulation on the value of technological innovations Branching value of cash management services –for example, Branching restrictions in U.S. affect the value of cash management services, – 2 dimentions of Technology we will discuss are  Product revenue side / Operating cost side

16-13 Effects of Technology on Revenues & Costs-3  Revenue effects: –Facilitates cross-marketing  Mixed success ∙ Example: Citigroup and insurance –Technology increases innovation (new products) –Service quality and convenience is another dimention  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

16-14 Effects of Technology on Revenues & Costs-4 benefits costs side revenue side  The benefits are considered more on the costs side rather then revenue side. –Economies of Scale: –Potential average cost advantage for larger FIs  Economies of scale imply that the unit or average cost of producing FI services in aggregate falls as the size of the FI expand.  Potential elimination of smaller banks? –Technological investments are risky diseconomies of scale  Potential diseconomies of scale (increase in the average costs of production as the output of an FI increases)

16-15 Economies of Scale in FIs The unit or average cost of producing FI services in aggregate (or some specifics services) falls as the size of the FI expands. (Sc)

16-16 Effects of Technological Improvement The effects of improving technology over time is to shift the AC curve downward but with a larger downward shift for large FIs If not (due to excess capacity, or integration problems etc.) than small FIs with simple and easily managed computer systems without a huge fixed cost will have advantage causing diseconomies of scale. Diseconomies of scale imply that small FIs are more cost efficient than large FIs and that in a freely competitive environment for financial services.

16-17 Effects of Technology on Revenues & Costs-5  Economies of Scope :  The ability of FIs to generate synergistic cost savings through joint use of inputs in producing multiple products.  Diseconomies of Scope : Instead of joint production specialization may have cost benefits in production and delivery of some FI services.  FIs are multiproduct firms producing services involving different technological needs.  Improving technology in one service may synergistic benefits in lowering the costs of some other areas.  Economies of scale ignores this interrelationship while Economies of scope does not

16-18 Calculation of Average Costs

Testing for Economies of Scale and Scope  Production approach: –Views FI as producing output of services using inputs of labor and capital Cost function = f(y,w,r) (output of services, wage, rent)  Intermediation approach: –Includes funds used to produce intermediated services among the inputs Cost function = f(y,w,r, k) (and cost of funds)

Empirical Findings on Cost Economies of Scale and Scope  Evidence of economies of scale for banks up to the $10 billion to $25 billion size range.  X-inefficiencies (managerial performance and other hard-to-quantify factors) 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?

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

16-22 Technology and Evolution of the Payments System

16-23 Technology and Evolution of the Payments System –U.S. reluctance to abandon the use of checks. Closing the gap will take time. –U.S. payments system  FedWire  Clearing House Interbank Payments System (CHIPS) –Combined value of transactions often more than $4.5 trillion per day  For more information on the Clearing House Interbank Payments System, visit: CHIPS

16-24 Risks that arise in an Electronic Transfer Payment System :Daylight Overdraft Risk  At the end of the banking day at 6.30 PM EST the bank should not have a negative reserve position with FED, by rules. (Banks must maintain cash reserves on deposit at the FED)  What is true at the end of the day is not true during the day.  Usually banks run daylight overdrafts on their reserve accounts at the Fed as their payment outflow messages exceed their payment inflow messages. ( within day lending by Fed )  Fed bears the Fedwire credit risk of bank failures by granting overdrafts without charging a market interest rate.  On CHIPS, privately owned payment system, operations are different but similar.

16-25 Risks that arise in an Electronic Transfer Payment System  International Technology Transfer Risk –While US FIs were unable to transfer their tech. İt is just the opposite for foreign FIs entering into US market.  Crime and Fraud Risk –Fraud risk, especially from FI employees –Riggs National Bank transactions with Saudisith Saudis –Wachovia investigated in relation to money laundering –Costs of complying with Patriot Act

16-26 Risks that arise in an Electronic Transfer Payment System  Regulatory Risk facilitates avoidance of regulation –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  Tax Avoidance –Internal pricing mechanisms to shift profits to low tax regimes –UBS AG: the Hong Kong connection  Competition Risk: nonfinancial firms Competition Risk –GMs credit card operation –AT&T has also a financial institution. –Industrial loan corporations (ILCs)  Technology allows locating in Utah where regulation is more favorable  Requirement to register ILCs as bank holding companies

Other Operational Risks

16-28 Controlling Operational Risk  Loss prevention: –Training, development, review of employees  Loss control: –Planning, organization, back-up  Loss financing: –External insurance  Loss insulation: –FI capital

Regulatory Issues  As FIs’ use of technology increases, operational risk increases as well. (1980s-1990s lost over 200 billion Usd due to Op. Risk)  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

16-30 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

16-31 Thanks.