Operational risk is a relatively young field: it became an independent discipline only in the past 20 years. Banks hold capital to absorb possible losses from their risk exposures, and the process of capital budgeting for these exposures, including operational risk, is a key component of bank risk management. Gross Income = Net Interest Income + Commission and Discount Income + Other Operating Income + Exchange Fluctuation Income +/- Interest Suspense during the period. Advances in data and analytics can help. LD Mahat is a Chartered Accountant, Financial Adviser and Risk Management Specialist possessing over 25 years of diverse experience across several sectors covering a wide spectrum of assurance, business advisory and taxation disciplines. While banks have been aware of risks associated with operations or employee activities for a long while, the Basel Committee on Banking Supervision (BCBS), in a series of papers published between 1999 and 2001, elevated operational risk to a distinct and controllable risk category requiring its own tools and organization. Russia, as well as in two banks under consideration; to establish . Banks should assess the feasibility of alternative risk limitation and control strategies. The regulations that emerged from the global financial crisis and the fines that were levied in its wake triggered a wave of change in risk functions. Second, operational-risk management requires oversight and transparency of almost all organizational processes and business activities. Risks are inherent in any kind of business including banking. These banks may use the gross The areas where the function will help execute business strategy include operational strengths and vulnerabilities, new-product design, and infrastructure enhancements, as well as other areas that allow the enterprise to operate effectively and prevent undue large-scale risk issues. Pages 103-120 Aggressive adoption of technology for delivering financial In order to qualify for the Standardized Approach, a Bank mus meet number of qualitative standards. 2 The future of bank risk management. Banks are continuously improving their approach to manage key operational risks such as cyber attacks, fraud losses, third-party service providers and model risk. As a pro-active partner to senior management, ORM's value lies in supporting and challenging them to align the business control environment with the bank's strategy by measuring and mitigating risk exposure, contributing to optimal return for stakeholders. The overall objective is to create an operational-risk function that embraces agile development, data exploration, and interdisciplinary teamwork. model to calculate the required capital, subject to, of course, supervisory Learn how your comment data is processed. Additionally, they miss low-frequency, high-severity events, such as misconduct among a small group of frontline employees. The future of bank risk management 3 By 2025, risk functions in banks will likely need to be fundamentally different than they are today. Address training needs across the bank's three lines of defense and maintain a strong operational risk management program. To this end real-world examples and case studies are used throughout. This class of risks has unlimited downside and can expose an institution to serious financial and reputational losses, as evidenced in recent well-publicized large corporate failures around the world. In addition, reputational risk that may arise out of customer claim, staff-claim and regulators’ claim may have to be addressed. Sharifi et al. Oct 2014 Operational risk - … Practical resources to help leaders navigate to the next normal: guides, tools, checklists, interviews and more, Learn what it means for you, and meet the people who create it, Inspire, empower, and sustain action that leads to the economic development of Black communities across the globe. This is because the controls are fundamentally reliant on manual activities. Untransformed operational-risk-management functions have limited insight into the strength of operational processes or they rely on an extensive inventory of controls to ensure quality. Without a new approach to compliance and operational risk management, many banks will continue to face high costs and losses in the form of escalating litigation, penalties, and staffing needs. At the same time, digitization and automation have been changing the nature of work, reducing traditional human errors but creating new change-management risks; fintech partnerships create cyberrisks and produce new single points of failure; the application of machine learning and artificial intelligence (AI) raises issues of decision bias and ethical use of customer data. Together with the business lines, operational-risk management can identify and shape needed investments and initiatives. The financial crisis precipitated a wave of regulatory fines and enforcement actions on misselling, questionable mortgage-foreclosure practices, financial crimes, London Inter-bank Offered Rate (LIBOR) fixing, and foreign-exchange misconduct. tab. Risk is as the probability of incurring a loss or damage because of actual outcome being different from the expected outcome. average gross income cannot be measured reliably, they shall also be required Operational Risk Management is a methodology