ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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Preparedness of Indian Banks in Managing Operational Risk

While the recent incidents of catastrophic business failures and Basel II requirements of capital charge for operational risk have increased awareness about the latter, it has also sparked a debate on its measurement as well as its management. This is an analysis of the compelling reasons for an objective and effective management of operational risk and a brief recall of the present methods for measuring and modelling it. Subsequently, through the results of a survey to take stock of the preparedness of Indian banks in managing such risk, the authors find that the Indian banking sector is still in its preparatory stage and is constrained in implementing a sound operational risk management system as it is wanting in risk transfer and its quantification.

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SPECIAL ARTICLEmay 3, 2008 EPW Economic & Political Weekly481988. This emphasised credit risk while duly recognising the importance of off-balance sheet exposures. Global regulators fol-lowed suit by finding ways to economise capital. Since then, how-ever, there has been a growing recognition of the limitations of BaselI, which largely ignored both the heterogeneity of the asset class and its differential risk sensitivity. This led to the emergence of the new Basel Accord – BaselII– squarely focusing on risk management through proper development of a unique internal rating framework for the assessment of capital adequacy. Basel II encompasses all three risks inherent in the business – credit risk, market risk and operational risk (OR), of which the most difficult and hence, controversial, part has been the assessment, measure-ment and quantification of OR.1Financial institutions are risk managers that have the ability to measure and manage risk exposure. As risk intermediaries, they continuously monitor themselves so as to remain within the critical limits of risk exposure for solvency. Thus, not just man-agement of risk but an accurate measurement of it, on which it crucially hinges, is essential for prudent risk management. Of the three risks – credit, market and operational risk, OR is the most difficult to observe and hence, to quantify. However, financial institutions, including banks, are susceptible to losses resulting from operational failures, which undermines the public’s trust and erodes customer confidence. A fundamentally strong firm can recover from market and credit risk events while it may be almost impossible to recover from certain operational risk events [Allen et al 2004]. The magnitude of a single operational failure is invariably catastrophic and forces closing down the business once and for all. Although financial institutions have coped with OR for years, recent major business catastrophes, like the sudden loss of reputation of Arthur Anderson in the wake of the Enron scandal, loss of independence of Barings Bank as a result of Nick Leeson’s rogue trading operation or UBS’ loss of $ 100 million due to a trader’s error, have underscored the need for a more scientific approach. Further, the Basel II requirement for capital charges towards OR has made it a strategic parameter for financial institu-tions. With deregulation, globalisation and growing technology dependence, the complexity of business has increased. The time has come to view OR as a comprehensive system not only for oper-ational excellence but to stay in the business as well.The rest of the paper is arranged as follows. Section 1 briefly describes the implication of Basel II in the context of OR. Section 2 briefly sketches the worldwide development as well as the deve-lopments in the present banking scenario in India. Section 3 presents the result of a detailed survey carried out for the study to take stock of the preparedness of Indian banks in managing OR. Finally, Section 4 concludes by summarising the study.1 MeasurementApproachesOR has been acknowledged as a major contributor to banks’ risk position. Current estimates suggest that allocation of total finan-cial risks in a bank is roughly 60 per cent of credit risk, 15 per cent of market risk and 25 of operational risk. The new capital accord BaselII specification on allocating risk capital forOR explicitly emphasises this importance ofOR in financial institutions. This underlines one of the major differences between Basel II and Basel I. BaselII introduces three distinct approaches for calculating capital charge forOR. These methods reflect dif-ferentlevels of risk sensitivity, allowing banks to choose the approach that best fits their operations and organisational risk management maturity.1.1 Basic Indicator ApproachBanks using the Basic Indicator Approach (BIA) have to hold capi-tal for OR equal to a fixed percentage of a single indicator. The current proposal for this indicator is gross income. The charge may be expressed as follows: KBIA = EI.α where KBIA is the capital charge under the BIA, EI is the level of an exposure indicator for the whole institution, provisionally gross income, α is a fixed per-centage, set by the committee, relating the industry-wide level of required capital to the industry-wide level of the indicator.TheBIA is intended to be applicable to any bank regardless of its complexity or sophistication, although the committee does not expect that supervisors will permit internationally active banks and banks with significant OR exposure to use such an approach.1.2 Standardised ApproachIn the case of the Standardised Approach (SA), the bank’s activities are divided into eight business lines. A broad indi-cator is specified to reflect the size or volume of a bank’s activities in each area. Table 1 shows the proposed business lines and indicator.For each busi-ness line, the capi-tal charge is cal-culated by multi-plying the broad indicator by a factor (denoted beta) assigned to that business line. Beta will be set by the com-mittee and serves as a rough proxy for the industry-wide rela-tions between the OR loss experience for a given business line and the aggregate level of the indicator for that business line.If a bank is unable to allocate an activity to a business line, it is proposed that income relating to that activity should be subject to the highest beta factor for which the bank reports activity. Cur-rently gross income is proposed to be used as the indicator in all business lines for the sake of simplicity, comparability, reduction of arbitrage possibilities and most significantly, a lack of evidence of greater risk sensitivity of other indicators. The total capital charge is calculated as the simple summation of the regulatory capital charges across each of the business lines. 8KTSA =Σ Eiβi i=11.3 AdvancedMeasurementApproachThe Advanced Measurement Approach (AMA) is the most risk sensitive among the three approaches currently being developed for regulatory capital purposes. The regulatory capital requirement Table 1: Business Linewise Beta FactorsBusiness Lines Indicators Beta Factors (%)Corporate finance Gross income β1Trading and sales Gross income β2Retail banking Gross income β3Commercial banking Gross income β4Payment and settlement Gross income β5Agency services and custody Gross income β6Asset management Gross income β7Retail brokerage Gross income β8
