Impact Of Operational Risk Management Banking Profitability Finance Essay

Desire the study and understanding that how the impact of Operational Risk Management is on banking profitability in Pakistan. The primary focus of the study is as explanatory so proposed study will use quantitative design in with structured questionnaires will be filled and find out Operational Risk Management about Banking Profitability. A risk management process that includes the three basic elements of assessing risks, controlling risk exposure, and managing risks will help banks and regulators attain goals.

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Due to a number of social, political, and economic problems Pakistan suffers.  According to a recent survey, in Asia about 90 percent of banks consider operational risk as important as market or operational risks. Overall all study says that ORM can be implemented if economic condition is stable.

Risk Management features is an important feature in the financial markets. Changes in markets, techniques, technologies, and products have changed the landscape of Operations and fueled the explosive development of Operational Risk management. Basically operational risk involves breakdowns in internal control and majorly corporate governance. Breakdowns lead the operations due to error, fraud or failure to perform financial activity. The financial and public companies authorities are demanding a far greater level of disclosure and awareness by directors about the risks they manage and the effectiveness of the controls they have in place to reduce or mitigate these risks. All these changes and circumstances have triggered the need for an efficient Operational Risk Management system in Organizations. Executive management and BOD of any organization now willingly expect about prompt solution of Operational Risk (OR) because it can directly hit their stake holders trust on an organization or any financial institutes. Basically ORM is a decision making tool- used by people at all levels to increase operational effectiveness by anticipating hazards and reducing the potential for loss, thereby increasing the probability of a successful mission. ORM is an effective tool for maintaining readiness in peacetime and success in conflict because it helps conserve assets so they can be applied at the decisive time and place. British Bankers’ Association (1997) and Jameson (1998)

Traditionally many enterprises face and manage such type of problem in parts but some small enterprises tackle such type of cases and situation by maintaining or creating their own analysis and assumptions.

Background:

In the every business environment Operational risk (OR) is there. It is the oldest risk facing by banks and other financial institutions. Any financial Institution will face operational risk long before it decides on its first market Trade or credit transaction. Of all the different types of risk facing financial Institutions, OR can be among the most devastating and the most difficult to anticipate. The spectacular collapse of Barings in 1995, the terrorist attack on the World Trade Center in September 2001, the $691 million in losses due to fraud reported by Allied Bank in 2002, and the Widespread electrical failure experienced by over 50 million people in the northeastern United States and Canada in August 2003 is all concrete but Very different illustrations of operational risk. The rapid pace of technological Change, removal of traditional trade barriers, expanding customer base Through globalization and e-commerce, and mergers and consolidations Have led to the perception that OR is increasing. Indeed, although many functions can be outsourced, OR cannot. Increasingly, banks and other financial institutions are establishing OR management functions at the senior executive level in an effort to better manage this class of risk. In this chapter we discuss the definition of OR, outline the regulatory background, and describe the role of statistical methods in measuring, monitoring, and assessing operational risk. Basically we should search about operational Risk. There is no generally accepted definition of OR in the financial community. This lack of consensus relates to the fundamental nature of operational risk itself. Its scope is vast and includes a wide range of issues and problems that fall outside of market and operational risk. A useful starting point is to acknowledge that OR encompasses risk inherent in business activities across an organization as well as Banking sector especially. This notion of OR is a broader concept than "operations" or back and middle office risk and affords differing definitions. Basel Committee on Banking Supervision (1999, 2001a, 2001b, 2001c, 2003) and Alexander (2003).

Purpose Statement:

The primary purpose of this study of to determine the impact of Operational Risk Management on banking profitability in Pakistan. The secondary purpose of this study is to imitate the existing studies conducted by Patrick T. Harker & Larry W. hunter " Future of banking Profitability" and by Brendon Young & Sam Theodore" Analytical frame work for Operational Risk Management of Banks" profitability in order to evaluate the applicability of western concept in Pakistan.

Why to conduct this study in Pakistan!

Looking all over Pakistan Risk is involved in every business such as banking sector. It is mostly due to instability of economy, Stock Exchange Rates, State bank policies and many more. In Pakistan most of the Banking sector running on Risk basis as economic conditions. But by implementing Operational risk management it can easier to locate major factors that directly effect the operation loses in banking sector of Pakistan.

