Learning Objectives: Describe how to identify causal relationships and how to use Risk and Control Self-Assessment (RCSA), Key Risk Indicators (KRIs), and education to measure and manage operational risks. Describe the allocation of operational risk capital to business units. Explain how to use the power law to measure operational risk. Explain how the moral hazard and adverse selection problems faced by insurance companies relate to insurance against operational risk.
24.9.1. SecureTrust Financial, a multinational financial institution, has been grappling with a surge in operational risk events across its various business units. The risk management committee has conducted a comprehensive analysis to identify the causal relationships behind these events and has proposed several measures to mitigate the risks. The analysis revealed the following:
I. Trade settlement error rate
II. System downtime frequency and duration
III. Employee absenteeism rate
IV. Percentage of employees who have not completed mandatory AML training
Which of the following combinations of actions would be most effective and cost-efficient in measuring and managing SecureTrust Financial's identified operational risks?
a. Implement a robust RCSA program involving all business units to identify potential risk exposures, establish KRIs I and III to monitor human errors and employee absenteeism, and provide targeted training to employees in the trade settlement department.
b. Conduct periodic RCSA exercises focused solely on the IT department, establish KRIs II and IV to track system performance and regulatory compliance, and invest in a complete overhaul of the bank's IT infrastructure.
c. Establish all four KRIs (I, II, III, and IV) to monitor various aspects of operational risk, implement a bank-wide education program on operational risk management, and outsource the trade settlement process to a third-party provider.
d. Focus on KRIs I and II to monitor trade settlement errors and system downtime, conduct RCSA exercises exclusively for the trade settlement and IT departments, and provide mandatory AML training to all employees.
24.9.2. CapitalEdge Bank gathers historical data on IT system failures, including the frequency and severity of incidents, and determines that for IT system failures, K = 8,000 and α = 2.0. They want to set aside adequate capital to cover potential losses. CapitalEdge Bank wants to estimate the 99.5th percentile of the loss distribution.
This means that there is a 99.5% chance that operational risk loss will not exceed what amount?
a. $950.41
b. $1264.91
c. $789.21
d. $1453.35
24.9.3: Golden Horizon Bank is considering purchasing an insurance policy to cover potential losses from its trading activities. The bank's risk management team is aware of the potential issues of moral hazard and adverse selection when obtaining insurance coverage.
Which of the following BEST describes how Golden Horizon Bank and the insurance company can mitigate the problems of moral hazard and adverse selection in this situation?
a. Golden Horizon Bank should disclose its insurance coverage to its traders to encourage them to take on more risk, while the insurance company should charge a higher premium to account for the increased risk.
b. Golden Horizon Bank should keep its insurance coverage private to prevent traders from taking on excessive risk, while the insurance company should thoroughly assess the bank's internal risk controls and adjust the premium accordingly.
c. Golden Horizon Bank should implement strict trading limits and risk management policies, while the insurance company should offer coverage without assessing the bank's internal controls to avoid adverse selection.
d. Golden Horizon Bank should purchase the insurance policy with the lowest premium, while the insurance company should offer the same premium to all banks regardless of their risk profile to ensure fairness.
Answers here:
24.9.1. SecureTrust Financial, a multinational financial institution, has been grappling with a surge in operational risk events across its various business units. The risk management committee has conducted a comprehensive analysis to identify the causal relationships behind these events and has proposed several measures to mitigate the risks. The analysis revealed the following:
- A significant number of operational losses were attributed to human errors, particularly in the trade settlement process.
- The bank's legacy IT systems have been experiencing frequent downtime, leading to delays in transaction processing and customer dissatisfaction.
- There has been a notable increase in the number of employees taking excessive sick leaves, which has impacted productivity and raised concerns about potential fraud.
- The bank has been subject to regulatory fines due to non-compliance with anti-money laundering (AML) regulations.
I. Trade settlement error rate
II. System downtime frequency and duration
III. Employee absenteeism rate
IV. Percentage of employees who have not completed mandatory AML training
Which of the following combinations of actions would be most effective and cost-efficient in measuring and managing SecureTrust Financial's identified operational risks?
a. Implement a robust RCSA program involving all business units to identify potential risk exposures, establish KRIs I and III to monitor human errors and employee absenteeism, and provide targeted training to employees in the trade settlement department.
b. Conduct periodic RCSA exercises focused solely on the IT department, establish KRIs II and IV to track system performance and regulatory compliance, and invest in a complete overhaul of the bank's IT infrastructure.
c. Establish all four KRIs (I, II, III, and IV) to monitor various aspects of operational risk, implement a bank-wide education program on operational risk management, and outsource the trade settlement process to a third-party provider.
d. Focus on KRIs I and II to monitor trade settlement errors and system downtime, conduct RCSA exercises exclusively for the trade settlement and IT departments, and provide mandatory AML training to all employees.
24.9.2. CapitalEdge Bank gathers historical data on IT system failures, including the frequency and severity of incidents, and determines that for IT system failures, K = 8,000 and α = 2.0. They want to set aside adequate capital to cover potential losses. CapitalEdge Bank wants to estimate the 99.5th percentile of the loss distribution.
This means that there is a 99.5% chance that operational risk loss will not exceed what amount?
a. $950.41
b. $1264.91
c. $789.21
d. $1453.35
24.9.3: Golden Horizon Bank is considering purchasing an insurance policy to cover potential losses from its trading activities. The bank's risk management team is aware of the potential issues of moral hazard and adverse selection when obtaining insurance coverage.
Which of the following BEST describes how Golden Horizon Bank and the insurance company can mitigate the problems of moral hazard and adverse selection in this situation?
a. Golden Horizon Bank should disclose its insurance coverage to its traders to encourage them to take on more risk, while the insurance company should charge a higher premium to account for the increased risk.
b. Golden Horizon Bank should keep its insurance coverage private to prevent traders from taking on excessive risk, while the insurance company should thoroughly assess the bank's internal risk controls and adjust the premium accordingly.
c. Golden Horizon Bank should implement strict trading limits and risk management policies, while the insurance company should offer coverage without assessing the bank's internal controls to avoid adverse selection.
d. Golden Horizon Bank should purchase the insurance policy with the lowest premium, while the insurance company should offer the same premium to all banks regardless of their risk profile to ensure fairness.
Answers here:
