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Quality Control & Operational Risk November 2003
Agenda • Introductions • Outline of a Derivative Transaction • Quality Control in Financial Services – where are we in relation to other industries • War Story
Outline of a Derivative Transaction Example: Ford Motor company (FMC) wishes to begin manufacturing in an Eastern European country and does not want exposure to currency risk. FMC issues a bond for HUF 20bn paying a fixed HUF rate, then swaps the HUF currency risk into USD with an investment bank Trade Data $1bn/HUF20bn FMC pays fixed amount Broker Dealer assumes floating ccy risk Option to call in 5 years OperationalActivities Confirm economic data Perform margin procedures Produce Confirmations Settle any cashflows Economic Risks:- What is the cost of confirming the first decimal incorrectly How soon will a mistake be identified Are the right ISDA terms used and agreed – what is the cost of an incorrect calculation agent
Quality Control in Financial Services – where are we in relation to other industries • A Bit of History • No weighting was given to the Operational risk associated with a transaction though there was obviously thorough thought and analysis given to the credit and economic risk of the trade. It is only within the last 5 years the financial industry has thought about this risk. • Operational Failure Risk • Over the last few years we have actively applied resources to this issue of Operational Risk and sought analogies in the insurance and engineering world to better understand and to quantify the Operational risk associated with a transaction • Why: • Avoid catastrophic loss • Apply “smart” exception processing and prioritizing • Provide data for analysis to avoid re-occurrence • Apply infrastructure investment more scientifically
Quality Control in Financial Services – what are we looking for • In building an Operational Risk Model we apply three broad factors • People Risk • As in any industry, employees operate at different levels of competency generally based on experience:- I.e apply a weighting to years of experience • Fraud – understand here the opportunity for fraud could occur • Process Risk • This risk increases exponentially with the maturity of a process I.e. Derivative transactions have a higher degree of risk than an equities transaction. However, equities may face an entirely different risk of capacity constraints. • Technology Risk • This is the most transparent to understand – but not the easiest to quantify
War Story Unfortunately there are multiple stories. Tonight we can talk about AIB.