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Class 6 Operational risk

Class 6 Operational risk. What did we learn from the JPMorgan case?. What are the sources of operational risk?. Risk arising due to deficiencies or mistakes from: Internal procedures (control systems) Personnel Information systems and technologies External events.

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Class 6 Operational risk

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  1. Class 6Operational risk

  2. What did we learn from the JPMorgan case?

  3. What are the sources of operational risk? Risk arising due to deficiencies or mistakes from: • Internal procedures (control systems) • Personnel • Information systems and technologies • External events • Internal Fraud - misappropriation of assets, tax evasion, bribery • External Fraud - theft of information, hacking damage, third-party theft/forgery • Employment Practices & Workplace Safety - discrimination, compensation, … • Clients, Products, & Business Practice - market manipulation, antitrust, product defects, fiduciary breaches, account churning • Damage to Physical Assets - natural disasters, terrorism, vandalism • Business Disruption & Systems Failures - utility disruptions, soft/hardware failures • Execution, Delivery & Process Management - data entry errors, accounting errors, failedmandatoryreporting, negligentlossofclientassets

  4. What is special about operational risk? • Company-specific • Inverse relation between expected loss and probability of occurrence • HFLS: high frequency, low severity • LFHS: low frequency, high severity • Intentional (fraud) vs unintentional (mistakes) • Hard to quantify • Especially intentional LFHS • Interaction with market and credit risk • Role of human factor

  5. Baringsand Nick Leeson • 1992: Leeson was appointeda generalmanageroffutures operationsinSingapore • Had to do futures arbitrage between Singapore and Osaka, but started speculative trades • He also kept a position of ChiefTraderresponsibleforsettlinghistrades • Booked losing trades to account 88888 • End 1992: hidden losses of £2 mln • End 1994: hidden losses of £208 mln • Jan 1995: earthquake in Kobe, massive margin calls • The bank lost over $1 bln, was sold for $1 to ING

  6. Red flags • Concentrationofpower • Controlofthetradingfloorandbackroomsettlements • Concentration of cash flows • Onetenthofthepre-taxprofitsgeneratedbyBaringsin 1993 • Undiscovered by the internalauditin 1994 • Transferofover 25%ofabank'ssharecapitaloutofthecountryduring 1993 and 1994 • Undiscovered by theBankofEngland

  7. Leeson: personal fate • ‘I wasn’t running the position anymore. The position was running me.’ • ‘I’ve never felt lonelier in my whole life.’ • Ran away and was caught in the airport • Sentenced to 6.5 years in Singapore, released from prison in 1999 (cancer) • Divorced with his wife (and married a new one). • “Despite rumours of secret bank accounts and hidden millions, I did not profit personally from my unlawful trading. • To be absolutely honest, sometimes I wish I had.” • He is a regular guest on the after-dinner speaking circuit. • He still finds time to deal in the stock markets, but only with his own money. • Two books: Rogue Trader and Back from the Brink: Coping with Stress

  8. SocieteGenerale and Jerome Kerviel • 2000: started to work at SocGen, back-office • 2004: moved to DeltaOne doing long-short trades • Futures on European stock indices • Many large-volume transactions • 2005: made an unhedged bet on markets falling, covered with fictitious opposite trades • Earned €500,000 after terror acts in London • By end-2007, earned over €1.4 bln • Hid using netting of real and fictitious trades (cracked bank’s IT system) • Nov 2007: Eurex warned SocGen about its ‘non-standard’ operations • Jan 18: bank controllers discovered unhedged positions of €50 bln • The bank had to close them in Jan 21-23 with the loss of €4.7 bln

  9. Bernard L. MadoffInvestmentSecurities LLC • Oneofthetopmarketmakers (US#6 in 2008) and "third-market" providers (directexecution of ordersfromretailbrokers) • Оne of the founders of NASDAQ, once chairman of the NASD • Since 1980s: investment advisory business • Clients put their money to the brokerage account with discretionary mandate for trading by BMIS (usually indirectly, via one of feeder funds) • Clients: large banks, funds of funds, charities, wealthy individuals • Dec 10, 2008:Madofftoldhissonsthisis aPonzischemeor“onebiglie” • Paying off to old clients from the new clients’ inflows • Losing $50 bln, $300 mln remaining • Dec 11, 2008: FBI arrested Madoff and charged him with securities fraud • Largest losses: • Fairfield Greenwich Securities($7.50B),Tremont Capital Mgt ($3.3B), Banco Santander ($2.87B), Bank Medici ($2.1B), Fortis ($1.35B), HSBC ($1B), RBS ($260M), BNP Paribas (€350M), Nomura (¥27.5B)

  10. Red flags • Portfolio mgt, brokerage, custody and administration done within the firm • In any (mutual or hedge) fund these functions are done independently • Feeder funds had independent service providers, but relied on Madoff’s information • Obscure auditor: small firm managed by Madoff’s friend • Unusual “market rate” brokerage fee (no management/performance fee) • Little staff with many Madoff’s family members involved • No Madoff mention at the feeder funds • SEC registration as investment advisor only from 2006 (<15 clients) • (Almost) no access to Madoff'sstrategy or books(for duediligence) • In the beginning: S&P100 stocks & collar / convertible arb / futures • No onlineaccesstoclients’ accounts, statements sent by mail • Madoff returns were impossible to replicate • Modestbutsteadyreturns: around 10% with low volatility • Only 10 down months out of 215 • H. Markopolos sent many warning letters to SEC in 2001-2008 • Madoff was several times investigated by SEC for front running, nothing found

  11. 150 financial pyramids were uncovered in the US in 2009, with the total losses of $16b

  12. What we know about fraud from the surveys(see CIMA guide on fraud risk management) • Companies may be losing as much as 7% of their annual turnover as a result of fraud • Corruption is estimated to cost the global economy about $1.5 trillion each year • Only a small percentage of losses from fraud are recovered by organisations • A high percentage of frauds are committed by senior management and men • Greed is one of the main motivators for committing fraud • Fraudsters often work in the finance function • The prevalence of fraud is increasing in emerging markets

  13. In-class discussion • How to design a fraud scheme in a bank? • Corporate loans • Retail loans • Trading • …and how to deter it? • How to prevent fraud? • How to detect fraud? • How to respond to fraud?

  14. How to quantify operational risk? • Key performance indicators • E.g., # wrong operations • Key control indicators: • E.g., # prevented mistakes • Key risk indicators • Forecast OR based on performance and control indicators • Identifying anomalies • Analysis of P&L volatility unexplained by market and credit risk • Causal models • Measure losses using conditional probabilities

  15. How to manage operational risk? • Several layers of control • Line managers • Risk managers • Internal control • No conflicts of interests • Double checking • External control • Confirmation and audit • Financial transactions system • Front / Back / Middle-office • Information system • Data bases, software • Security, aggregation, interaction • Ethics culture

  16. How is usually fraud detected?

  17. Do you agree? “Moral is not priced in the markets”

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