Chapter 8: Operational Risk Flashcards
Operational Risk Definition
The risk of loss resulting from inadequate or failed…
* internal processes,
* people,
* systems,
* or external events
It encompasses a wide range of potential losses, from minor errors to major fraud or system failures.
Basel II definition excludes reputational and strategic risks, but these can be severely impacted by operational risk events.
Conduct Risk
- The risk that a bank’s actions result in negative outcomes for its customers.
- Subset of operational risk, but often managed separately due to its potential severity.
- Driven by factors like:
1. misaligned incentives,
2. conflicts of interest,
3. inadequate customer understanding. - Regulators are increasing focus emphasising fair treatment and suitable products for customers.
Operational Risk Measurement
- Involves collecting and analysing historical loss data, often stored in an internal loss database.
- Data qualities: captured consistently, with appropriate frequency and level of detail.
- Basel standards categorise operational risk events into seven Level 1 categories, further broken down into Level 2 and Level 3 categories.
- Loss amounts are typically collected above a certain threshold, ensuring material risks are captured.
Operational Risk Capital Measurement Approaches
Basic Indicator Approach (BIA):
* Capital is a fixed percentage of average annual gross income.
* Simple but not risk-sensitive.
Standardized Approach (TSA):
* Capital is calculated based on gross income from different business lines, each with a specific beta factor.
* More risk-sensitive than BIA.
Advanced Measurement Approach (AMA):
* Banks use internal models to estimate operational risk capital.
* Requires robust data and sophisticated modeling capabilities.
Basel III - New Standardized Approach (NSA):
* Replaces existing approaches from 2023.
* Uses a business indicator and internal loss multiplier to calculate capital requirements.
* Aims to be more risk-sensitive and comparable across banks.
Anti-Money Laundering (AML)
and Know Your Customer (KYC)
- AML aims to prevent criminals from disguising illegally obtained funds as legitimate income.
- KYC requires banks to verify customer identities and monitor transactions for suspicious activity.
- Banks should adopt a risk-based approach to AML/KYC, with enhanced due diligence for higher-risk customers.
- Regulators play a crucial role in setting and enforcing AML/KYC standards.
Anti-Money Laundering (AML) Definition
The prevention of criminals disguising illegally obtained funds as legitimate income.
AML Process
- Placement: Illegal funds are introduced into the financial system.
- Layering: The origin of funds is concealed through complex transactions.
- Integration: Disguised funds are used for legal purposes.
AML Key Organisations
- BCBS (Basel Committee on Banking Supervision): Sets standards and guidelines for combating money laundering and terrorist financing.
- FATF (Financial Action Task Force): An inter-governmental body that develops and promotes AML/CFT (Combating the Financing of Terrorism) policies.
- FATF 40 Recommendations: A comprehensive set of guidelines for countries to implement effective AML/CFT measures.
Bank’s Role in AML
- Risk-Based Approach: Identify and assess risks associated with different customer types and transactions.
- Customer Due Diligence (CDD): Verify customer identities and monitor transactions.
- Suspicious Transaction Reporting (STR): Report unusual activity to relevant authorities.
- Record Keeping: Maintain accurate records of customer information and transactions.
AML Lines of Defense
- 1st Line: Business units responsible for implementing AML/CFT controls.
- 2nd Line: Independent oversight by compliance and risk management functions.
- 3rd Line: Internal or external audit provides assurance on the effectiveness of AML/CFT measures.
Categories of Operational Risk
ICES FED
- Internal fraud
- Clients, Products, and Business Practices
- External fraud
- employment practices and workplace Safety
- Business disruption and system Failures
- Execution, Delivery, and Process Management
- Damage to Physical Assets
