Operational Risk Management in Banking Sector: an Overview

ReseaRch stem Commerce great deal 3 Issue 1 January 2013 ISSN 2249-555X in operation(p) Risk Management in bank buildinging sphere of influence An every(prenominal) overview Keywords Rakesh Chutia Assistant, State aver of India Margheita-786181 Dist. -Tinsukia Assam ABSTRACT operative hazard is inseparable in all margeing products, activities and processes and brasss and the effective direction of running(a) take chances is of prevalent importance for e really briming companys board and senior trouble.With globalization and deregulation of financial marts, increase competition combined with the advent of in high spirits-end, innovative, educate engineering science tremendous changes clear taken place in the products statistical distribution channels and service delivery mechanism of the swaning sector. These have introduced to a greater extent complexities into the banking operations and consequently the jeopardy patterns and profiles of the industriou sness have also become complex, respective(a) and catastrophic. The New Capital Adequacy cloth of the Reserve Bank of India requires bank to maintain cracking explicitly towards operative endangerment.This paper tries to study the heterogeneous methodologies used by the banks in their functional put on the line counseling activity and to study the regulatory fabric related to working(a) chance management. mental hospital Since the late 1990s, globalization, deregulation, consolidation, outsourcing, breaking of geographical barriers by use of advanced technology, egression of e-commerce etc. have significantly changed the pipeline, economic and regulatory climate of the banking sector. These developments introduced more complexities into the activities of banks and their tryiness profiles.Consequently a series of high profile operational red events at Societe Generale, UBS, AIB, and National Australia Bank etc. have led banks and their managements knowledge domai n over to increasingly view operational danger management as an integral part of their hazard management activity like the management of market jeopardy and credit venture. The identification and measurement of operational risk is a significant issue for modern- solar day banks, particularly since the decision by theBasel Committee on Banking Supervision(BCBS) to introduce a uppercase dash for this risk as part of the new capital adequacy mannikin (Basel II). operable risk has been defined by the Basel Committee on Banking Supervision as the risk of loss outcomeing from inadequate or failed congenital processes, people and systems or from orthogonal events. This definition is based on the underlying causes of operational risk. It seeks to station the causes of a loss event and at the broadest level includes the breakdown by four causes people, processes, systems and external chemical elements. Operational risk whitethorn materialise directly, e. g. , in electronic fund t ransfer (transfer of funds to the wrong person) or could result indirectly as a credit or market loss.Since at that place is a close linkage of operational risk with other(a) typefaces of risks, it is very important for banks to first have a clear understanding of the model of operational risk before designing the appropriate operational risk measurement and management framework. Different types of operational risk in Banking Sector The Basel Committee has identified the following types of operational risk events as having the capableness to result in substantial losses for banks Internal fraud. For example, intentional misreporting of positions, employee theft, and insider duty on an employees own account. Externalfraud. Forexample,robbery,forgery,chequekiting, and damage from computer hacking. Employment practices and body of work safety. For example, workers compensation claims, violation of employee health and safety rules, organised labour activities, contrariety clai ms, and general liability. Clients, products and transaction practices. For example, fiduciary breaches, misuse of confidential customer information, incorrect trading activities on the banks account, money laundering, and sale of unlicensed products. Damagetophysicalas sort outs. Forexample,terrorism,vandalism, earthquakes, fires and floods. Business disruption and system failures. For example, hardw atomic number 18 and softwargon failures, telecommunication problems, and utility-grade outages. Execution,deliveryandprocessmanagement. Forexample data entry errors, collateral management failures, incomplete legal documentation, and unauthorized access given to client accounts, non-client counterparty misperformance, and vendor disputes. OPERATIONAL jeopardize focal point PROCESS Operational Risk management generally encompasses the process of identifying risks to the bank, measuring exposures to those risks), ensuring that an effective capital planning and remindering prog ramme is in place, monitoring risk exposures and check capital needs on an ongoing basis, taking steps to underwrite or mitigate risk exposures. Identification of operational risk. Banks should identify and measure the operational risk inherent in all products, services,activities,processesandsystems.You can canvass also Portfolio