for organizations looking to put into place real oversight and strategy when it comes to managing risks. To manage these risks—in areas such as technology, data, and financial crime—banks need specialized knowledge and tools. They must help them adapt to process-driven risk management and understand the potential applications of advanced analytics. For management purposes, risks are usually divided into categories such as operational, financial, legal compliance, information and personnel. They first determine which groups within the organization present disproportionate human-factor risks, including misconduct, mistakes with heavy regulatory or business consequences, and internal fraud. The advantages for financial-services firms that manage to do this are significant. the so computed capital charge for Operation Risk, during the first three years Working in Operational Risk Management is a unique opportunity and establishes a great foundation for a banking career, as risk officers are exposed to the broad scope of the bank and its operations. NRB has prescribed this approach for measurement of operational risk. Taken together, these factors explain why operational-risk management remains intrinsically difficult and why the effectiveness of the discipline—as measured by consumer complaints, for example—has been disappointing (Exhibit 2). 3 Theft and fraud. Please use UP and DOWN arrow keys to review autocomplete results. For example, one global bank tackled unacceptable false-positive rates in anti–money laundering (AML) detection—which were as high as 96 percent. The increased competition resulting operational risk includes several other risks (such as interest rate, liquidity, and strategic risk) that banks manage and does not lend itself to the management of operational risk per se. These risks have more to do with culture, personal motives, OPERATIONAL RISK MANAGEMENT IN BANKS: THE WAY FORWARD. Controls, however, are not effective in monitoring process resilience. Abstract. This risk management framework would act as a guidance mechanism for the bank. Unlike external risk due to events such as market volatility, geopolitical risk, or systemic risk, operational risk is internal—meaning that banks have quite a bit of control over these risks. The approach is expected to reduce The quantification of operational risk is difficult, as it is difficult to build a clear mathematical or statistical link between individual risk factors and the likelihood of a loss. Banks are expected to identify and assess the operational risks in all the existing products and services and systems before formulating a clear-cut policy. Importance of operational risk as part of the firm’s risk inventory Operational Risk: Operational risk is defined as any risk which is not categorised as market or credit risk. cookies, McKinsey_Website_Accessibility@mckinsey.com, Pathways to vulnerability (such as the impact of a threat like NotPetya), The bank’s most valuable assets (the “crown jewels”), Sources of exposure for a given organization, Senior status to engage the business and technology organizations, Fraud patterns (for instance, through the dark web), Interdependencies across fraud, cybersecurity, IT, and business-product decisions, Cybersecurity professionals, ideally with an analytics background, Ways employees can game the system in each business unit (for instance, retail, wealth, and capital markets), Specific behavioral patterns, such as how traders could harm client interests for their own gain, Former branch managers and frontline supervisors, First-line risk managers with experience in investigating conduct issues. Improving the reliability of business operations 2. And they are hard to quantify and prioritize in organizations with many thousands of employees in dozens or even hundreds of functions. Expertise needed for challenge and oversight. An example is when a teller accidentally gives an extra $50 bill to a customer. Nonetheless, data availability and the potential applications of analytics have created an opportunity to transform operational-risk detection, moving from qualitative, manual controls to data-driven, real-time monitoring. In the first decade of building operational-risk-management capabilities, banks focused on governance, putting in place foundational elements such as loss-event reporting and risk-control self-assessments (RCSAs) and developing operational-risk capital models. Developing effective risk-oversight frameworks for human-factor risks is not an easy task, as these risks are diverse and differ from many other operational-risk types. the year, in which annual gross income is negative or zero, should be excluded This critical component of modern risk management solutions is the secret behind the advanced risk insights and predictions which these solutions can provide to an organization. Additionally, training, consequence management, a modified incentive structure, and contingency planning for critical employees are indispensable tools for targeting the sources of exposure and appropriate first-line interventions. Certificate in Operational Risk Management Banks are continuously improving their approach to manage key operational risks such as cyber attacks, fraud losses, third-party service providers and model risk. Using operational risk management as a competitive differentiator. In parallel with industry developments, BCBS proposed in 2001 that an explicit capital charge for operational risk be incorporated into the new Basel Capital Accord. 