Operational, Financial, and Strategic Risk CHAPTER 4

What is Operational Risk?  Generally considered the risk incurred by the organization’s internal decisions and activities.  Definition varies by industry and organization  Financial institutions and their regulators define operational risk as any risk that is not market risk or credit risk, which would include hazard risk;  Basel II defines operational risk as the risk of loss from inadequate or failed internal processes, people and systems, or from external events;  Other organizations view hazard risk and operational risk as separate categories;  Regardless of definition, an organization should categorize four elements that may cause operational risks:  People  Process  Systems  External events

Why the recent emphasis on operational risk? Losses in the financial services sector Corporate losses and threats in several industries Advances in technology and expectations for precision Business complexity Natural and terrorist catastrophes (III Fact book, p ) – plus global supply chain Increased competition and tighter profit margins Increased regulation Insurance environment and trends in risk management E-commerce

How can risk managers mitigate People risk? Recruitment to identify the correct skills needed Due diligence in hiring selection procedures with background checks, testing, legal guidelines, etc. Train employees to perform professionally Manage and reinforce employee behavior Provide infrastructure to achieve desired behavior by employees Have Executive succession plan

Process Risk Includes the procedures and practices organizations use to conduct their normal activities; managing these risks includes a framework of procedures and a mechanism to make sure firm operates within stated procedures A risk often occurs at the point at which a practice departs from a procedure E.g., failure to document an employee’s harassing comments and later have wrongful termination claim

Systems Risk Risks associated with equipment and technology, including software and intentional and accidental failure and security risks. Eg., a data breach at a financial organization in which customer identification and records are stolen can cause large loss and possibly bankrupt the firm.

External Events that May lead to Operational Risk Natural disasters that may lead to business interruption or property loss Loss of main customer customer Loss of key supplier Utility failure or inadequacy or loss of other infrastructure (e.g., road in front of business is closed due to construction for six months) Software changes

Key Risk Indicators (KRIs) for Operational Risk Categories KRIs by class of people: ◦Education ◦Experience ◦Staffing levels ◦Employee surveys ◦Customer surveys ◦Compensation and experience ◦Bonus incentives ◦Authority levels ◦Management experience

Key Risk Indicators (KRIs) for Operational Risk Categories (cont.) KRIs by class of processes  Quality scorecards  Analysis of errors  Areas of increased activity or volume  Review of outcomes  Internal and external review  Identification of areas of highest risk  Quality of internal audit procedures

Key Risk Indicators (KRIs) for Operational Risk Categories (cont.) KRIs by class of systems:  Benchmarks against industry standards  Internal and external review  Analysis to determine stress points and weaknesses  Identification of areas of highest risk  Testing  Monitoring

Financial Risk  Financial Risk - uncertainty involving a myriad of risks including financing and financial transactions;  Study of financial risk has evolved under the theme of modern portfolio theory that was initiated by Dr. Harry Markowitz in 1952, which used variance and standard deviation of a portfolio as the measurement of risk.  Purpose of the study of financial risk is to optimize the relationship between risk and return.  Hedging – holding one asset to offset the risk associated with another  Futures contracts -  E.g., holding a futures contract to lock in the price of fuel when an airline company anticipates rising fuel prices   Khan Academy has several good explanations  contracts/v/futures-introduction

Major Types of Financial Risk: 1. Market Risk  Results from changes in the value of financial instruments  Major categories:  Currency Price risk – changes in exchange rates  E.g., Value of euro (currency was “born in 1999 and notes and coins began to circulate in 2002)   $1 = 1.34 eu 9/17/13  $1 = eu 9/15/08  $1 = eu 9/2003 Interest Rate risk – the risk that future values may decline due to changes in interest rates;  This is an important risk to insurers as their investments are often held in bonds and insurers are dependent on investment income to pay claims;  Products such as swaps may be used to handle this type of risk;  Swap – an agreement between two organizations to exchange pmts based on the value of an asset, yield, or index over a specified time period. rate-swap-1http:// rate-swap-1  LIBOR – London Interbank Offered Rate  Zero Coupon Bond

2. Credit Risk  Also called default risk  Has only negative connotation  Selling Loans to investors was the RM practice of many banks  Packaging loans and selling pieces as securities – securitization of mortgages  pagewanted=all pagewanted=all

3. Price Risk  The potential change in revenues due to a change in price of a product or raw material;  Two features:  The price charged for the product or service  The price of assets purchased or sold by an organization.

Value at Risk and Earnings at Risk To discern how to allocate RM resources, the RM should determine the range of potential financial outcomes. Value at risk – the possibility of a loss of an investment’s value exceeding a pre-determined threshold. ◦Typically a low probability; ◦E.g., a one-day 5% VaR of $300,000 means there is a 5% probability of losing $300,000 or more over the next day. Earnings at risk – the maximum expected loss of earnings within a specific degree of confidence ◦Is determined by modeling and computerized statistical tests such as Mote Carlo simulations

Regulation of Insurers and Financial Entities Regulators are looking more closely at risk-based capital adequacy and regulatory capital since Risk capital is the minimum or reasonable level of capital required to provide a cushion against unexpected loss of economic value at a financial institution. ◦The required risk capital is usually within a confidence interval of 95%; ◦In 1988 the US joined other member nations of the Bank of International Settlements (BIS) to implement two risk-based capital ratios, called Tier ! And Tier 2 ◦These outlined Equity capital requirements and Leverage guidelines.

Economic Capital for Insurers The amount of capital required to maintain solvency – to have a Market value of surplus (MVS) greater than zero. Takes into consideration several risks faced by the insurer including the following: ◦Market risk (change in value of publicly traded assets) ◦Credit risk (defaulting on debt in the marketplace) ◦Liquidity risk (losses due to low net working capital) ◦Insurance risk (adverse loss experience or catastrophe losses) ◦Operational risk (losses due to failed internal processes)

Economic Factors to Consider in ERM GDP ◦Growth or recessionary era? Appropriate time to introduce new product Inflation ◦Large increases in inflation or deflation may cause firm to cut prices Financial Crises ◦Often limits credit for suppliers and customers International trade ◦Trade agreements and tariffs Demographics ◦Who will bear the burden for health care? Customers and suppliers? Political risk ◦Any government action that may favor domestic vs. foreign organizations operating in another country ◦E.g., Exxon getting $250 million settlement from Venezuela over Expropriated Assets in 2012 ◦