Irwin/McGraw-Hill 1 Operational and Technology Risk Chapter 14 Financial Institutions Management, 3/e By Anthony Saunders

Irwin/McGraw-Hill 2 Sources of Operational Risk Employees Technology Customer relationships Capital assets External

Irwin/McGraw-Hill 3 Importance of Technology n Efficient technological base can result in: Lower costs »Through improved allocation of inputs. Increased revenues »Through wider range of outputs.

Irwin/McGraw-Hill 4 Impact on Wholesale Banking n Improvements to cash management Controlled disbursement accounts Account reconciliation Wholesale lockbox Electronic lockbox Funds concentration

Irwin/McGraw-Hill 5 Impact on Wholesale Banking (continued) Electronic funds transfer Check deposit services Electronic initiation of letters of credit Treasury management software Electronic data interchange

Irwin/McGraw-Hill 6 Impact on Retail Banking Automated teller machines Point-of-sale debit cards Home banking Preauthorized debits/credits billing Online banking Telephone banking Smart cards

Irwin/McGraw-Hill 7 Effects of Technology on Revenues and Costs n Revenue effects: Facilitates cross-marketing Increases innovation Service quality effects n Cost effects: Technological improvements »Shift in cost curve.

Irwin/McGraw-Hill 8 Effects on Costs (continued) n Economies of scale Optimal size depends on shape of average cost curve. n Economies of scope Multiple outputs may provide synergies in production.

Irwin/McGraw-Hill 9 Testing for Economies of Scale and Scope n Production approach: Views FI as producing output of services using inputs of labor and capital. C = f(y,w,r) n Intermediation Approach: Includes funds used to produce intermediated services among the inputs. C = f(y,w,r, k)

Irwin/McGraw-Hill 10 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.

Irwin/McGraw-Hill 11 Technology and Evolution of the Payments System n U.S. Payments system: FedWire Clearing House Interbank Payments System (CHIPS) Combined value of transactions often more than $2.5 trillion per day.

Irwin/McGraw-Hill 12 Risks Arising in Wire Transfer System Daylight overdraft risk »FedWire settlement at 6:30 EST »Example of magnitude of daylight overdraft risk: Bank of New York (BONY) »Regulation F sets exposure limits to individual correspondent banks.

Irwin/McGraw-Hill 13 Risks (continued) n International Technology Transfer Risk n Crime and Fraud Risk n Regulatory Risk Technology facilitates avoidance of regulation by locating in least regulated state or country. n Tax Avoidance n Competition Risk