SPECIAL ARTICLEEconomic & Political Weekly EPW may 3, 200849for OR under the AMA would be based on an estimate of OR derived from a bank’s internal risk measurement system. This risk estimate would be subject to a floor-based on the SA capital charge forOR. Bankers desirous to use AMA will be subjected to a set of criteria.For following the AMA, banks must have proven capability in the following aspects in addition to other qualitative requirements:Internal Data: Banks must track internal loss data as a prerequi-site for the development of a credible OR measurement system. External Data: A bank’sOR measurement system must use rele-vant external data (either public data and/or pooled industry data). These external data should include data on actual loss amounts, information on the scale of business operations where the event occurred, information on the causes and circumstances of the loss events or other information that would help in assessing the rele-vance of the loss event for other banks.Scenario Analysis: A bank must use scenario analysis of expert opinions in conjunction with external data to evalu-ate its exposure to high-severity events. This approach draws on the knowledge of experienced business managers and risk man-agement experts to derive reasoned assessments of plausible severe losses.Business Environment and Internal Control Factors: In addi-tion, a bank’s firm-wide risk assessment methodology must cap-ture key business environment and internal control factors that can change its OR profile.2 Developments in OR ManagementWorldwide, quantification of OR is still a nascent subject. The pio-neers have been the banking and financial institutions. However, as reported in the latest Quantitative Impact Study (QIS5) by Bank for Interna-tional Settlements (BIS), out of 357 banks surveyed, only 22 gave an estimate of OR capital charge using the AMA all of which belong to the G-10 countries. Interestingly, the study also reveals that OR is the main driver for increasing the minimum required capital. It is the single largest positive con-tributor to the increase in risk capital among all other exposures, including credit exposure and market exposure. However, there is considerable dispersion among OR maturities, as banks are in different stages of systems development. Table 2 shows the numbers of G-10 banks using each approach to OR in their capital calculation. Estimates for the AMA are still a challenge for manyinstitutions, with less than half of the G-10 group 1 banks being able to provide anAMA estimate, which could be used in this analysis.Although there is a trend towards moving to advanced approaches, many G-10 banks are still not able to estimate opera-tional risk using AMA [BIS 2005]. Table 3 presents a comparative study of OR management of a few major banks from emerging and developed countries.The banking sector in India started opening up during the 1990s. Financial sector reforms set in motion in 1991 with the first Narasimham Committee report changed the face of Indian Banking. This was followed by the introduction of risk weighted capital adequacy norms and prudential norms in 1992. In 1993, deregulation of interest rates, prudential norms for maximum non-performing assets (NPAs) and in the very next year, banking ombudsman scheme came into force. The second Narasimham Committee report of banking sector reform was published in 1997. In 1998 the Reserve Bank of India (RBI) issued guidelines on risk management.Commensurate with financial sector reforms, major trends in the global banking and financial sectors have been reflected in the Indian banking sector. The Indian banking sector has been witnessing a spate of mergers. This trend towards financial supermarkets brings along with it the challenge of managing and excelling huge scale operations. Technology has totally altered traditional banking.2 Emergence of new techno-logies has enabled banks to sustain explosive growth. But it has also made them vulnerable to increased risks associated with reliability of technology and processes, data security and disaster recovery issues. In India, the capital adequacy norms were adopted in 1992 fol-lowing the Basel Accord, 1988. In its policy approach towards BaselII, the RBI asked the banking sector to draw a roadmap for Basel II implementation in its annual statement in May 2004. This was followed up by a guideline on OR published in February 2005. Although presently the RBI requires commercial banks to follow the BIA for OR, the policy statement of theRBI towards Basel II is adopting inter-national best practices. It is envisaged that the capital requirement forOR under other methods, especially underAMA, may be consider-ably less. However, this entails a reliable quantification of OR. Apart from saving on capital charge, banks have other incentives for quantification of OR. It can lead to a more economic allocation of capital among different business units (such as, risk adjusted returns on capital; a popular measure in the banking sector). Comprehensive OR management Table 2: Number of G-10 Banks Using Different Approaches Approach Group 1 Group 2Basic indicator approach 2 81Standardised approach 32 65Advanced measurement approach 22 0Total 56146Source: QIS5, BIS, June 2006.Table 3: Comparison of OR Management across BanksBank MethodologyStatusState Bank of India BIA Integrated risk management under progressICICI Bank BIA Pioneer of risk based audit methodology in IndiaUTI Bank BIA Plans for risk profiling and identifying KPIs during 2006-07Bank of China BIA Pilot project regarding control and KPIs undertakenIndustrial and Commercial OR monitoring index Integrated system with OR manual Bank of China system in addition to BIA Hang Seng Bank BIA Contingency plans for OR developedDeutsche Bank Economic capital Plans to adopt to AMA method for calculation by bottom up economic capital calculation in recent future self-assessment approach; monitoring risk profiles with KPIs; and AMA for internal capital allocation Source: Annual reports of the above banks for 2005.