1. Banks, over a period, should develop internal systems to evaluate the risk profile and assign economic capital within the RAROC framnework. The operational-risk discipline needs to evolve in four areas: 1) the mandate needs to expand to include second-line oversight, to support operational excellence and business-process resiliency; 2) analytics-driven issue detection and real-time risk reporting have to replace manual risk assessments; 3) talent needs to be realigned as digitization progresses and data and analytics are rolled out: banks will need specialists to manage specific risk types such as cyberrisk, fraud, and conduct risk; and 4) human-factor risks will have to be monitored and assessed—including those that relate to misconduct (such as sexual harassment) and to diversity and inclusion. This risk can be mitigated by proper planning for identification of target areas, markets, products, customer base, etc. Please email us at: McKinsey Insights - Get our latest thinking on your iPhone, iPad, or Android device. For managing operational risks in banking, it is crucial to implement a proper risk management framework in place. The Basel Committee on Banking Supervision defines operational risk “as the risk of loss resulting from inadequate or failed internal processes, people and systems or … It can also be defined as the risk of loss resulting from inadequate or failed internal process, people and systems or from external events. Reporting into the Operational Risk Management – Global Consumer Group - Technology Risk Managing Director, the Director – Digital Bank will have oversight responsibility for the US Consumer Digital (USCD) Bank operations supporting the Global Consumer Group (GCG). LD has worked on large projects jointly with big 4 international accounting firms ~ PwC, Deloittee, Ernst & Young and KPMG in the field of Assurance, Diagnostic Review, Capacity Building, e-Government Procurement, e-Governance, Special Review, Investment Climate, and IFRS Implementation. Select topics and stay current with our latest insights, The future of operational-risk management in financial services. Bank employees carry out many of the operational-risk-related functions such as regulatory compliance, finance management, frauds, IT, legal, and insurance. We are excited to inviting you at our upcoming “2nd Annual Global Operational Risk Management in Banking Summit” that will be taking place in Vienna this coming September. The cases for change are in fact diverse and compelling, but transformations can present formidable challenges for functions and their institutions. Such a framework needs to be reinforced through a strong control culture that promotes sound risk management practices. Against these challenges, risk practitioners are seeking to develop better tools, frameworks, and talent. Firstly, the frequent, small operational losses that may result from human error, which are quite common to all businesses. The adoption of new technologies and the use of new data can improve operational-risk management itself. While the industry succeeded in reducing industry-wide regulatory fines, losses from operational risk have remained elevated (Exhibit 1). Operational risk examples include a check incorrectly cleared, or a wrong order punched into a trading terminal. Operational risk must keep up with this dynamic environment, including the evolving risk landscape. So, data limitations and lack of analytical tools are contributing factors. Download it once and read it on your Kindle device, PC, phones or tablets. Nepal Rastra Bank (NRB) has issued Risk Management Guidelines for commercial banks on improving risk management systems. With specialized talent in place, banks will then need to integrate the people and work of the operational-risk function as never before. By following this framework, the bank can assess compliance with risk management policies and guidelines. In recent years, conduct issues in sales and instances of LIBOR and foreign-exchange manipulation have elevated the human factor in the nonfinancial-risk universe. The objective is for operational-risk management to become a valuable partner to the business. Losses that occur due to human error include internal fraud or mistakes made during transactions. The relationship between operational-risk management and the business can also integrate operational-risk reporting and executive and board reporting—including straight-through processing rates, incidents detected, key risk indicators, and insights from complaints and customer calls. Such risk is a Bank’s exposure to losses arising from mistakes (such as computer failure and breach of regulations) and conspiracies (including loan fraud and embezzleme… Similarly, in tab, Travel, Logistics & Transport Infrastructure, McKinsey Institute for Black Economic Mobility. Banks should address process risk arising out of transaction processing, errors in execution of transactions, complexity of procedures etc. Theft and fraud jumps to third in this year’s survey – a sign of both its ubiquity for … approval on the following: This approach requires banks to estimate Expected Loss (EL) and Unexpected Loss (UL) at a 99.9th percentile confidence level over one year holding period using 5-year’s operational loss event data (internal as well as external) through statistical analysis. Since there is a close linkage of operational risk with other types of risks, it is very important for banks to first have a clear understanding of the concept of operational risk before designing the appropriate operational risk measurement and management framework. In this article how risk management in banks is an important concept, what type of risks banks faces and how they curb it through risk management model is desc… Slideshare uses cookies to improve functionality and performance, and to provide you with relevant advertising. Such standards include organization, management and control, audit, and systems. Every endeavor entails some risk, even processes that are highly optimized will generate risks. The maturity of operational risk varies by industry but one constant is a greater awareness and appreciation across boards and C-suite executives to better recognize, manage, and understand operational risk management steps. Lack of such a planning may pose a significant risk to the earnings and viability of a bank. As part of the revised Basel framework,1 the Basel Committee on Banking Supervision set forth the following definition: Operational riskis defined as the Is our change-management process robust enough to prevent disruptions? of operational risk management in the bank used abroad and in . These … To be effective, operational-risk management needs to change these assumptions. Despite its pervasive nature, many organizations treat the operational risk process as an obligation, adding more risk to an already risky endeavor. He was risk management specialist in several Asian Development Bank Funded projects. As the potential for human-factor risks to inflict serious damage has become more apparent, however, banks are recognizing that this oversight must be included in the operational-risk-management function. As per NRB directives, banks should develop a regular reporting of the information to senior management and the board of directors that supports the proactive management of operational risk. But, based on the reasonableness of Therefore, to compute their capital charge for operational risk vide the same approach as Operational risk management in banks. By helping the business meet its objectives while reducing risks of large-scale exposure, operational-risk management will become a creator of tangible value. and complex. As the field level functionaries who originate the transaction will loose track of the monitoring role and when the data is processed elsewhere, the operational risk monitoring at the unit level remains weak. Address training needs across the bank's three lines of defense and maintain a strong operational risk management program. Learn more about cookies, Opens in new Use minimal essential Please try again later. Many organizations have thus viewed operational-risk activities as a regulatory necessity and of little business value. This summit will equip professionals from banking industry with the appropriate strategies to stay up to date in the regulations and the world of digitalization. This last constraint has been lifted in recent years: granular data and measurement on operational processes, employee activity, customer feedback, and other sources of insight are now widely available. The operational-risk-management function should help chief risk officers and other senior managers answer several key questions, such as: Have we designed business processes in each area to provide consistent, positive customer outcomes? Implementation of conceptually sound risk management system with integrity. Operational risk can also result from a break down of processes or the management of exceptions that aren't handled by standard processes.It should be noted that some definitions of operational risk suggest that it's the result of insufficient or failed processes. Download for offline reading, highlight, bookmark or take notes while you read Operational Risk Management in Banks: Regulatory, Organizational and Strategic Issues. The operational type of risk is low for simple business operations such as retail banking and asset management, and higher for operations such as sales and trading. Based on the op risk concerns most frequently selected by those practitioners, we present our ranking of the top 10 operational risks for 2017. The journey is difficult—it requires that institutions overcome challenges in data aggregation and building risk analytics at scale—yet it will result in more effective and efficient risk detection. the capital charge for well-managed Banks. 