Operational and Technology Risk Chapter 14

1
Operational and Technology RiskChapter 14

• Financial Institutions Management, 3/e
• By Anthony Saunders

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Sources of Operational Risk

• Employees
• Technology
• Customer relationships
• Capital assets
• External

3
Importance of Technology

• Efficient technological base can result in
• Lower costs
• Through improved allocation of inputs.
• Increased revenues
• Through wider range of outputs.

4
Impact on Wholesale Banking

• Improvements to cash management
• Controlled disbursement accounts
• Account reconciliation
• Wholesale lockbox
• Electronic lockbox
• Funds concentration

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Impact on Wholesale Banking (continued)

• Electronic funds transfer
• Check deposit services
• Electronic initiation of letters of credit
• Treasury management software
• Electronic data interchange

6
Impact on Retail Banking

• Automated teller machines
• Point-of-sale debit cards
• Home banking
• Preauthorized debits/credits
• E-mail billing
• Online banking
• Telephone banking
• Smart cards

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Effects of Technology on Revenues and Costs

• Revenue effects
• Facilitates cross-marketing
• Increases innovation
• Service quality effects
• Cost effects
• Technological improvements
• Shift in cost curve.

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Effects on Costs (continued)

• Economies of scale
• Optimal size depends on shape of average cost
  curve.
• Economies of scope
• Multiple outputs may provide synergies in
  production.

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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)

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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.

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Technology and Evolution of the Payments System

• U.S. Payments system
• FedWire
• Clearing House Interbank Payments System (CHIPS)
• Combined value of transactions often more than
  2.5 trillion per day.

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Risks Arising in Wire Transfer System

• Daylight overdraft risk
• FedWire settlement at 630 EST
• Example of magnitude of daylight overdraft risk
  Bank of New York (BONY)
• Regulation F sets exposure limits to individual
  correspondent banks.

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Risks (continued)

• International Technology Transfer Risk
• Crime and Fraud Risk
• Regulatory Risk
• Technology facilitates avoidance of regulation by
  locating in least regulated state or country.
• Tax Avoidance
• Competition Risk