Operational Risk Management

Member Education Series Seminar Indian Institute of Banking & Finance Nagpur November 2005
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Agenda

Definition Causes/Contributors Process Gross Income Computation of Capital Charge Approaches Assessing events Measurement basis Monitoring Data requirements Management tasks

Definitions
Operational risk (OpRisk)has been defined by the Basel Committee on Banking Supervision as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. Management of Operational Risk means and includes identification, assessment, monitoring and control/mitigation of this risk.
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Causes of OpRisk
Internal fraud External fraud Employment practices and workplace safety Clients, products and business practices. Damage to physical assets. Business disruption and system failures Execution, delivery and process management
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Causes of OpRisk
Highly Automated Technology Emergence of E- Commerce Emergence of banks acting as very large volume service providers Outsourcing Large-scale acquisitions, mergers, demergers and consolidations Engagement in risk mitigation techniques giving rise to legal risk
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Contributors to OpRisk

People Risk Process Risk Transaction Risk Documentation/contract risk. Operational Control Risk Model Risk Systems Risk Technology Risk MIS Risk. Legal and Regulatory Risk Event Risk

OpRisk Management process

Appropriate policies and procedures Efforts to identify and measure operational risk Effective monitoring and reporting A sound system of internal controls, and Appropriate testing and verification of the Operational Risk Framework
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Concept of Gross Income

The Basel Committee has allowed each relevant national supervisor to define gross income. RBI defines gross income as follows,

Gross income = Net profit (+) Provisions & Contingencies (+) operating expenses (Schedule 16) (-) profit on sale of HTM investments (-)income from insurance (-) extraordinary / irregular item of income (+) loss on sale of HTM investments
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Computation of Capital Charge

Standardized Capital change based on single risk indicator
Operational Risk Foundation Capital based on business lines and industry standards

Advanced Capital based on business lines and internally calculated standards

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OpRisk Approaches
Approach Basic Indicator Standardized Advanced Measurement Capital charge equals internally generated measures based on, Internal loss data External loss data Scenario analysis Business environment and internal control factors Recognition of risk mitigation (upto 20%) Calculation of Capital charge Average of Gross Income for three years as indicator Capital charge equals 15% of the indicator Gross income per regulatory line as indicator Depending on business line 12, 15 or 18 % of the indictor as capital charge Total capital charge equals sum of charge per business line

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Approach

Basic Indicator

OpRisk Approaches
Standardized Active involvement of Board of directors and Senior management Existence of OpRisk Management function Sound OpRisk Management system Systematic tracking of loss data

Advanced Measurement Same as standardized plus Measurement integrated into day-to-day risk management Review of management and measurement processes by internal/extern al auditor Numerous quantitative standardsin particular 3-5 years of historic data
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Qualifying criteria

No specific criteria Compliance with the Basel Committees Sound Practices for the Management and Supervision of Operational Risk recommended

Standardized Approach--Capital Charge

Corporate finance Gross income b1 Trading and sales Gross income b2 Retail banking Gross income b3 Commercial banking Gross income b4 Payment and settlement Gross income b5 Agency services Gross income b6 Asset management Gross income b7 Retail brokerage Gross income b8

18 18 12 15 18 15 12 12
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Recognizing/Assessing Risk Events

(i) Experience - The event has occurred in the past (ii) Judgment - Business logic suggests that it is a risk (iii) Intuition - Events where appropriate measures saved the institution in the nick of time (iv) Linked Events - This event resulted in a loss resulting from other risk type (credit, market etc.) (v) Regulatory requirement ASSESSMENT Self assessment Risk mapping Key Risk indicators 14

Factors: Assessing Potential risk areas

(i) Staff related factors such as productivity, expertise, turnover (ii) Extent of activity outsourced (iii) Process clarity, complexity, changes (iv) IT Indices (v) Audit Scores (vi) Expected changes or spurts in volumes

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Risk Measurement: Basis

(i) Total number of risk events (ii) Total financial reversals (iii) Net financial impact (iv) Exposure: Based on expected increase in volumes (v) Total number of customer claims paid out (vi) IT indices: Uptime etc. (vii) Office Accounts Status: such as changes in balances
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Monitoring Operational Risk--Issues

Operational loss events Identification of appropriate indicators Frequency of monitoring and reporting MIS Business line identification Corporate finance, Trading and sales, Retail banking, Commercial banking, Payment and settlement , Agency services, Asset management, and Retail brokerage.

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OpRisk Management & Data Needs

Data Collected Loss Event Data Causal Data Loss Effect Key Risk Indicators (KRIs) Proxies Risk Inventories Structured Self Assessment Data External Data

Data Types Transactional Operational/CRM Analytical Risk management Economy/Industry

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Management tasks

Decision whether control for risk minimization or bear Risk mitigation tools as complementary to control Investment in technology and Information security Outsourcing policy-- development and adoption Impact of operational break downs and loss--intra and outside bank Business Continuity plans and testing Review of Business Continuity plans

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Organisational Set-up

Board of Directors Risk Management Committee of the Board Operational Risk Management Committee Operational Risk Management Department Operational Risk Managers Support Group for operational risk management

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THANK YOU

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