operational risk Flashcards
(25 cards)
What is operational risk?
Risk associated with numerous failures in financial institutions, including transaction processing risk and broader financial risks.
Operational risk has been linked to significant failures, such as the Barings Bank collapse.
What was the consequence of the operational risk failure at Barings Bank?
$1.5 billion loss and liquidation of the bank.
This incident highlights the severe consequences of operational risk failures.
What are the two definitions of operational risk?
Narrow: risk confined to transaction processing. Wide: any financial risk other than market and credit risk.
The definitions reflect the complexity and scope of operational risk.
What are the components of operational risks according to the UK FSA?
- Operational risk: losses due to complex systems and processes
- Operational settlement risk: lost interest/fines due to failed settlements
- Model risk: losses due to imperfect model or data
- Fraud and legal risk: reputational/financial damage due to fraud
- Misselling risk: losses due to unsuitable sales.
These components highlight various sources of operational risk.
What characterizes ‘market’ banks?
- Primarily involved in trading
- Large trading volume
- Changing and complex products
- Autonomous traders
- Sophisticated investors.
Market banks operate under different risk profiles compared to credit banks.
What characterizes ‘credit’ banks?
- Primarily involved in lending activities
- Smaller trading volume
- Standardized and less complex products
- More structured policies and procedures
- Less sophisticated retail investors.
Credit banks focus on different types of financial activities and risk management.
Which type of risk is considered high for market banks and low for credit banks?
Operational settlement risk.
This distinction highlights the varying risk profiles between different types of banks.
What are the internal operational risks according to the British Bankers’ Association?
- People risk
- Process risk
- Technology risk
- Employee collusion/fraud
- Accounting error
- Data quality
- Employee error
- Capacity risk
- Programming errors
- Employee misdeed
- Contract risk
- Security breach
- Employers liability
- Mis-selling/suitability.
Internal operational risks encompass a wide range of factors affecting bank operations.
What are the external operational risks according to the British Bankers’ Association?
- External risk
- Physical risk
- Legal
- Fire
- Money laundering
- Natural disaster
- Outsourcing
- Physical security
- Political
- Terrorist
- Regulatory
- Theft
- Supplier risk.
External risks can significantly impact the operations of financial institutions.
What are the two approaches to measure operational risk?
- Top-down model: firm-wide or industry-wide data
- Bottom-up model: individual process or business unit level.
These approaches help in understanding and managing operational risk effectively.
What is an expected loss in the context of operational risk?
Operational loss that is expected to occur, typically high frequency, low severity events.
Expected losses are absorbed as part of normal operational costs.
What is an unexpected loss in the context of operational risk?
Difference between expected loss and quantile loss at a confidence level, typically low frequency, high severity events.
Unexpected losses require capital reserves or insurance to cover.
What is a catastrophic loss in operational risk?
Loss in excess of unexpected loss, infrequent and damaging events.
Catastrophic losses are not easily offset against capital.
What are some reasons why purchasing operational loss insurance may not be a solution?
- Moral hazard
- Adverse selection.
These issues can complicate the effectiveness of insurance in managing operational risk.
What is the role of internal controls in minimizing operational risk?
- Segregation of duties
- Dual entries
- Controls over amendments.
Internal controls are critical for managing operational risks effectively.
What are catastrophe bonds?
Bonds with embedded options triggered by internal or external events or an index value.
These financial instruments are designed to provide capital relief during catastrophic events.
What are the two types of liquidity risk?
- Funding risk
- Market liquid risk.
Understanding these types is essential for effective liquidity risk management.
What is model risk?
Risk associated with using financial models to simulate complex relationships.
Model risk arises from the inherent limitations and flaws in financial models.
What can cause model risk?
- Incorrect model application
- Implementation risk
- Calibration errors
- Programming errors
- Data problems.
Each of these factors can lead to significant inaccuracies in risk assessment.
What is the first step during risk management processes?
Risk identification.
This step is crucial for effective risk management.
What is the definition of operational risk?
The potential for losses due to a failure in the operational processes or in the systems that support them.
This definition encompasses various aspects of operational risk.
Which statement about operational risk is TRUE?
Measuring operational risk requires both estimating the probability of an operational loss event and the potential size of the loss.
Accurate measurement is essential for effective risk management.
Which of the following is NOT an example of ‘model risk’?
The model is validated by an independent risk professional employed by the institution, but who works in another division.
This scenario does not directly contribute to model risk.
What is moral hazard in the context of insurance?
The effect reduction in control of losses by an individual insured due to the protection provided by insurance.
Moral hazard can lead to increased risks for insurers.
