Operational Risk Control with Basel II (eBook)

Cover 1
Contents 5
Foreword 11
Preface 15
Acknowledgements 19
Part 1 Operational risk is present at any time in every enterprise 31
1 Management control of operational risk 33
1.1 Introduction 33
1.2 The presence of operational risk in an organization 34
1.3 The management of operational risk events 38
1.4 Supervisory response to operational risk 41
1.5 A strategy for bringing operational risk under control 44
1.6 Operational risk must be managed at all organizational levels 48
1.7 Turning operational risk control into a senior management tool 51
Notes 1 55
2 Classification, identification and monitoring of operational risk 56
2.1 Introduction 56
2.2 Basel Committee directives in understanding operational risk 57
2.3 Classification of operational risks and the Basel Committee 60
2.4 A classification and identification system for operational risks 62
2.5 The Chorafas parallel code system as an organizational infrastructure 65
2.6 Quantitative and qualitative approaches to operational risk identification 67
2.7 A framework for monitoring operational risk 70
2.8 The art of operational risk modeling 72
2.9 The role of internal control and auditing in operational risk management 74
Notes 2 77
3 Legal risk 79
3.1 Introduction 79
3.2 Back to basics: the definition of tort 80
3.3 Responsibilities resulting from legal risk 82
3.4 Contractual aspects of legal risk 85
3.5 Crossborder legal risk and bankruptcy laws 88
3.6 Legal risk may be an impediment to a solution to a banking crisis 91
3.7 Huge credit losses, securitized corporates, and legal risk 93
3.8 Compliance risk: a case study with the Year 2000 problem 96
Notes 3 99
4 Management risk 100
4.1 Introduction 100
4.2 Management risk in the power crisis in the United States 101
4.3 The changing nature of energy business calls for high grade management skill 104
4.4 An operational risk which morphs into major credit risk 106
4.5 The derivatives losses of EDS: a different management risk 108
4.6 Management risk at Tyco International 112
4.7 The CEO should be an example of virtue, not of malfeasance 115
4.8 Conflicts of interest: from IPOs to disappearing technology firms 117
Notes 4 118
5 Information technology risk 120
5.1 Introduction 120
5.2 Technology risk defined 121
5.3 The growing role of IT and its risks 125
5.4 Advanced IT solutions and smart environments 128
5.5 Business continuity and IT-related operational risk 132
5.6 System reliability should always be a major objective 135
5.7 Trading, payments, settlements, and operational risks associated to IT 139
5.8 Operational risk that may result from IT outsourcing and insourcing 141
Notes 5 143
Part 2 Capital requirements for operational risk and Basel II solutions 145
6 Allocation of capital to operational risk according to Basel II 147
6.1 Introduction 147
6.2 Regulatory capital vs economic capital 148
6.3 Economic capital and levels of confidence 150
6.4 A bird's-eye view of models for operational risk reserves 154
6.5 The choice among methods for operational risk modeling 158
6.6 Capital standards and operational risk control costs 161
6.7 Allocating regulatory capital and economic capital to operational risk 163
6.8 Capital at risk with operational type losses: a case study 165
6.9 Operational risk control at the Erste Bank 168
Notes 6 170
7 Five models by the Basel Committee for computation of operational risk 171
7.1 Introduction 171
7.2 The effort to measure operational risk and the basic indicator approach 172
7.3 Capital charges under the Basel Committee's standard approach 175
7.4 The effort to develop advanced measurement approaches 180
7.5 Capital allocation with loss distribution approach 182
7.6 Databasing and datamining information on operational risk 186
7.7 Early findings with operational risk models, and the notion of model risk 189
Notes 7 192
8 High frequency events, low frequency events and the Six Sigma method 193
8.1 Introduction 193
8.2 Understanding the concepts of high frequency and low frequency events 194
8.3 Characteristics of high frequency and low frequency events 198
8.4 Experimentation and system design for operational risk control 200
8.5 Tools most useful in the analysis of operational risks 204