Management QuizzesEffectiverisk identification should consider both internal factors (such as the banks structure, the nature of the banks activities, the quality of the banks human resources, organizational changes and employee turnover) and external factors (such as changes in the industry and technological advances) that could adversely affect the achievement of the banks objectives. AssessmentofOperationalRisk. Inadditiontoidentifying the risk events, banks should assess their vulnerability to these risk events.Effective risk discernment allows a bank to better understand its risk profile and most effectively nates risk management resources. A mongst the possible tools that may be used by banks for assessing operational risk are ? Self Risk Assessment A bank assesses its operations and activities against a menu of potential operational risk vulnerabilities. This process is internally driven and oftentimes incorpo pass judgment checklists and/or workshops to identify the strengths and weaknesses of the operational risk environment. 6 X Indian JOURNAL OF APPLIED enquiry ReseaRch PaPeR Risk Mapping In this process, various business units, organizational functions or process flows are mapped by risk type. This instance can reveal areas of weakness and help prioritise subsequent management action. ? Key Risk Indicators Key risk indicators are statistics and/ or metrics, often financial, which can declare oneself insight into a banks risk position. Such indicators may include the number of failed trades, staff turnover rates and the frequency and/or severity of errors and omissions. Measurement. A key element of risk manage ment is measuring the size and scope of the banks risk exposures.However, there is no clearly established, single method to measure operational risk on a bank-wide basis. Banks may develop risk assessment techniques that are appropriate to the size and complexities of their portfolio, their resources and data availability. A good assessment model essential cover certain standard features. An example is the hyaloplasm approach in which losses are categorized according to the type of event and the business line in which the event occurred. Banks may value their exposure to operational risk using a variety of approaches.Forexample,dataonabankshistoricallossexperience could provide meaningful information for assessing the banks exposure to operational risk and developing a policy to mitigate/control the risk. MonitoringofOperationalRisk. Aneffectivemonitoring process is congenital for adequately managing operational risk. Banks should implement a process to regularly monitor operat ional risk profiles and material exposures to losses. In addition to monitoring operational loss events, banks should identify appropriate indicators that provide early warning of an increased risk of futurelosses.Such indicators should be forward-looking and could reflect potential sources of operational risk such as rapid growth, the unveiling of new products, employee turnover, transaction breaks, system downtime, and so on. There should be regular reporting of pertinent informationtoseniormanagementandtheBoardofDirectors that supports the proactive management of operational risk Controls/MitigationofOperationalRisk. Withregardto operational risk, several methods may be adopted for mitigatingtherisk. Forexample,lossesthatmightarise on account of natural disasters can be ascertain against. buttones that might arise from business disruptions due to telecommunication or galvanizing failures can be rationalise by establishing redundant backup facilities. Loss due to internal fac tors, like employee fraud or product flaws, which may be difficult to identify and insure against, can be mitigated through strong internal auditing procedures. The Board of Directors and senior management must make efforts for establishing a strong internal control culture in which control activities are an integral part of the regular activities of a bank.Banks should sporadically review their risk positation and control strategies and should adjust their operational risk profile accordingly using appropriate strategies, in light of their boilersuit risk appetite and profile. Investment in appropriate processing technology and information technology security are also important for risk mitigation. Banks should also have in place contingency and business continuity plans to ensure their ability to serve on an ongoing basis and limit losses in the event of severe business disruption.OPERATIONAL RISK MANAGEMENT APPROACHES IN BASEL II The Basel framework (2004) proposes a range of approaches for setting divagation regulatory capital for operational risk under Pillar 1 The staple fibre Indicator approach shot (BIA), The Standardised Approach(TSA)andtheAdvancedMeasurementApproach (AMA). Allthethreeapproachesdifferintheircomplexityand the banks are encouraged to remind on the spectrum of approaches as they obtain more sophistication in their risk management practices.The Basic Indicator Approach is the simplest approach for estimating regulatory capital, wherein slew 3 Issue 1 January 2013 ISSN 2249-555X banks are required to set by an amount equal to the average over the previous three years of 15% of positive annual gross income. In The