FEAS Yearbook FEAS Yearbook 2003 | Page 13

HEWLETT-PACKARD Short of not being in business at all, operational risks are part of the game and managers do not have any choice about being exposed to them. They can reduce their exposure by a number of means described later but they cannot avoid them as they could the other risk categories. There are very few choices of avoidance that do not call into question the basic business models. As an example, a virus attack on a data centre can only be avoided to a certain degree since the attack is malicious and uses historical data to succeed. Operational risk losses also have no relation to the value of the assets exposed to risk. If a server costing 50k$ is exposed, the cost of data recovery, downtime, cleaning-up, accounting, reputation can be one hundred times as great. If a generator breaks and a business continuity plan fails? It is fairly common to try to apply the same modelling techniques to operational risk as those applied to credit and market risk. The success ranges from none to limited. A model could show that a certain sequence or grouping of events leads to a risk appearing (this is event correlation). This would be based on historical data by definition and should lead to some action to stop the risk occurring – such as avoiding the events or changing them in some way. As a one-time exercise to identify and eliminate obvious risks, this makes sense. As a way forward it is similar to treating the symptoms and not the cause. The very nature and scope of operational risk makes these approaches an endless, time-consuming and costly exercise with no guarantee of success, ever. In the cases of malicious acts causing operational risks, it would be counterproductive since a malicious act will always try something that has not been done before and this type of modelling would act as an excellent oracle. In short, it is a waste of time. OPERATIONAL RISK – SOURCE, CONTROLS, ACCOUNTING AND HISTORY and the same scenario holds true for any management control. Where do the risks come from? Operational risk comes from people, processes and technology as well as external events, and it is no secret that financial institutions are entirely dependent upon technology. Without the IT infrastructure, all but a few private banks would cease to be able to trade. As a simple example, how many clerks could raise an invoice (assuming they were allowed to do it manually)? When asked to raise an invoice, the natural reaction is to press a button – technology use has led to a situation of complete dependency and the actual content and legal use of an invoice in this example is no longer in the capacity of operational people. Whether we like it or not we need to deal with this situation as it actually is. It is a bit like picking mushrooms – just because you found one does not mean the next will be found nearby. The IT infrastructure is a fundamental of business operations and this is where the first search for operational risk should begin. The second area is a combination of people and processes – people run processes that are defined by people. In general, processes have been audited a hundred times and have usually been defined by intelligent people. Processes fail for two reasons (apart from malice) – they are ill defined for the objectives they hope to achieve or people do not obey them to the letter. It is rare that a process needs redefinition or re-engineering to reduce the operational risk. Auditing and management controls Auditing has a fairly clear objective – ensuring that things are as they are intended to be. This assumes that the intended state is well defined, which may not be the case. The other constraint on auditing (in the search for operational risk at least) is that there is a practical requirement that says that auditors will usually look at controls for evidence of deviations and will use some form of sampling on data. There is simply too much data to look at every transaction. So, why not have a set of simple management controls that are audited and reported to management? Suppose one of the controls was a trial balance on a database that was executed and audited every week and which was correct? What would this prove? It would prove that at the end of the week, it was correct. It would tell nothing about next week and may even have misled you about the previous week. It would tell management nothing about the vulnerability of the processes or whether there was some operational risk exposure or whether an event would occur tomorrow. It would not matter if this balance had been correct every week for the last twenty years. This is the problem of operational risk In short, auditing and management controls are not effective tools in the control of operational risk – they help only. Accounting for losses When a loss occurs in the traditional areas of risk (credit and market), the accounting methods and standards are known and practiced. When an operational risk occurs, there is not the prior art in accounting for it. The tools exist but are rarely used. As an example, a credit of 50k$ lost is accounted for as a 50k$ loss. An operational server loss with an asset value of 50k$ could well cost the company 2m$ in losses associated with recovery but will most probably be accounted for as expenses, neglecting the original intent of tracking all financial and non financial impacts. This has some considerable impact since the idea of Basel 2 is that operational losses will be used to calculate capital adequacy. If there is not a culture that fully accounts for operational loss (including reputational loss incidentally), then capital adequacy will be understated. This, however, is a minor inconvenience in comparison with the impact on the books or the impact of having an actual loss of 2m$ which may repeat itself. Operational loss history A provision in Basel 2 is that a historical database of losses be available with three years data. Whilst it is true that a historical database tells the past with some accuracy (bearing in mind the accounting problems cited above), it tells little about the future. Just because you have had no car accidents for ten years does not mean you won’t have one tomorrow. Worse, the current provisions are flexible such that external data can be presented if internal data is neither accurate nor available and there seems to be no minimum quantity requirement – ten losses are as good as ten thousand. All in all, the loss database approach is conceptually flawed for the search for operational risk. As a simple example, a virus attack last year caused a certain loss. Next week a different virus attack can occur –in this example in a technical sense, the loss database tells us what won’t happen in the future since it is unlikely you would be caught twice with the same trick. This is a fundamental flaw of the loss database approach – it tells you the ones that caught you out and tells nothing about control or future operational risk scenarios. FEDERATION OF EURO-ASIAN STOCK EXCHANGES YEARBOOK 2003/2004 PAGE 11