Financial Supply Chain Dynamics Operational Risk Management and use of RFID Technologies

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1 Financial Supply Chain Dynamics Operational Risk Management and use of RFID Technologies By Harry Reddy MLOG 2005 Introduction The banking industry is undergoing mergers and acquisitions to consolidate operations and to adopt new technologies in order to develop innovative products and services, thus achieving both economies of scale and scope. However, some well known banks (eg., Citibank Private Bank in Japan) are either forced to close down their operations or faced cost overruns (eg., Barings Bank in England) due to lack of or inadequate operational risk management. On the other hand, product-centric businesses are facing complex supply chain management issues and hence are engaged in devising effective solutions that could offer potential help for the financial industry. At the same time, the RFID (Radio Frequency IDentifier) technologies are providing promising future for creating innovation and providing the mechanism to manage operational risks effectively in some key areas where vulnerabilities are at high stake. The financial supply chain of retail banking industry is analyzed to come-up with an effective framework to manage operational risks, and RFID technologies are studied to come-up with solutions to manage operational risks where appropriate. Industry Background The banking industry is consolidating as its profits following cyclical economical cycle. For example in 2002, shareholders lost about $350 billion in market capitalization in the banking industry (BCG, 2003). Total returns for shareholders were minus 11 percent - which nevertheless still outperformed the overall stock market, where a welldiversified shareholder lost 17 percent of investment on average (BCG, 2003). Among nations, Germany and Switzerland were hit hardest. Among segments, asset management, investment banking, and transaction banking were the worst performers [BCG, 2003]. Page 1 of 15

2 The ten largest banks raised their share in worldwide market capitalization from 19 percent in 1998 to 24 percent in 2002, mainly through mergers and acquisitions. Today s largest three banks (Citigroup, Bank of America, and HSBC Holdings) have increased their market cap on average by 25 percent per year, reaching a total market cap of more than $100 billion each [BCG 2003]. There are three distinct ways to generate innovation in banking: 1) generating new ideas and screening them, (2) understanding customers needs, and (3) conducting trials and experimentation to determine the utility and effectiveness of potential new innovations. The performance charts of the ten biggest bank holding companies (BHCs) and all other banks are shown below in Figure 1. Source: Tower Group Figure 1. Total Capital Ratios The above Figure 1 shows that the average capital adequacy ratio of bigger banks is still lower than that of all other banks, which indicates that bigger banks would continue to pursue in consolidating their assets by acquiring other banks. Page 2 of 15

3 Let s see how banking industry is performing in terms of generating the shareholder value. We measure the shareholder value by Return-On-Equity (ROE), as shown in the following figure 2. The graph shows that the biggest banks have much more variability in their performance than the smaller banks. It is counter intuitive since bigger banks have large asset base and could withstand the cyclical economic profits, and it could however be explained in terms of operational risk management. The bigger banks are exposed for large operational risks. Source: Tower Group Figure 2. Quarterly ROE To identify the drivers behind such phenomenon we have to closely look into operational risk management and its associated business strategies. The data shown above is in accordance with the incidents reported in the last few years the bigger banks are failing to manage the operational risks and hence loosing huge amounts of money (e.g., Orange County Crisis lost $1.6B, Baring Securities lost $750M, and Citigroup had to close Citibank Private Japan operations in late 2004 for failure to meet the regulations). Page 3 of 15

4 Financial Supply Chain Dynamics The financial supply chain used to be simple, but with the advent of technologies such as online payments and government deregulation in banking, the opportunities for designing effective financial supply chains are increased. For example, previously, every time a foreign company issued a purchase order to one of its suppliers in China, it had to open a letter of credit with its bank, a process that required presenting a stack of documents. The bank would then courier the letter of credit to the manufacturer's bank, a journey that could often take a week. The Chinese bank would then review the documents and inform the factory it could receive payment as soon as it shipped the order. The entire transaction could take as much as two weeks, during which time the company s money had left its accounts but hadn't yet paid for the goods (Kahn, Gabriel 2004) The regulations also include paper to electronic payments (Stetter, G.M., 2003). Until recently, companies could afford and see what payment trends would eventually gain widespread acceptance and then adopt them. That wait and see strategy is not working anymore. Companies must make conscious decisions as to how they will deal with: 1. New legislation (e.g., Check 21) 2. New industry practices (check conversion and/or truncation) 3. New and more sophisticated forms of fraud 4. Technology (systems integration, imaging) Operational Risk Management According to Mckinsey Report (2004), there is little correlation between the actual failure of banks with either forecast or historical figures. The graph of these figures is depicted as follows. Page 4 of 15

5 Figure 3. Bank Failure Rates Actual Vs. Forecast The reason for such variation might be due to poor operational risk management that the thesis is going to focus on. In light of failures of several banks in the recent history, the internal body, Banking International Settlement (BIS), has come-up with Basel II accord which could be followed by banks to improve the operational risk management, however, this accord is not mandatory. According to the Basel II Report (2003) the risks are described as a catch-all name for a set of very different risk types, including those the related to staff, processes, systems, and acts of God, that are inherent to the practice of doing business. These risks can range from such extreme events as the 2001 World Trade Center bombing to simple Page 5 of 15