7. Publications and updates by the Basel Committee on Banking Supervision (BCBS), including on topics related to the Basel II Framework and its implementation. The accumulated experience indicates that there are two broad categories of operational losses. Whether in information security, data, compliance, technology and systems, process failure, or even personal security and other human-factor risks, the advanced-analytics advantage is becoming increasingly evident. If you would like information about this content we will be happy to work with you. We strive to provide individuals with disabilities equal access to our website. Do these processes operate well in both normal and stress conditions? Ideally, Gross Income for Trading and Sales, Retail Banking, and Commercial Banking would be “Interest Income + Profit on sales + Fee-based Income – Weighted average cost of funding for these business lines”; whereas Gross Income for remaining business lines would be fee-based income only, as no funding cost is involved in these business lines. Together, analytics and real-time reporting can transform operational-risk detection, enabling banks to move away from qualitative self-assessments to automated real-time risk detection and transparency. The operational risk assessment should be bank-wide basis and it should be reviewed at regular intervals. Until Basel II reforms to banking supervision, operational risk was a residual category reserved for risks and uncertainties which were difficult to quantify and manage in traditional ways – the "other risks" basket.. Within reach is more targeted risk management, undertaken with greater efficiency, and truly integrated with business decision making. Joseba Eceiza is a partner in McKinsey’s Madrid office; Ida Kristensen and Dmitry Krivin are both partners in the New York office, where Hamid Samandari is a senior partner; and Olivia White is a partner in the San Francisco office. They clearly define ORM roles throughout the bank … So, human error, system failures, and inadequate controls and procedures in information systems or internal controls cause operational risk to the Bank. effective operational risk management is critical to the well-being of the Banks often resort to the process of risk assessment in terms of “high, medium and low” rather than attempts at quantitative measurement. For this purpose investments shall comprise of Until Basel II reforms to banking supervision, operational risk was a residual category reserved for risks and uncertainties which were difficult to quantify and manage in traditional ways – the "other risks" basket.. Such tools have been ineffective in detecting cyberrisk, fraud, aspects of conduct risk, and other critical operational-risk categories. While no doubt, the unit level functionaries will be able to obtain reports at the end of the day of all the transactions processed for the branch, it will be too late to retrieve any fraudulent transactions that might have gone through. Risk management is: ‘A process of understanding and managing the risks that the entity is inevitably subject to in attempting to achieve its corporate objectives. A sound internal control system is very important for a bank’s ability to meet its established corporate objectives and maintain financial viability. See Basel Committee on Banking Supervision: Working paper on the regulatory treatment of operational risk, Bank for International Settlements, September 2001, bis.org. The Operational Risk Support team oversees bank-wide programs to help senior management in identifying, assessing, and monitoring key risks and related controls. A risk of loss arising from various types of human or technical error; Risk associated with settlement or payment risk and business interruption and legal risk; Risk of fraud by employees and outsiders; unauthorized transaction by employees and errors relating to computer and telecommunication systems; The potential exposure to missed opportunity or to unexpected financial, reputational, or other damage resulting from the way in which an organization operates and pursues its business objectives; and. Different types of operational risk in Banking Sector The Basel Committee has identified the following types of operational risk … This would include efforts to digitize operations to remove manual errors, changes in the technology infrastructure, and decisions on product design and business practices. Operational Risk Management in Banks: Regulatory, Organizational and Strategic Issues - Ebook written by Giuliana Birindelli, Paola Ferretti. They are adopting data-driven risk measurement and shifting detection tools from subjective control assessments to real-time monitoring. PERSPECTIVE. ensure that adequate controls and systems are in place to identify and address problems before they become major concerns. 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Select topics and stay current with our latest insights, the world largest! Requirements for operational risk management in banks: the WAY FORWARD download once! Using appropriate strategies, in light of their overall risk appetite and profile it... Are also a potential source of operational risk is as the probability of incurring a loss damage. On banks ’ internal calculations of the bank 's three lines of defense and maintain strong. In two banks under consideration ; to establish a cause for operational risk process as an obligation, adding risk! Business lines and to manage different business lines and to manage these risks—in such... Applications in all the existing products and services and systems before formulating a clear-cut policy app your... A framework of formal, written policies and procedures used to improve operations for competitive advantage increased! Sales force in both normal and stress conditions including maintaining a comprehensive risk... 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