Chapter 13 Technology and Other Operational Risks.

Chapter 13

Technology and Other Operational Risks

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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 CornettSlides prepared by Maike Sundmacher

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What are the Sources of Operational Risk?• Technology

• Employees

• Customer relationships

• Capital assets

• External (e.g. external fraud).


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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


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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.


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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.


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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,


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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.


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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,• E-mail billing,• Online banking,• Smart cards (stored-value cards).


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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.


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Technology and Revenues

Revenue effects:• Facilitates cross-marketing,

• Increases innovation,

• Service quality and convenience effects,

• Survival of small banks and value of ‘human touch’.


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Technology and Costs

Cost effects:• Economies of Scale: optimal size depends on shape

of average cost curve.

i

ii S

TC AC

Where:

ACi = average costs of the ith FI,

TCi = total costs of the ith FI,

Si = size of the FI measured by assets, deposits or loans.


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Cost effects – Economies of Scale:


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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.


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Economies of Scope:• An FI’s ability to generate synergistic cost savings

through joint use of inputs in producing multiple outputs.

• I.e.:

),0( and )0,( 21 XACXAC BA

• Results in:

)X(0,AC ,0)(XAC )X,X(AC 2B1ABA 21


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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?


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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%.


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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%


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Diseconomies of Scope:• The costs of joint production of FI services exceed the

costs of independent production.

ACFS > TAC

• May occur if highly specialised technology in one area proves to be inefficient for other areas.


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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.


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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.


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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.


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Technology and the Payments System


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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.


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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.


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Other Operational Risks


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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.


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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 1980.• Call for regulatory reform initiated by the Basel

Committee on Banking Supervision in 1999.• 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.


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For information on regulatory approaches to operational risk, see:

• APRA: www.apra.gov.au,• BIS: www.bis.org

(under heading: Basel Committee on Banking Supervision).


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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.


Chapter 13 Technology and Other Operational Risks.

Documents

maike sundmacher slide

financial benefits

profitability technology

mcgrawhill australia

cornett slides

impact of technology

cash management

quality of technology