Quality Control & Operational Risk

November 2003

2

Agenda

• Introductions

• Outline of a Derivative Transaction

• Quality Control in Financial Services – where are we in relation to other industries

• War Story

3

Outline of a Derivative Transaction

Trade Data$1bn/HUF20bn

FMC pays fixed amount

Broker Dealer assumes floating ccy risk

Option to call in 5 years

Operational ActivitiesConfirm economic data

Perform margin proceduresProduce Confirmations

Settle any cashflows

Example:

Ford Motor company (FMC) wishes to begin manufacturing in an Eastern European country and does not want exposure to currency risk. FMC issues a bond for HUF 20bn paying a fixed HUF rate, then swaps the HUF currency risk into USD with an investment bank

Economic Risks:-

What is the cost of confirming the first decimal incorrectlyHow soon will a mistake be identifiedAre the right ISDA terms used and agreed – what is the cost of an incorrect calculation agent

4

Quality Control in Financial Services – where are we in relation to other industries

A Bit of History

No weighting was given to the Operational risk associated with a transaction though there was obviously thorough thought and analysis given to the credit and economic risk of the trade. It is only within the last 5 years the financial industry has thought about this risk.

Operational Failure Risk

Over the last few years we have actively applied resources to this issue of Operational Risk and sought analogies in the insurance and engineering world to better understand and to quantify the Operational risk associated with a transaction

Why:

• Avoid catastrophic loss• Apply “smart” exception processing and prioritizing• Provide data for analysis to avoid re-occurrence• Apply infrastructure investment more scientifically

5

Quality Control in Financial Services – what are we looking for

In building an Operational Risk Model we apply three broad factors

People Risk

As in any industry, employees operate at different levels of competency generally based on experience:- I.e apply a weighting to years of experienceFraud – understand here the opportunity for fraud could occur

Process Risk

This risk increases exponentially with the maturity of a process I.e. Derivative transactions have a higher degree of risk than an equities transaction. However, equities may face an entirely different risk of capacity constraints.

Technology Risk

This is the most transparent to understand – but not the easiest to quantify

6

War Story

Unfortunately there are multiple stories. Tonight we can talk about AIB.