,Lecture 13,Chapter 4 Operational Risk Management,1. Introduction 2. OR Measurement 3. OR Management: Process and framework 4. OR Management: Mitigation techniques 5. Capital allocation and requirement,Introduction to Operational Risk Management,1.1 Importance of ORM 1.2 Definition 1.3 Typology 1.4 Types of loss 1.5 Major issues on ORM 1.6 Difficulties and Problems of ORM,1.1 Importance of operational risk management,Securitization, Deregulation, Globalization, Growing sophistication of financial instruments and technology Examples:. See: BIS Sound practices for the management and supervision of operational risk, July 2002, P2 The survey of British Bankers Association and Coopers Scenario Analysis/Subjective Loss Estimate Models Expected Loss Models Statistical/Actuarial/Loss Distribution Loss Models Factor-derived Models Please see Hoffman Book: Managing Operational Risk, page 10 and Chapter 9(page 181-),2.5 Databases for ORM,Banks have now begun to develop databases of historical OR events in an effort to quantify unexpected risks of various sorts and to develop statistically defined “worst case” estimates that may be applicable to a select sub-set of a bank businesses. This is a new and evolving area of risk measurement. A bank internal loss database will mostly likely be relatively small, and it is unlikely to reflect the major losses suffered occasionally by its peers. Hence, to be useful, the database should also reflect the experience of others.,3. Operational Risk Management: Process and framework,3.1 Approaches to Risk Management: Process and framework vs. Transactional 3.2 Eight elements of bank-wide ORM framework 3.3 Who should manage operational risk? 3.4 Organizational structure and Independence of RM 3.5 Managing OR as a partnership 3.6 Roles of audit in ORM 3.7 Sound Practices for ORM,3.1 Approaches to Risk Management: Process and framework vs. Transactional,The contribution to risk management can be categorized in two ways. One is in providing a firmwide process and framework. : policy setting, developing risk management standards, monitoring, and portfolio management(of data, or of hedges, etc) of measuring firmwide OR capital. The second is a transactional role, such as active involvement and consultation in deal review because of specialized knowledge (e.g., of risk management techniques such as contract engineering, or of insurance and risk finance, for instance, at the corporate level) Environment and culture: A firm-wide ideology, vision and mandate,3.2 Eight elements of bank-wide ORM framework,Setting policy identifying risk Constructing business process maps, Building a best-practice measurement methodology, Providing exposure management, Installing a timely reporting capability Performing risk analysis inclusive of stress testing And allocating economic capital as a function of operational risk,design a common language,3.3 Who should manage operational risk?,To avoid an conflict of interest, no single group with the bank should be responsible for simultaneously setting policies, taking actions and monitoring risk Senior management is responsible for setting policies concerning OR, and delegating them to inferiors for their development and submitting them to the board of directors for approval Business management has the authority to take action, being responsible for controlling the amount of OR taken within each business line. The infrastructure and governance groups share with business management the responsibility for managing operational risk. Group risk management function take the responsibility for the development of a methodology for measuring and monitoring ORs. This function also attempt to manage the firms OR on a portfolio basis. In this regard, the risk management functions works very closely with, but independently from, business management, infrastructure and the other governance groups. Internal audit function take responsibilities of assure senior management that their delegated responsibilities are actually being tended to, and the resulting processes are effective.,3.4 Organizational structure of RM and Independence of RM,BOD,Risk Committee,IT .,H. R,R (2) foreign exchange risk and commodities risk throughout the bank. Market risk measurement: (1)Mark-to-market principle is adopted in measuring market risk. (2)Some derivative products, deliberately used to hedge the trading activities, should be excluded from the market risk measure but become subject to the credit risk capital requirements. (3)In measuring their market risks, a choice between two broad methodologies will be permitted. One alternative is standardizes approach and the other is internal models, which are subject to a set of quantitative and qualitative criteria. Corresponding capital to market risk:The principal form of eligible capital to cover market risks consists of shareholders equity and retained earnings and supplementary capital as defined in the 1988 Accord. But