Objectives of Study:

To enhance the profitability of banking sector by reducing the operational risk from its management.

To enhance research ability by literature reviewing the articles.

To know how economic condition affects banking profitability.

Significance of Study:

Based on the available literature, this study, which has not been previously conducted in Pakistan, would benefit the field for the following reasons. It would help the economists to get an easy understanding of what creativity in Financial and Banking policies are. Financial and Banking practitioners would also get a clear concept about how creative process gets affected by risk management. The study of financial and banking operations are important as much work has not been done over it, as evidenced by the review of published literature (Imran, June 2007).

Hypothesis:

The study on Operational Risk Management has conducted by Ali Samad Khan agent of Word Bank. This study conducted just in international context that why operational risk involve in banks’ profitability. I conduct this study in national context in Pakistan majorly in banking sector. This study is more beneficial for our banking sector profitability.

Literature Review:

As the concern about operational risk is rather new in the banking area, the literature on this topic, both by scientific researchers and practitioners, is currently booming, mostly on quantitative methodologies and tools than can be applied to this issue.

Pakistan is totally bankrupt from foreign donors and the refused to give more loans to them. They warn Pakistan Government that if they can’t cut off their defense expenditure then country will suffer higher rate of inflation. Operational risk management in the banking sector is a key issue linked to financial system stability. Unsound risk management practices governing bank lending played a central role in recent episodes of financial disturbance, most notably during the Asian financial crisis of 1997-98. The current regulatory framework governing the standards of bank capital, the 1988 Basel Capital Accord, played a part in this crisis. Major flaws made it ineffective in promoting sound risk management practices, as it did not sufficiently discriminate between different levels of risk, and in certain areas encouraged excessive risky lending and investing. (pecc.net/finance/forum2003.)

Due to number of social, political and economic problems Pakistan suffers.  Pakistan is experiencing unwanted growth with a population approximately half that of the United States in an area slightly less than the size of two California’s. While projections designate that the population growth rate of Pakistan may actually be decreasing, those same projections also predict that by the year 2050 Pakistan will have assumed its place as the third most populated nation in the world.  Quickly growing population, along with political tensions, both internal and external, and an economy trapped in a cycle of debt, all serve to prevent Pakistan from attaining the progress it needs to advance, and perhaps to survive. (people.usd/~clehmann/pop_prob/pakistan/problems). The Basel Committee on Banking Supervision has moved to revise the framework. A new capital accord (Basel II) is now being finalized to replace the current one. The introduction of Basel II is a significant measure that promises to promote sound risk management practices. It seeks to enhance the risk sensitivity of capital requirements, promote a comprehensive coverage of risks, offer a more flexible approach through a menu of options, and is intended to be applied to banks worldwide. It incorporates minimum capital requirements into a three-pillar structure that includes robust supervisory review and a greater role for market discipline through more meaningful disclosure. (Financial Institutions Center The Wharton School University of Pennsylvania).

Consider the case of National Bank, one of the larger American commercial banks, with branches in many states, which has a retail banking arm that is in many respects typical of the industry. Over the past year, a research team at the Wharton School, funded by the Transformation to Quality Organizations Program at the National Science Foundation, has been tracking the process of change at National, uncovering both the good and the bad. (Patrick T. Harker September 1998)

In recent years, regulators and the financial institutions have recognized the importance of measurement and management operational risk, particularly in Asia countries like China and Hong Kong. According to a recent survey, in Asia about 90 percent of banks consider operational risk as important as market or operational risks. In China, operational risk and morale hazard have been considered the major sources of risks for banks. For Bank of China (BoC), over the past five years, from the public sources, the operational risk related events have created over 10 billion RMB financial damages. Which included the one billion RMB loss from Gaoshan incident and 2.4 billion RMB losses from the Zhou Zhengyi incident at its Hong Kong Branch? (ShowMedia/bank_for_banks/news/archive, newsletter_jan2003).