8.6 Using Six Sigma to improve management control over operations 207
8.7 The practical implementations of Six Sigma are convincing 210
Notes 8 213
9 Market discipline, contrary opinion and scoreboard solutions 214
9.1 Introduction 214
9.2 The Basel Committee on scoreboards and market discipline 215
9.3 The use of templates with scoreboards 218
9.4 Developing more sophisticated scoreboard practices 221
9.5 Extreme value theory and genetic algorithms for operational risk control 225
9.6 A common project on operational risk by a group of financial institutions 228
9.7 A devil's advocate in operational risk management 232
Notes 9 234
Part 3 Control of technical risk and operational risk in the insurance industry 237
10 The science of insurance and the notion of technical risk 239
10.1 Introduction 239
10.2 The science of insurance 240
10.3 Definition of risk factors and their aftermath 243
10.4 Underwriting risk in insurance and the actuaries 246
10.5 Assets held by insurers and their risks 249
10.6 The insurance of operational risk and its underwriting 253
10.7 Services provided by reinsurance: a proxy for insurance of operational risk 256
Notes 10 259
11 The use of insurance policies to mitigate operational risk 260
11.1 Introduction 260
11.2 Cost of equity, cost of debt, and cost of insurance 261
11.3 Operational risk securitization and moral hazard 263
11.4 Advent of insurance-linked protection vehicles and underwriters risk 267
11.5 Integrative approaches through alternative risk transfer 270
11.6 Frequency and impact of events in operational risk transfer through insurance 273
11.7 Insurers who donÌt do their homework get burned 275
11.8 Challenges with value accounting in the insurance business 277
11 Notes 280
12 Role of rating agencies in the creditworthiness of insurance firms 281
12.1 Introduction 281
12.2 Independent rating agencies, their business and their role 283
12.3 Insurance companies and independent rating agencies 285
12.4 Qualitative and quantitative approaches to rating insurance companies 289
12.5 Information is the critical product of rating agencies 292
12.6 Analytical studies are the way of being in charge of risks 296
12.7 Operational risk with marine insurance underwriting: a case study 298
Notes 12 303
13 Tort is technical and operational risk of insurers 304
13.1 Introduction 304
13.2 Why tort reform is necessary 305
13.3 Learning from the precedent of Y2K tort 307
13.4 Compensation for claims: a case study with asbestos 309
13.5 Asbestos claims have been a nightmare to the insurance industry 311
13.6 Challenges facing major financial institutions and their daily business 314
13.7 Tort exposure and management risk correlate 317
Notes 13 319
14 The challenge of terrorism and insurer of last resort 320
14.1 Introduction 320
14.2 Business disruption resulting from 9/11 322
14.3 Learning from technical limits with insurance of natural catastrophes 324
14.4 Policies for rethinking insurability of operational risks 328
14.5 Benefits catastrophe bonds might provide 331
14.6 Lloyd's record losses with 9/11: a prognosticator of future red ink? 333
14.6 Governments as insurers of last resort: a precedent with deposit insurance 337
Notes 14 339
Part 4 The importance of cost- consciousness in operational risk control 341
15 Deficient cost control is the result of management risk 343
15.1 Introduction 343
15.2 The low cost producer holds the upper ground 344
15.3 Alert companies are in charge of their risks and of their costs: Berkshire and TIAA 349
15.4 An example of controllable technology spending 352
15.5 Isaac Newton appreciated that throwing money at the problem leads nowhere 354
15.6 Putting into action a costing and pricing mechanism for operational risk control 358
Notes 15 360
16 Cost control is indivisible from operational risk management 361
16.1 Introduction 361
16.2 The cost of staying in business 362
16.3 Operational risk control and the administrative budget 364
16.4 Are mergers and disinvestments a good way to cut costs? 368
16.5 Why fat executive options work against shareholder value 371
16.6 What it means to be in charge of re-engineering 373
16.7 Establishing and sustaining a transnational advantage 376
16.8 Capitalizing on the evolving role of financial instruments 378
Notes 16 380
Index 381