6 execution failures, such as a missed deadline that resulted in revenue loss. The risks at banks are depicted as follows (BIS, 2003) The Basle Accord has the following three pillars defined in order to protect the banks from failing in operational risk management. Minimum Capital Requirements Supervisory Process Market Discipline Source: BIS. Figure4. Basle Capital Accord The banking business plan risk has high probability of occurring but the loss arising out of it in case this risk event happened is small. On the other hand, the transferable risk such as insurance has small probability of facing the risk but has high loss due to this risk. Whereas, the middle risk has medium-to-small probability of facing Page 6 of 15

7 risk but the effect on loss is medium-to-high, which is the sitting in the middle of the curve as shown below. of operational losses Source: Crouhy, M., Galai, D., and Mark, Robert (2001). Risk Management, New York: McGraw- Hill. Figure 5. Loss vs. Severity The financial supply chains are depicted as shown below. Figure 6. Financial Supply Chains Page 7 of 15

8 The dark-shaded blocks are newly focused areas and the light-shaded blocks are traditionally focused areas. By merging these two focus areas, the banks have to devise right operational risk management framework in the context of ever increasing complexity in supply chain management. The complexity is increasing because of electronic settlement of payments and lack of effective document control management. The cash management, electronic payments and document management can be RFIDenabled to tag the audit trail and locate the document whenever necessary. RFID Technologies in Banking The RFID technologies are creating new opportunities for banking industry in order to effectively manage the operational risks and increase efficiency. The banking industry has been successfully utilizing the ICT (Information, Computers and telecommunications) for creating digitization, but with the digitization comes operational risk management issues such as tracking access to physical assets. The RFID can provide the solution to fix this problem it provides tracking mechanism to physical assets and yet it will provide the digitization for electronic data storage and manipulation. The operational risk management in the banking industry can be effectively addressed in the following areas. Cash Management ($) Custodian & Promissory Notes Management Document & Workflow Management Customer Profiling (but, there are privacy concerns!) Physical Assets Management Check Verification Payments Access Data Trail to Cash, Custodian & Promissory Notes, Documents and Physical Assets (This is pervasive through all the above options) Page 8 of 15

9 The RFID Check payment (Celent 2003) is shown below. Figure 7. RFID Check The RFID Auto-payment is shown below. Figure 8. RFID Express payment at American Express Page 9 of 15

10 Research Survey The questionnaire for survey is designed keeping in view of the operational risk management, operations strategy, business strategy, and the linkages among these. The data is gathered from sixteen banks, sampling from various categories such as national banks (Citibank, Wells Fargo, Lehman Brothers, SBI), international banks (MTB, UFJ, Shinsei Bank, Sumitomo, HSBC, Citibank Japan, Suruga Bank, Deautsue Bank, BNP, UBS), and regional banks (California Bank, World Savings, Key Bank).. The questions are separated into six major categories as follows: Causes of operational risks Events of operational risks Losses as a result of operational risks Risk types Business strategy Operational processes These six categories are further divided into 46 questions. The data analysis found that the strategy is very different for different banks when they are perceived to be related to the operational risk management, except three distinct strategic options employed: 1) Cost Position 2) Corporate Governance 3) Growth Therefore, I d argue that the managing operational risks in isolation won t result in containing the risk losses, but if they are aligned with business strategy the containment of risk losses seem to be a reality. However, interestingly the differentiation of product didn t figure in operational risk management. I have also analyzed the data by doing clustering as shown below. Page 10 of 15

11 Figure 9. Clustering of Responses There three distinct clusters, each associated with Cost Position, Growth Position and Corporate Governance Position. Page 11 of 15

12 ORM Business Areas for RFID Technologies The following wheel diagram would summarize all the business areas of a bank where RFID technologies could be used to minimize the operational risks. Figure 10. ORM Business Areas for RFID Use ORM Framework The following is the self-explained operational risk management framework that is devised to mitigate the operational risks effectively. Page 12 of 15

13 Figure 11. ORM Framework This framework shows that the ORM should start with best practices such as Basel II but excel through various bank specific strategy and structures in order to be effective. Conclusion The operational risk management is indeed very critical and it should be aligned with bank s business strategy such as competing on Cost, Growth, or Corporate Governance (including Operational Control). The most important operational risk management is with the people and document, and they could be mitigated to some extent by adopting the RFID technologies.. This work could be further carried out by examining the more data with different geographical regions to compare and contrast with the findings. Also, since banking industry is going to implement operational risk management techniques in the near Page 13 of 15

14 future, it would be interesting to study what actually they have done and what was in fact expected, and how successfully they could i8mplement the proper operational risk management solutions in place. Page 14 of 15

15 References Stetter, G.M., 2003, The Transformation of Treasury: Forces of Change, AFP Exchange, Bethesda, Nov/Dec. Vol.23, Iss. 6; pp. 66. Banking Strategies, BIS, 2003 Tower group Inc, 2003 Citibank website, Boston Consulting Group (BCG), 2003, Mckinsey & Company, 2004, Page 15 of 15