However, this is just the tip of the big iceberg that many people believed only less than five (5) percent of operational risk related frauds or incidents had been caught or reported. Also the nature of the operational risks in the western countries and in China or some Asian countries are quite different that the losses from operational risks in western countries were mostly the expected losses, however, the losses of such risks in Asia were mostly unexpected losses that came from extreme events. Developments on the use of highly automated technologies, such as, Straight Throughput Processing (STP), the growth of use of e-banking, e-finance, and ATM, the growth of complexity of financial services and products, the increase of globalization and overseas branches, the trend of large-scale mergers and acquisitions (M&A), as well as the increase of outsourcing all indicated that the operational risk exposures are substantial and growing. As a result, there is an increasing demand on sound operational risk management at financial institutions especially after the introduction of Basel II New Economy Accord, in which operational risk was the first time to be included in the calculation of capital adequacy requirement (CAR). (Yen Jerome)

A risk management process that includes the three basic elements of assessing risks, controlling risk exposure, and managing risks will help banks and regulators attain these goals. Banks may employ such a process when committing to new electron IC banking and electronic money activities, and as they evaluate existing commitments to these activities. (Syed Hussain Shiraz Jan-Feb 2003).

The SBP announce their dealing in;

Foreign currency options

Forward Rate Agreement

Interest Rate Swaps. (Jacklin, C: "Bank Capital Requirements Sept 1993)

Foreign currency options are permitted in currencies only no entity may offer any PKR/USD or PKR/other currency options unless specifically permitted by SBP. However, period is limited to a maximum of one year. All exposures must be covered on back-to-back basis from a foreign bank or local banks’ branches abroad.

All actions associated with operational risk management governed by 4 Principles. These continuously employed principles are applicable before, during and after all tasks and operations, by individuals at all levels of responsibility.

Avoidable risk is that which carries no equal return in terms of benefits or opportunities. The most logical choices for accomplishing an operation are those that meet all requirements with the minimum acceptable risk. The corollary to this axiom is "accept necessary risk," required to successfully complete the operation or task.

The appropriate decision-maker is the person who can allocate the resources to reduce or eliminate the risk and implement controls. The decision-maker must be authorized to accept levels of risk typical of the planned operation (loss of operational effectiveness, normal wear and tear on materiel). He should elevate decisions to the next level in the chain of management upon determining that those controls available to him will not reduce residual risk to an acceptable level.

High-risk endeavors may be undertaken when there is clear knowledge that the sum of the benefits exceeds the sum of the costs. Balancing costs and benefits is a subjective process, and ultimately the balance may have to be arbitrarily determined by the appropriate decision-maker.

In the planning stages of an operation risks are more easily assessed and managed. The later changes are made in the process of planning and executing an operation, the more expensive and time-consuming they will become. (FAA System Safety Handbook, Chapter 15: December 30, 2000)

Now the question is that what effect bank’s profitability suffered?

Certain banks have used the benefit of Forced Sale Value of commercial, residential and industrial properties (land and building only) held as collateral as allowed by State Bank of Pakistan Circulars.

Contributing to approximately Rs. 16 billion increases in profit before tax. (Banking Survey 2010)

Operational risk is the risk of loss resulting from inadequate or failed internal processes, systems and people or from external events. Besides establishing a tolerance, level for operational risk, the BOD needs to ensure that the senior management has put in place adequate systems, procedures and controls for all significant areas of operations. Further, the management of the bank should effectively communicate laid down procedures / guidelines down the line and put in place a reasonable set up to implement the same. (George Parker, New York, 1994)

Two major risks that the SBP guidelines ignore are human resources and reporting risk. Human resources are the most valuable assets of any organization. The departure of an employee with specialized knowledge can bring certain systems to a halt. The Bank of Credit and Commerce International was liquidated only when Agha Hassan Abedi was incapacitated. . Disastrous actions were necessitated against Mehran Bank and Indus Bank only because of failure to report problems and policy inconstancies on time. (Sanford C, 1993)

Exaggerated values of assts and liabilities, accumulation of colossal bad debts and resultant failed policies were mainly because of failure in reporting of real values.

Failure to retain employees is a bad indicator of overall bank management – responsibility that rests with the board of directors. Basle Accord-II requirement that banks hold adequate capital to provide for every risk, without concessions for portfolio diversification, will squeeze bank profits.

