Those are just a handful of the instances of so-called operational risk factors that made their way through the press. But for each of those cases, there are hundreds, if not thousands of others which never do.
The parties involved-typically two broker dealers or banks, or a financial firm and its customer-"settle" any disputes privately. The injured party is always made whole often through a handshake of sorts over the telephone or through an email.
Rarely, if ever, do such issues ever make their way through the court system. And for good reason. The motto: treat others as you wish to be treated appears to be key. "Nobody wants to sue anybody for fear they could easily find themselves in the same boat in the future," says one recently retired former operations executive at a major New York bank. "The blue code of silence applies and nobody ever crosses that line."
Among the most common operational mistakes cited by two dozen operations executives contacted by Securities Industry News last week: IT glitches; failed settlement of trades, incorrect valuations, unreconciled transactions among counterparties and service providers; and erroneous processing of corporate action notifications.
While there are no official estimates of the total costs financial firms bear for operational risk, there are some estimates. In 2002 messaging network provider Swift estimated that the "lack of straight through processing" cost the financial industry about $12 billion; the cost was attributed to manual processing and fixing failed trades. In 2006, London-based research firm Oxera said that firms spend between $400 million and $900 million annually to fix corporate action errors.
"In some complicated reorganizations, the investor could be asked to vote on whether it wanted to accept cash or shares or a combination of the two," said one operations executive. "If the bank interprets the wrong amount of cash, or the wrong number of securities and passes the information onto the fund manager, the fund manager could make the wrong choice and find out after the fact. And if the fund manager gets the information on the corporate action too late to make a decision on what it wants, it won't collect anything. Several other operations experts at custodian banks told Securities Industry News that a delay in sending out a corporate action notification late or including the wrong details could cost a financial intermediary as much as $10 million. And that's a conservative estimate.
Banks with large asset servicing arms do annually put a percentage of their operating revenues in a reserve to pay for mistakes in securities processing. The percentage, while not disclosed, typically represents an analysis of past losses projected onto expected volumes for settlement other activities. The largest part of the reserve usually goes to paying for errors in corporate action notifications.
Mistakes in processing corporate actions are often due to mistranslation or misinterpretation, as information moves between messages sent or received in different formats. As a result, some financial firms are now advocating that corporations use the extensible business reporting language (XBRL) to identify each element of a corporate action notice. Such a move, advocated by XBRL US, the US arm of XBRL international, message network Swift and the Depository Trust & Clearing Corp., would allow financial firms to quickly generate Swift-based message formats from the XBRL tags.
In the case of settlement failures, incomplete or erroneous information on the terms of the trade are often to blame. Also contributing are mistakes in settlement instructions as well as losing track of securities out on loan which need to be delivered.
Failures to settle trades on time are rare and on average amount to less than 1 percent of a firm's trading volume. But each fix adds up, from $10 to as much as $1,000 depending on the time it takes to correct the error. And that doesn't include the cost of replacing securities which were not delivered on time or paying interest on funds not sent on time.
So how do firms measure just how much these operational risk they are exposed to? The Basel II Accord does allow banks to come up with some calculation based on one of three methodologies: a flat 15 percent of its total annual gross income or other predetermined percentage of multiple operating units. Financial institutions can also depend on their own calculations by extrapolating data on past losses. U.S. banks are expected to take the third so-called advanced measurement approach.
In either case, losses are not being measured accurately or consistently, on a daily basis. "Firms can account for future unexpected losses but not current potential losses in their day to day workings," says Alan Grody, president of Financial InterGroup, a New York financial services consultancy, and former professor of risk management at New York University's Stern School of Business
Grody and Peter Hughes, a former Chase Manhattan risk management executive, have come up with what they believe is a better way of measuring real-time operational risk from the current transactions a bank or other financial firm undertakes. "The calculation uses risk weightings which take into account the technical expertise of the people involved in the process, the accuracy of the data used and the level of automation," explains Hughes. "The weightings are used to measure each business process's exposure to risk in risk units."
Hughes compares the risk units to a FICO credit score which can be consolidated to come up with an enterprise-wide score. Such a methodology, he says, allows a firm to drill down into the causes of any deficiencies creating unintended operational risk. "It is meant to complement the regulatory capital being set aside for operational risk so that risk mitigation can be done in day-to-day operations," says Hughes.
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