Operational risk control with Basel II : basic principles and capital requirements

Part 1: Operational risk is present at any time in every enterprise 1 1 Management control of operational risk 3 1.1 Introduction 3 1.2 The presence of operational risk in an organization 4 1.3 The management of operational risk events 8 1.4 Supervisory response to operational risk 11 1.5 A strategy for bringing operational risk under control 14 1.6 Operational risk must be managed at all organizational levels 18 1.7 Turning operational risk control into a senior management tool 21 2 Classification, identification and monitoring of operational risk 26 2.1 Introduction 26 2.2 Basel Committee directives in understanding operational risk 27 2.3 Classification of operational risks and the Basel Committee 30 2.4 A classification and identification system for operational risks 32 2.5 The Chorafas parallel code system as an organizational infrastructure 35 2.6 Quantitative and qualitative approaches to operational risk identification 37 2.7 A framework for monitoring operational risk 40 2.8 The art of operational risk modeling 42 2.9 The role of internal control and auditing in operational risk management 44 3 Legal risk 49 3.1 Introduction 49 3.2 Back to basics: the definition of tort 50 3.3 Responsibilities resulting from legal risk 52 3.4 Contractual aspects of legal risk 55 3.5 Crossborder legal risk and bankruptcy laws 58 3.6 Legal risk may be an impediment to a solution to a banking crisis 61 3.7 Huge credit losses, securitized corporates and legal risk 63 3.8 Compliance risk: a case study with the Year 2000 problem 66 vi Contents 4 Management risk 70 4.1 Introduction 70 4.2 Management risk in the power crisis in the United States 71 4.3 The changing nature of energy business calls for high grade management skill 74 4.4 An operational risk which morphs into major credit risk 76 4.5 The derivatives losses of EDS: a different management risk 78 4.6 Management risk at Tyco International 82 4.7 The CEO should be an example of virtue, not of malfeasance 85 4.8 Conflicts of interest: from IPOs to disappearing technology firms 87 5 Information technology risk 90 5.1 Introduction 90 5.2 Technology risk defined 91 5.3 The growing role of IT and its risks 95 5.4 Advanced IT solutions and smart environments 98 5.5 Business continuity and IT-related operational risk 102 5.6 System reliability should always be a major objective 105 5.7 Trading, payments, settlements, and operational risk associated to IT 109 5.8 Operational risks that may result from IT outsourcing and insourcing 111 Part 2: Capital requirements for operational risk and Basel II solutions 115 6 Allocation of capital to operational risk according to Basel II 117 6.1 Introduction 117 6.2 Regulatory capital vs economic capital 118 6.3 Economic capital and levels of confidence 120 6.4 A bird’s-eye view of models for operational risk reserves 124 6.5 The choice among methods for operational risk modeling 128 6.6 Capital standards and operational risk control costs 131 6.7 Allocating regulatory capital and economic capital to operational risk 133 6.8 Capital at risk with operational type losses: a case study 135 6.9 Operational risk control at the Erste Bank 138 7 Five models by the Basel Committee for computation of operational risk 141 7.1 Introduction 141 7.2 The effort to measure operational risk and the basic indicator approach 142 7.3 Capital charges under the Basel Committee’s standard approach 145 7.4 The effort to develop advanced measurement approaches 150 7.5 Capital allocation with the loss distribution approach 152 7.6 Databasing and datamining information on operational risks 156 7.7 Early findings with operational risk models, and the notion of model risk 159 Contents vii 8 High frequency events, low frequency events and the Six Sigma method 163 8.1 Introduction 163 8.2 Understanding the concepts of high frequency and low frequency events 164 8.3 Characteristics of high frequency and low frequency events 168 8.4 Experimentation and system design for operational risk control 170 8.5 Tools most useful in the analysis of operational risks 174 8.6 Using Six Sigma to improve management control over operations 177 8.7 The practical applications of Six Sigma are convincing 180 9 Market discipline, contrary opinion and scoreboard solutions 184 9.1 Introduction 184 9.2 The Basel Committee on scoreboards and market discipline 185 9.3 The use of templates with scoreboards 188 9.4 Developing more sophisticated scoreboard practices 191 9.5 Extreme value theory and genetic algorithms for operational risk control 195 9.6 A common project on operational risk by a group of financial institutions 198 9.7 A devil’s advocate in operational risk management 202 Part 3: Control of technical risk and operational risk in the insurance industry 207 10 The science of insurance and the notion of technical risk 209 10.1 Introduction 209 10.2 The science of insurance 210 10.3 Definition of risk factors and their aftermath 213 10.4 Underwriting risk in insurance and the actuaries 216 10.5 Assets held by insurers and their risks 219 10.6 The insurance of operational risk and its underwriting 223 10.7 Services provided by reinsurance: a proxy for insurance of operational risk 226 11 The use of insurance policies to mitigate operational risk 230 11.1 Introduction 230 11.2 Cost of equity, cost of debt, and cost of insurance 231 11.3 Operational risk securitization and moral hazard 233 11.4 Advent of insurance-linked protection vehicles and underwriters risk 237 11.5 Integrative approaches through alternative risk transfer (ART) 240 11.6 Frequency and impact of events in operational risk transfer through insurance 243 11.7 Insurers who don’t do their homework get burned 245 11.8 Challenges with value accounting in the insurance business 247 viii Contents 12 Role of rating agencies in the creditworthiness of insurance firms 251 12.1 Introduction 251 12.2 Independent rating agencies, their business and their role 253 12.3 Insurance companies and independent rating agencies 255 12.4 Qualitative and quantitative approaches to rating insurance companies 259 12.5 Information is the critical product of rating agencies 262 12.6 Analytical studies are the way of being in charge of risks 266 12.7 Operational risk with marine insurance underwriting: a case study 268 13 Tort is technical and operational risk of insurers 274 13.1 Introduction 274 13.2 Why tort reform is necessary 275 13.3 Learning from the precedent of Y2K tort 277 13.4 Compensation for claims: a case study with asbestos 279 13.5 Asbestos claims have been a nightmare to the insurance industry 281 13.6 Challenges facing major financial institutions and their daily business 284 13.7 Tort exposure and management risk correlate 287 14 The challenge of terrorism and insurer of last resort 290 14.1 Introduction 290 14.2 Business disruption resulting from 9/11 292 14.3 Learning from technical limits with insurance of natural catastrophes 294 14.4 Policies for rethinking insurability of operational risks 298 14.5 Benefits catastrophe bonds might provide 301 14.6 Lloyd’s record losses with 9/11: a prognosticator of future red ink? 303 14.7 Governments as insurers of last resort: a precedent with deposit insurance 307 Part 4 The importance of cost-consciousness in operational risk control 311 15 Deficient cost control is the result of management risk 313 15.1 Introduction 313 15.2 The low cost producer holds the upper ground 314 15.3 Alert companies are in charge of their risks and of their costs: Berkshire and TIAA 319 15.4 An example of controllable technology spending 322 15.5 Isaac Newton appreciated that throwing money at the problem leads nowhere 324 15.6 Putting into action a costing and pricing mechanism for operational risk control 328 Contents ix 16 Cost control is indivisible from operational risk management 331 16.1 Introduction 331 16.2 The cost of staying in business 332 16.3 Operational risk control and the administrative budget 334 16.4 Are mergers and disinvestments a good way to cut costs? 338 16.5 Why fat executive options work against shareholder value 341 16.6 What it means to be in charge of re-engineering 343 16.7 Establishing and sustaining a transnational advantage 346 16.8 Capitalizing on the evolving role of financial instruments 348