A likely scenario is that Basel Accord-II requirements may push banks into finding ways of passing many of their risks on to other market players. This harsh reality, which recently surfaced in some European countries, amounted to transferring risk from institutions (banks) that had greater credit expertise and long standing relationships with their borrowers, on to institutions that were ill equipped for managing it.

For the moment, such a development seems a remote possibility in Pakistan because insurance companies don’t cover even some of the insurable risks. But nevertheless, it is a possibility. (Singleton, K, Jacklin, C, 1994) Should that happen risk will not evaporate; it will start accumulating in less regulated sectors, with eventual consequences that could be as damaging as the failure of co-op banks and investment companies was during the 1990s?

The present accounting system is based on historical costs and accruals. As a result changes in economic values are not reflected in reported value of financial statements. The second problem relates to the dimensionality of risk exposure. (KPMG Peat Marwick, Dr. Ishrat Hussain, January 2004) Even if a full market value accounting system were employed the income statement will capture only ex-post changes in assets and liabilities values and not ex-ante risk exposure.

The SBP through its circular No BSD-17 of November 26, 2004 allowed Banks and DFI’s to undertake derivatives business provided they met the eligibility criteria and had obtained Authorized Derivatives Dealer or Non-Market Maker Financial Institutions status from the SBP.

A derivative is a financial instrument, which is erratically a promise to convey ownership. All derivatives are based on some underlying cash and real product. These cash products are:

i. Spot Foreign Exchange Rates

ii. Commodities

iii. Equities

iv. Bonds

iv. Money-market negotiable debt securities

V. Over the counter money market product Options, futures forwards and swaps.

The SBP through circular BSD-17 allowed dealings in

i. Foreign currency options

ii. Forward Rate Agreement

iii Interest Rate Swaps.

Foreign currency options are permitted in G-7 currencies only no entity may offer any PKR/USD or PKR/other currency options unless specifically permitted by SBP. There is no restriction on the minimum or maximum size of "notional principal amounts of FX options. However, tenor is limited to a maximum of one year. All exposures must be covered on back-to-back basis from a foreign bank or local banks’ branches abroad.

Dealing in forward rate agreement is permitted in Pak Rupees only. There is no restriction on the size of notional principal. However tenure is limited to maximum of two years. Interest rate swaps are permitted in Pak Rupees only. There is no restriction on the size of notional principal but tenor is limited to a maximum of 5 years. (SBP, 2009-10)

Banks are increasing their focus on other segments, for example the SME sector and consumer finance with declining spreads in corporate finance. While this shift is expected to preserve declining margins, it also exposes the banks to higher level of risk. The increase in risk / reward appetite would obliviously require more stringent risk management system for preserving asset quality. While there is a general improvement in risk management system across the banking sector, there is less than adequate sensitivity about ensuring that the risk appetite remains consistent with the capacity of individual banks to manage it.

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In Pakistan, most of the financial institutions have separate risk management department. They are working on managing all types of risk but are lacking for behind in the use of financial mathematics, financial engineering and information technology to measure and monitor financial risk. (State Bank Circular No BSD-17-dated Nov 26, 2009)

Risk is simply uncertainty. It is not only the incidence of adverse outcomes but unforeseen favorable outcomes are also a form of risk. Foregoing opportunities is as significant as actual losses. Risk can be avoided by not undertaking transaction (s) that carries risk. It can be reduced through actions that lower the severity of loss. It can be retained by accepting the loss when it occurs. It can be transferred by causing another party to accept the risk. All risks that are not avoided or transferred are retained by default.

The business of financial institutions, as intermediaries, is essentially the business of bearing risk for a price. Without accepting risk there is little reason for their existence. However, any risk that compromises the survival of the firm cannot be adequately compensated. Equilibrium between risk and return must be maintained. Recognizing both the potential value of opportunity and the potential impact of adverse effects is of immense importance. It requires forward planning approach, identifying uncertainties, anticipating potential outcomes and making risk management an integral and vital part of strategic management. (Jamal Zubairi, May 14, 2010)

Financial institution functions within legal and regulatory constraints that limit then risk management alternatives. The State Bank of Pakistan is the regulatory authority of financial institutions operating in Pakistan.

https://www.metricstream.com/solution_briefs/ORM.html

To improve their internal risk processes, data infrastructure and analytical capabilities banks are making significant investments. Likewise other risks, the ultimate responsibility of operational risk management rests with the board of directors. (Roth bard, 26th June, 2008) Both the board and senior management should establish an organizational culture that places a high priority on effective operational risk management and adherence to sound operating controls. The board should establish tolerance level and set strategic direction in relation to operational risk. Such a strategy should be based on the requirements and obligation to the stakeholders of the institution. Senior management should transform the strategic direction given by the board through operational risk management policy. Although the Board may delegate the management of this process, it must ensure that its requirements are being executed.