No 23% Yes 69% Yes 77% No 31%
0% 20% 40% 60% 80% 100% Reduced losses Lower regulatory capital Quality and stability of earnings Enhanced competitiveness Survival Resource allocation Better pricing Lower operating costs Lower insurance costs Stock performance Others Lower financing costs
0% 20% 40% 60% 80% 100% Technology and infra problems Lack of skilled people Difficulty in cost-benefit analysis Lack of common definition Bureaucratic culture Others Limited budget Pressure on cost cutting Business unit freedom Management buy-in
Excellent 8% Good 15% Competitive 46% Need to improve 31% > 3 years 25% < 3 months 8% 3-6 months 8% 6 months 1 year 42% 1-3 years 17%
SPECIAL ARTICLEmay 3, 2008 EPW Economic & Political Weekly52Sage ADSeventh South Asian Orientation Course in Human Rights and Peace Studies, 2008Applications are invited for the Seventh South Asian Orientation Course in Human Rights and Peace Studies. The last date for receiving applications is 31 May, 2008. The application form can be downloaded from www.safhr.org The course will have a three months long distance learning beginning between 1 July 2008 and 30 September 2008; and, a two-week long Direct Orientation in November 2008 in Kathmandu, Nepal. The distance-learning will be conducted on SAFHR’s secure e-learning platform. Participants will also receive the course material on CDs. However, familiarity with e-learning skills and proficiency in the English language are essential. Between twenty to twenty-five participants, preferably between ages 25 and 45, will be selected on the basis of the nature and the quality of their involvement with the issues of human rights, peace, democracy and development in the region. Each applicant has to send a filled in application form, mentioning where he or she has seen the course advertisement, with two references, and a 1000-word essay explaining the relation of the applicant’s work to human rights and peace studies and reasons for applying for the course. The selection will be guided by the necessity to have a balanced representation of participants from all the countries in the region, women activists, refugee activists, media practitioners, members of minority groups, researchers, academics, policy makers, leaders of non-governmental organizations and government officials. A maximum of three participants from outside South Asia will be selected. For the direct orientation, the participants will have to find their own funding to travel. SAFHR will provide boarding and lodging. A limited number of fellowship for travel is available. This will be granted on the basis of separate application by selected candidates.The selected participants from South Asia will have to deposit a registration fee of US $ 100 by June 30, 2008. Participants from outside South Asia have to pay US $ 400. The enrollment of the participants will be confirmed only after that. For further information on the course structure, content and methodologies and to read the fifth course report, http://www.safhr.org/pdf/Peace%20studies%20report5.pdf. Electronic, facsimile and postal submissions are acceptable. Those sending the applications by post or courier should do so to the SAFHR at the following address:South Asia Forum for Human Rights (SAFHR)3/23 Shree Durbar Tole, Patan Dhoka, LalitpurG. P. O. Box; 12855, Kathmandu, NepalTel: 00977 1 5541026 Fax: 00977 1 5527852E-mail: peacestudies@safhr.org; URL: www.safhr.org
0% 20% 40% 60% 80% 100% Loss data collection and analysis Self risk assessment Key performance indicators Event-cause-effect analysis Score cards Scenario analysis Value-at-risk Quality and stability of earnings Others Extreme value theory Risk-adjusted return on capital Cost/income analysis

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