Operational, Financial, and Strategic Risk

1. Operational, Financial, and Strategic Risk Chapter 4

2. 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

3. 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. 124-5) – plus global supply chain • Increased competition and tighter profit margins • Increased regulation • Insurance environment and trends in risk management • E-commerce

4. How can risk managersmitigate 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

5. 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

6. 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.

7. 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

8. 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

9. 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

10. 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

11. 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 - http://www.youtube.com/watch?v=TClcxy4Ku28 • E.g., holding a futures contract to lock in the price of fuel when an airline company anticipates rising fuel prices • http://video.cnbc.com/gallery/?video=3000118005 • Khan Academy has several good explanations • http://www.khanacademy.org/economics-finance-domain/core-finance/derivative-securities/forward-futures-contracts/v/futures-introduction

12. 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) • http://www.oanda.com/currency/historical-rates/ • $1 = 1.34 eu 9/17/13 • $1 = 1.445 eu 9/15/08 • $1 = 1.126 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. http://www.khanacademy.org/economics-finance-domain/core-finance/derivative-securities/interest-rate-swaps-tut/v/interest-rate-swap-1 • LIBOR – London Interbank Offered Rate • Zero Coupon Bond

13. 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 • http://www.nytimes.com/2009/12/24/business/24trading.html?pagewanted=all

14. 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.

15. 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

16. Regulation of Insurers and Financial Entities • Regulators are looking more closely at risk-based capital adequacy and regulatory capital since 2008. • 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.

17. 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)

18. 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 • http://laht.com/article.asp?CategoryId=10717&ArticleId=471161