The policy should include:

a) The strategy given by the board of the bank.

b) The systems and procedures to institute effective operational risk management framework.

c) The structure of operational risk management function and the roles and responsibilities of individuals involved. (SBP, 2009)

The policy should establish a process to ensure that any new or changed activity, such as new products or systems conversions, will be evaluated for operational risk prior to going online. It should be approved by the board and documented. The management should ensure that it is communicated and understood throughout in the institution.

The management also needs to place proper monitoring and control processes in order to have effective implementation of the policy. The policy should be regularly reviewed and updated, to ensure it continue to reflect the environment within which the institution operates.

Operational Risk Function

For effective management of operational risks in the bank a separate function of internal audit should be established. Such a functional set up would assist management to understand and effectively manage operational risk. The function would assess, monitor and report operational risks as a whole and ensure that the management of operational risk in the bank is carried out as per strategy and policy. (Aziz Ur Rehman, December 2009)

The function would help establish policies and standards and coordinate various risk management activities to accomplish the task. Besides, it should also provide guidance relating to various risk management tools, monitors and handle incidents and prepare reports for management and BOD.

By comparing operational risk with market and credit risk it is relatively difficult to identify or assess levels of operational risk and its many sources. Operational risk as an unavoidable cost of doing business that has accepted by an organization. Many now however collect data on operational losses, for example through system failure or fraud – and are using this data to model operational risk and to calculate a capital reserve against future operational losses.

Nowadays, a lot of companies make the differences between the risks that can be controlled and the ones that don’t. The controlled risks are the risks where the banks activities can influence the result and they can be cover normally, without the need of a third party. The uncontrolled risks are represented by the risks that can’t be internally controlled by the bank. They can be cover against the natural catastrophes through insurance, from an insurance company, a third party.

In 2001, The PNC Financial Services Group recommended a more concise definition for the operational risk, a definition that should be based more on direct losses and which exclude categorical the business risk, the strategic risk and the reputational risk, the operational risk is the risk of the income direct loss, which results from internal events connected to inadequate personal, important errors or illegal behavior because of the errors or the systems and processes inadequate, or from external events where the risks are not cover by the credit, market or interest rate risk ".

Thus the operational risk can be interpreted as a vulnerability of the financial institution, which can be reduced or eliminated though an increased control.

The important increase of the operational risk is due to organizational, infrastructure, business environment or improvement changes. These changes were materialized in the development of the technology, the increase of the attention to the transparency, the increase of the electronic commerce, the increase of the operations for the natural person and small economic agents, deregulation, the incompatibility of the systems, (Greory F, 1992) the increase use of the automatic technologies, globalization, the increase use of the external sources and the complicated technologies to reduce the credit and market risks. All these determined a healthy management of the operational risk and the inclusion in the internal process of a bank. (Bester, H, June 1999)

Thus, the financial institutions considers that this risk appears in the departments called „Operations" and are concretized into potential losses generated by errors and controls, systems and processes omissions. That is why it is not necessary to have a special department for the operational risk. Also, the risk management is made by a global risk committee.

But there are some institutions that consider the operational risk as the risk that not harmonize with the credit or market risks and which incorporates all the risks, except the credit risk and the market risk, in order to take into consideration all the potential influences over the profit and losses account. This thing brought some problems and thus the financial institutions decided to limit themselves to things that can be measured easily. (Diamond, D.W, September, 1998)

There are known two types of determinant factors for the operational risk that generate losses or the un-achievement of the estimated loss: internal factors, as example the inadequate development of some internal activities, staff unprepared, improper systems etc; external factors, as example the economic situation, changes in the banking system or technological achievements. These factors include: the necessity to develop in a short period of time a high volume of transactions, the necessity of using the electronic funds transfer and other telecommunication system in order to transfer the property of big amounts of money, the necessity of developing operations in different regions, the management of a high volume of monetary elements, the necessity of monitoring and solving the important exposures. (Radu Alina Nicoleta)

