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Chapter. 14. Technology and Other Operational Risks. Overview.

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Technology and Other Operational Risks


  • This chapter discusses the factors affecting 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.

Sources of operational risk
Sources of Operational Risk

  • Technology

  • Employees

  • Customer relationships

  • Capital assets

  • External

Importance of technology
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

Impact of technology
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

Impact of technology1
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.

Impact on wholesale banking
Impact on Wholesale Banking

  • Improvements to cash management

    • Controlled disbursement accounts

    • Account reconciliation

    • Wholesale lockbox

    • Electronic lockbox

    • Funds concentration

Impact on wholesale banking continued
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

Impact on wholesale banking continued1
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

Impact on retail banking
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

Effects of technology on revenues and costs
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 shareholder’s value

      • Losses on technological investments can weaken an FI

Effects of technology on revenues and costs1
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

Effects of technology on revenues and costs2
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.

Effects on costs continued






Effects on Costs (continued)

  • Economies of scale

    • Optimal size depends on shape of average cost curve.


Effects on costs continued1
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

Testing for economies of scale and scope
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)

Empirical findings
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.

Technology and evolution of the payments system
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.

Web resources
Web Resources

  • For information on the Clearing House Interbank Payments System, visit:


Web Surf

Wire transfer system risks
Wire Transfer System Risks

  • Daylight overdraft risk

    • FedWire settlement at 6:30 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.

Risks continued
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

Other operational risks
Other Operational Risks

  • Employees

    • Turnover

    • Key personnel

    • Fraud

    • Errors

    • Rogue trading (Barings, Allied Irish/Allfirst)

    • Money laundering

    • Confidentiality breach

Technology risks
Technology Risks

  • Programming error

  • Model risk

  • Mark-to-market error

  • Management information

  • IT/Telecomm systems outage

  • Technology provider failure

  • Contingency planning

Customer relationship risks
Customer Relationship Risks

  • Contractual disagreement

  • Dissatisfaction from poorly performing technology

  • Default

Capital asset risk
Capital Asset Risk

  • Safety

  • Security

  • Operating costs

  • Fire/flood

External risks
External risks

  • External fraud

  • Taxation risk

  • Legal risk

  • War

  • Market collapse

  • Reputation risk

  • Relationship risk

Controlling operational risk
Controlling Operational Risk

  • Loss prevention:

    • Training, development, review of employees

  • Loss control:

    • Planning, organization, back-up

  • Loss financing:

    • External insurance

  • Loss insulation:

    • FI capital

Optimal risk management


Optimal Risk Management


Regulatory issues
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

Pertinent websites
Pertinent Websites

  • For more information visit:

    American Banker


    Mortgage Bankers Assoc.

    Federal Reserve Bank

    The Economist

    The Wall Street Journal


Web Surf