BUS FINANCE 826

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BUS FINANCE 826
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Overview

• Operational returns and risks, and the importance
  of optimal management and control of labor,
  capital, and other input sources and their costs.
  The emphasis is on technology and its impact on
  risk and return.
• Examples Risks resulting from innovations in IT,
  and effects of terrorist attacks on key
  technologies.

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Sources of Operational Risk

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

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Importance of Technology

• Efficient technological base can result in
• Lower costs
• Through improved allocation of inputs.
• Increased revenues
• Through wider range of outputs.
• Earnings before taxes (Interest income -
  Interest expense) (Other income - Noninterest
  expense) - Provision for loan losses

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Impact of Technology

• Interest income can be increased
• Through wider array of outputs or cross selling.
• Interest expense can be decreased
• Through improved access to markets for
  liabilities
• Fedwire, CHIPS

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Impact of Technology

• Other income can be increased
• Through electronic handling of fee generating OBS
  activities such as LCs and derivatives
• Noninterest expenses can be reduced
• Through improved efficiency of back office
  operations using technology. Especially true for
  securities-related activities.

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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
• Facilitating B2B e-commerce
• Electronic billing

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Impact on Wholesale Banking (continued)

• Verifying identities
• Issue of law enforcement access to encrypted data
  since September 11, 2001
• Assisting small business entry into e-commerce

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Impact on Retail Banking

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

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Effects of Technology on Revenues and Costs

• Investments in technology are risky
• Potentially negative NPV projects due to
  uncertainty and potential competitive responses
• Potential agency conflicts
• Growth-oriented investments may not maximize
  shareholders value
• Losses on technological investments can weaken an
  FI

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Effects of Technology on Revenues and Costs

• Evidence shows the impact of regulation on value
  of technological innovations.
• Branching restrictions in U.S. affect the value
  of cash management services, for example.
• Less valuable in Europe where comparable
  restrictions are absent

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Effects of Technology on Revenues and Costs

• Revenue effects
• Facilitates cross-marketing
• Increases innovation
• Service quality effects
• Survival of small banks and value of human
  touch
• 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.

Size
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Effects on Costs (continued)

• Economies of scope
• Multiple outputs may provide synergies in
  production.
• Diseconomies of scope
• Specialization may have cost benefits in
  production and delivery of some FI services

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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

• Use of electronic transactions higher in other
  countries. (E.g., TARGET).
• U.S. Payments system
• FedWire
• Clearing House Interbank Payments System (CHIPS)
• Combined value of transactions often more than
  2.7 trillion per day.

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Web Resources

• For information on the Clearing House Interbank
  Payments System, visit
• CHIPS www.chips.org

Web Surf
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Wire Transfer System Risks

• Daylight overdraft risk
• FedWire settlement at 630 EST
• Example of magnitude of daylight overdraft risk
  Bank of New York (BONY)
• Regulation J guarantees payment finality of wire
  transfer messages by the Fed
• 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

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Other Operational Risks

• Employees
• Turnover
• Key personnel
• Fraud
• Errors
• Rogue trading (Barings, Allied Irish/Allfirst)
• Money laundering
• Confidentiality breach

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Technology Risks

• Programming error
• Model risk
• Mark-to-market error
• Management information
• IT/Telecomm systems outage
• Technology provider failure
• Contingency planning

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Customer Relationship Risks

• Contractual disagreement
• Dissatisfaction from poorly performing technology
• Default

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Capital Asset Risk

• Safety
• Security
• Operating costs
• Fire/flood

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External risks

• External fraud
• Taxation risk
• Legal risk
• War
• Market collapse
• Reputation risk
• Relationship risk

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Controlling Operational Risk

• Loss prevention
• Training, development, review of employees
• Loss control
• Planning, organization, back-up
• Loss financing
• External insurance
• Loss insulation
• FI capital

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Optimal Risk Management
Cost
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Regulatory Issues

• 1999 Basel Committee on Banking Supervision noted
  the importance of operational risks
• Required capital
• Basic Indicator Approach
• Standardized Approach
• Internal Measurement Approach
• Consumer protection issues

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Pertinent Websites

• For more information visit
• American Banker www.americanbanker.com
• BIS www.bis.org FDIC www.fdic.gov
• Mortgage Bankers Assoc. www.mbaa.org
• Federal Reserve Bank www.federalreserve.gov
• The Economist www.economist.com
• The Wall Street Journal www.wsj.com
• CHIPS www.chips.org

Web Surf