These factors are very important and the companies have to be very carefully, by monitoring them, because in the last period of time it was recorded a higher level of the operational risk. Especially this is due to organizational, infrastructure and business area changes. Also, we have the development that generated a higher attention for the operational risk and its inclusion in the internal capital allocation process of a bank. (Radu Alina Nicoleta)

The most used operational risk examples involves: system breakdowns or system errors; transactions process or control of errors; the activity stop; internal or external criminal acts; security disrespect or staff risks; improper control at all levels; the inexistence of the responsibility and of regulations for an integrated system, which can record wrongly data for a long period of time. (Bhattacharya, S, 1994)

The operational risk appears at different levels, as: personal level: human error, inexperience, fraud (they are recorded as destructions, false information or hide of information); procedures level: improper procedures and control regulations in order to create the reports for the national institutions responsible with the operational risk, to monitor and to take a decision; technique level: the implementation or the absence of the inadequate instruments used to measure the operational risk; technological level: system errors etc…

Through operational risk management the bank wants to reduce the errors and improper activities that have a strong impact over the clients, financial losses or give bad reputation to the company. If an operational loss generates positive net present value to financial institutions because the internal capital is completely used, the shares price will follow more than the loss value. The operational risk events can generate a bad quality for the management. (De Marzo. 2002)

Because the internal control represents a start point in the operational risk management process, in 1998 the Basel Committee imposed a regular frame for the internal control of the surveillance authorities.

Therefore, the last research presents some important elements as: the main initiative of the financial institutions regarding operational risk is to have a strong architecture of the risk data; although the operational risk is not a new element for the market, the operational risk management, in comparison with the other management areas, (Hellwig, H.) is a domain in a permanent development process; the number of the financial institutions that uses informatics’ software, for the operational risk management, increased rapidly, but the capacity of the systems continues to be a challenge; to develop the systems and the technological area, the main issue is the implementation data of the operational risk management and the regulation systems capacity; the operational risk management programs offer as results a higher protection and an increase of the shares values; to apply the new Basel Agreement is much more difficult than it was expected; the progress expected through Basel II is lower than the expectations; 89% (Regulatory authorities, 2007 policy) of the financial institutions analyzed are expecting to have a reduction of the capital through Basel II; applying Basel II Agreement the costs of the financial institutions will increased; almost half of the financial institutions analyzed proposed to realized more benefits than Basel II Agreement mentioned. (Mailath, G)

Operational risk management programs were made by a management committee that had as purpose to understand the institution risks, because of the operational risk exposure and the events produced during the last years. Therefore a new organizational model was build. This model had as main purpose the development and the implementation of the operational risk frame and also an advisory process at the level of each business line. The new frame of the operational risk management presents five development stages that have as purpose the priorities identification. Also, this frame has a strong connection with the integration processes, the instruments and strategies of reduction this type of risk. (SBP, 2004-05)

This politics take into consideration all the events that can generate this type of risk: internal fraud, external fraud, politics regarding staff and the safety of the working place; corporal assets; the stop and a bad performance of the systems; the treatment applied to clients and different business partners, the security of the "electronic banking" system.

Methodology:

The main purpose of selection the methodology is the nature of research problem because research problem is based on Financial by nature. So quantitative method used. Where structured questionnaires have been used by Brendon (1998) will be cross-sectional in nature at a single point in connection with two or more variables. The data collection tools used in this survey research will comprises a questionnaire designed by using Operational Risk Management (ORM), Economic Condition, State Bank Policies, Stock Exchange Rates and Banking Profitability as the main Variables. Questionnaires also have a number of strength which has been used by Brendon (1998).

