Operational Risk

Question 1

What other 4 risks does operational risk include?

Answer 1

It includes:
1) legal risk
2) fraud
3) physical risk,
4) environmental risk

Question 2

What is the primary goal of Basel

Answer 2

It is to identify and measure risks that FI face

Question 3

How can banks mitigate against operational risk ?

Answer 3

They can set aside enough capital (ensures buffer to absorb losses)

Question 4

What other risks is operational risk integrated with?

Answer 4

Operational risk is integrated with Credit risk and Market risk

Question 5

What two risks can it be hard to differentiate between?

Answer 5

Operational risk and Market risk

Question 6

What did Basel III aim to do?

Answer 6

It aimed to aimed to enhance internal processes of FI (identify and mitigate OR)

Question 7

What are the main sources of operational risk?

Answer 7

1) People risk
2) Internal operations
3) External events
4) Systems risk

Question 8

What is people risk?

Answer 8

It is employee behaviour

Question 9

What causes people risk?

Answer 9

1) Overworked
2)underpaid
3) poorly trained
employees

Question 10

What may cause internal processes (/operations) risk?

Answer 10

1) Overlap of responsibilities (may duplicate or fail to act)

2) Procedures have loopholes (employees can exploit for personal gain)

3) Moral hazard (take more risks because they don’t bear the full consequences

Question 11

What are external events?

Answer 11

These are things that are Beyond control of FIs

Question 12

What causes systems risk?

Answer 12

1) FIs have many systems and components

2) Poorly designed systems – malfunction

3) Heavily reliant on IT – vulnerable to cyber-attacks and viruses

Question 13

What are the 4 ways operational risk ca be managed?

Answer 13

1) Risk avoidance – refrain from activities

2) Risk reduction – determine probability and severity

3) Risk sharing – insurance

4) Risk retention – accept it and move on

Question 14

Why did stres testing become particularly significant during the financial crisis?

Answer 14

Because it is forward looking

Question 15

What is stress testing used for?

Answer 15

It is used to determine the ability of banks to handle crisis

Question 16

What did stress testing result in?

Answer 16

Stress testing resulted in stricter capital requirements - higher and better-quality capital

Question 17

What is the standardized approach?

Answer 17

It is an extension of the basic indicator approach that allows banks to divide activities into eight business lines and apply a weight

Question 18

What are the 4 steps of the Loss distribution approach?

Answer 18

1) Estimate severity:
in theory easy to collect – in practice difficult and inaccurate due to
reporting bias

2) Estimate frequency:
use statistical model to predict how often event will occur – Poisson distribution

3) Capital charge:
how much to set aside to meet Basel requirements – Monte Carlo simulations

4) Confidence interval:
keep capital between a certain range and attach probability to value in range