Standardised Approach, banks activities are divided into eight business lines Corporate finance, Trading & Sales, retail Banking, Commercial Banking, Payment & Settlement, Agency Services, Asset Management and sell Brokerage.While gross income continues to be the main indicator of operational risk as under the Basic Indicator Approach, the specific amount to be set obscure as a percentage of the gross income varies between business lines, ranging from 12 to 18% , as compared to the 15% overall under the Basic Indicator Approach. This approach is more refined than the Basic Indicator Approach as it takes into the account the fact that some business lines are riskier than others and indeed a higher proportion of capital has to be set apart for those business lines.The Advanced MeasurementApproach(AMA)isbasedonthebanksinternalmodels to quantify operational risk. The framework gives flexibility to the banks in the characteristics of the choice of internal models, though it requires banks to demonstrate that the operational risk measures piece a soundness standard comparable to a one-year keeping period and a 99. 9% confidence level, which means that a banks capital charge should be equal to at least 99. 9% quantile of their annual aggregate loss distribution.Banks are required to fac tor in four key elementsindesigningtheirAdvancedMeasurementApproach framework internal loss data, external loss data, scenario analysis and bank specific business environmental and internal control factors. The methodologies under the advanced approach are evolving and there are a range of methods in practice in banks internationally. OPERATIONAL RISK MANAGEMENT IN THE CONTEXT OF INDIAN BANKING SECTOR The Reserve Bank of India is the regulator and supervisor of the banking system in India and is entrusted with the task of framing the capital adequacy guidelines for banks in India under Basel II.Public sector banks, where the Government of India is the major shareholder, rule the Indian banking system, accounting for nearly three-fourths of total assets and income. These banks are bighearted and very old banks, operating through thousands of branches spread all over the country. The new private sector banks are fully automated from day-one and operate like other high-tech foreign b anks. The private sector banks have grown rapidly since the onset of reforms and have increased their share in total assets of the banking industry, whereas the public sector banks have witnessed shrinkage in their market share.The public sector banks have only recently started automating their processes and operations. This transition has present significant challenges in the management of operational risk to the banks as introduction of new technology and complete overhauling of the existing systems requires a re-engineering of business processes, instruction of manpower, audit in a computerized environment and other related operational risk challenges. The new generation private sector banks on the other hand have to deal with the risks arising from growth at a scorchingpace.WiththereformsintheIndianbankingsectorand banks macrocosm allowed to access new markets and sophisticated products, the Reserve Bank of India has also been repeatedly advising the banks to have in place an effective and resilient control framework in place to manage operational risks. Specific guidance on management of operational risk has also been issued as per which some banks particularly the larger and internationally active banks are expected to move along the range towards more sophisticated pproaches as they develop more sophisticated operational risk management systems and practices which meet the prescribed qualifying criteria. termination ManagingOperationalRiskisemergingasanimportantelement of sound risk management practice in modern day banks in the wake of phenomenal increase in volume of transactions, high degree of structural changes and complex technological support systems. RBI expects all Indian banks to strengthen their operation risk management system and to INDIAN JOURNAL OF APPLIED RESEARCH X 7 ReseaRch PaPeR e in readiness to graduate to more sophisticated approaches of operational risk management under Basel norms. In order to derive utmost gains banks need to gear up efforts for speedy and effective implementation of comprehensive Volume 3 Issue 1 January 2013 ISSN 2249-555X operational risk management frameworks and thereby bring more efficiency, transparency, profitability and sustainability into their operations. REFERENCE Reserve Bank of India, Department of Banking Operations and Development, Central Office, Mumbai, (2005), Draft guidance note on management of operational risk, 2.Basel Committee on Banking Supervision (August, 2003) The union Forum Operational risk transfer across financial sectors, 3. Usha, Janaki, Raman, (2008) Operational Risk Management in Indian Banks in the Context of Basel II A Survey of the State of Preparedness and Challenges in Developing the Framework, 4. Rao, D, Tripati and Ghosh, Prodipta, (2008) Preparedness of Indian Banks in Managing Operational Risk, 5. Kale, Ketan and Agarwal, Mohit, Marsh India, (2011) Operational Risk Mitigation & Basel II Accord Challenges & Opportunities. 8 X INDIAN JOURNAL OF APPLIED RESEARCH