The basic need or essence to conducting this study for evaluating risk in baking sector in Pakistan. Because as economic condition of our economy, our country businesses are on risk and I want to enhance risk management basically operational risk management. Mostly banks fail to overcome operational risks due to this problem banks get losses. Major problem of this matter is our economic condition which is still unstable currently due to crisis of resources. Because economic condition of Pakistan badly effected on State bank policies as well as Stock Exchange rates in markets. Banking sector in Pakistan has experienced profound changes over last decade. Since 2002 there has been a significant rapid increase in bank profitability. The commercial banking sector in Pakistan has come of age and is now well equipped in terms of technology, skills and financial resources to play an effective role in financial intermediation. With the privatization of HBL, 80% of banking business has now come under private management and the already competitive environment has become even more intense.

With declining spreads in corporate finance, banks are increasing their focus on other segments, e.g. the SME sector and consumer finance. While this shift is expected to preserve declining margins, it also exposes the banks to higher level of operational risk. The increase in risk / reward appetite would obliviously require more stringent risk management system for preserving asset quality. While there is a general improvement in risk management system across the banking sector, there is less than adequate sensitivity about ensuring that the operational risk appetite remains consistent with the capacity of individual banks to manage it.

In Pakistan, most of the financial institutions have separate operational risk management department. Two major risks that the SBP guidelines ignore are human resources and reporting risk. Human resources are the most valuable assets of any organization. The departure of an employee with specialized knowledge can bring certain systems to a halt.

Islamic banking industry has been growing promisingly since the establishment of the first Islamic bank in 1992. Lately, until end of 2007, there are three Islamic Commercial Banks followed by 25 Islamic Banking Unit and 114 Islamic Rural Banks integrating 683 offices around the country. Although they have fewer networks than conventional banks, this new industry has been showing a healthy financial intermediary and prudential banking operation. Financing to Deposit Ratio (FDR) has been laying between 100%-120% annually since 2001 and Non Performing Financing (NPF) positions between 2%-4%. Others, like total asset, total financing and total deposit have been growing more than 60% on average annually. In some extents, these banking performances indicate that Indonesian Islamic banking industry can effectively function as ideal financial intermediary. (Rifki Ismal)

Now a day’s economic condition of Pakistan is really affected on Bank’s profitability. Pakistan economic growth faced a serious set back in fiscal year 2009 because of the depressed consumer credit market, slow progress of public sector programmers, inflation, reduction in subsidies, security threat, instability in the state and energy crisis. Additionally, no attention was given to the agriculture sector. The exports declined by six percent and imports by 10 percent. The only thing that became a silver lining was the increment in remittances by 22%. Apart from ignorance, agriculture sector has shown credible results because of good weather. Major crops, wheat, rice and maize recorded impressive growth i.e. 7.7% against the target of 4.5%. Live stock and poultry also add to GDP as there was no viral disease this year.

Shortages of energy and power don’t let the boom entered into the industrial sector. In addition the sanction applied by IMF on different sectors creating a hurdle. This resulted in unemployment and services sector decline. Because of security crisis the graph of investment does not take any surge. The beginning of declining in core inflation is a hopeful factor but the domestic inflation is on peak. There is a marginal improvement in health and educational sectors but the poverty in country rise Pakistan has the highest population growth. The largest population represents a large potential market for goods and services yet the condition are deplorable.

There is no uniformity of approach in measurement of operational risk in the banking system. Besides, the existing methods are relatively simple and experimental, although some of the international banks have made considerable progress in developing more advanced techniques for allocating capital with regard to operational risk.

Measuring operational risk requires both estimating the probability of an operational loss event and the potential size of the loss. It relies on risk factor that provides some indication of the likelihood of an operational loss event occurring. The process of operational risk assessment needs to address the likelihood (or frequency) of a particular operational risk occurring, the magnitude (or severity) of the effect of the operational risk on business objectives and the options available to manage and initiate actions to reduce/mitigate operational risk. The set of risk factors that measure risk in each business unit such as audit ratings, operational data such as volume, turnover and complexity and data on quality of operations such as error rate or measure of business risks such as revenue volatility, could be related to historical loss experience. Banks can also use different analytical or judgmental techniques to arrive at an overall operational risk level. Some of the international banks have already developed operational risk rating matrix, similar to bond credit rating. The operational risk assessment should be bank-wide basis and it should be reviewed at regular intervals. Pakistani Banks have so far not evolved any scientific methods for quantifying operational risk. In the absence any sophisticated models, banks could evolve simple benchmark based on an aggregate measure of business activity such as gross revenue, fee income, operating costs, managed assets or total assets adjusted for off-balance sheet exposures or a combination of these variables.

Outsourcing of banking functions to specialist providers is common practice and nowhere is it more so than in the financial services industry. Enormous competition and rapidly dwindling bottom lines have forced firms to renew their focus on their cost strategy, of which outsourcing has become the most vital component. Firms are increasingly aware that non-core activities, which do not create immediate tangible value for the organization, can often be very well done by outside experts at a fraction of existing costs.

Outsourcing, especially offshore seems to offer significant benefits in terms of cost savings and conversion of fixed costs into variable costs. It seems all the more attractive to financial institutions and banks as significant effort are involved in back-office processing, which by nature is technology-intensive, repeatable and thus a strong case for outsourcing. Despite a lot of press reaction and people opposition, outsourcing is growing stronger day by day. Most of the larger firms around the world have begun outsourcing significant parts of their business to countries such as India which offer significantly better returns for the dollar. Some of the better-known names include Citibank, Standard Chartered Bank, Habib Bank Limited, Meezan Bank Limited, Allied Bank Limited, etc., and all of them have transferred a bulk of back-office operations and new system development to India and other lower cost markets. Some of them have even outsourced high-value and risk-sensitive work such as trend analysis for both derivatives and equity markets and are reaping the benefits of continued cost advantages and equally – if not superior – qualified technically and functionally competent personnel.

This does not mean that outsourcing does not have its own problems. Many of the banks and financial service organizations who were part of the first outsourcing wave that started without adequate research and preparation have had bad experiences. Even now, when processes are fairly standardized and evolved, firms are finding it difficult to coordinate, monitor and control performance of their vendors effectively. Still the value proposition of offshore vendors is so strong; many operational issues have not distracted people from going ahead.

It has been estimated that 69% of losses in capital markets and banking is due to systemic process and systems failures. This article attempts to explain the impact of the outsourcing of business processes, new technology development and existing system maintenance by external vendors and/or by subsidiaries of the firms in a geographically disparate location on the overall operational risk and whether it is possible for an arithmetic correlation between the two.

Now for this situation we collect data from different banks but firstly I’ll explain operational risk basically what is in banking situation. Operational risk is the wide risk factor in banking procedures in professional activity. Whether its corporation or business. We collect data from some different banks like HBL, AML, ABL, SCB etc… so our population is banks as named before;

Habib Bank Limited

Allied Bank Limited

Standard Chartered

Meezan bank Limited

Every bank has serious and major situation and that is Operational risk. Every one knows that this 21st century and globally our country also connect through web (Internet), so banking operations obviously performed by online facility. In banking activity their most precious essentials are their client’s personal financial data and secure data. To understanding it the common example is our ATM (Automatic teller Machines), these machines has common problem; some times they are not in service or link shown be down. These nominated banks shows keen interest about my study that what is the sophisticated solution for their problems.

In 2002-03, HBL face such major problem that they loose their client’s personal financial data due to sum operation failure. Due to this act 47% of them switch their account into other banks. Now they re-gain their position in financial market again. Economic instability of our beloved Country Pakistan directly hit on banking profitability due to market clashes. The operational risk occurs directly or indirectly for developing result from inadequate or failed internal processes, people and systems or from external events. It is important to note that this concept is based on the fundamental causes of operational risk. Basically this definition and its detailed specifications are particularly useful for managing operational risk within organizations. However, for the purpose of operational risk loss regarding financial data across banks, it is necessary to rely on definitions that are measurable and comparable. 

As credit risk and market risk, operational risk is not being researched before. The concept of outsourcing is only a few years old and very often there are lots of terrible financial clashed stories which tend to twist the historical loss event data availability leading to erroneous results. Operational risk is the amount that represents the maximum loss of a bank or for other institution that exposed over some given period, with a specific level of confidence. This figure, which many banks allocate at the level of 15% of regulatory capital, is based upon experience of operational failures.

Banks and firms have to track losses such as: legal costs, loss of reputation and unrealized profits. From "Top Down" banks/firms can approach Operational Risk which consists of seeking an overall measure, some percentage of gross income or a multiple of certain costs, suffered by the Bank without identifying specific risk events.

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