Page 28 - Banking Finance April 2019

ARTICLE

systems. The advanced risk management systems can wasted when there are false positives and that (ii) the
identify each type of risks in each of the activity results can be catastrophic if controls fail.
associated, resulting in proper identification of risk 7. We are familiar with the most common approach in
premia for each activity. The other bank which will not Operational Risk Management: Study each activity,
be able to price risks in each activity will be doing identify risk, assess the impact and likelihood without
something called in finance as ‘Peanut Butter Spread’. controls, recommend and implement controls, and
They will be distributing the risk premia among the continuously monitor and assess the residual risk in
activities. This distribution could result in higher pricing
terms of impact and likelihood. The effectiveness of the
for a less risky activity and possibly a lower pricing for a controls is then evaluated, usually on a three - to five-
relatively high-risk activity which eventually will mean point qualitative scale which is used to identify and
the customers will start shifting away low risk activities categories the residual risk, with such ratings as “High,”
from this bank and will start undertaking high risk “Significant,” and “Acceptable”.
activity with the other bank. After a certain point in
time, this bank unaware of the developments may 8. In the shepherd story, the control (shepherd) was
generating false alarms which induced a kind of
undertake a level of risk that jeopardizes its’ ability to
meet its’ liabilities to depositors and other entities. behavior in the action takers (villagers) to consciously
ignore such calls and hence not to take any action on
5. So, the basic objective of the risk management should
them. In real life, Organizations cannot just afford to
be to identify and quantify the risks being undertaken ignore this kind of ‘false positives’ and they remedy
and eventually price these risks on commercial lines. them by considering to allocate more resources to filter
This will provide necessary insights for the management real incidents / threats from these false positives.
in deciding on its strategy.
9. Banking executives and risk practitioners seeking to
detect and prevent low-frequency events are well verse
How to Price each Risk - Risk Identifica- with this problem of false positives. False positives can
tion and Controls- Need to Digitize and influence over time our behavior towards them. Be it a
Automate control like a faulty fire alarm which is not rectified, or
a system designed to identify credit risk in potential
6. Everyone here must have heard the story of the liar borrowers, or a system to identify money laundering.
shepherd who for fun used to lie and make hoax calls to Manual controls may result in high false-positive rates
the villagers to save his goats from the wolf and in detection processes and therefore warrant incisive
eventually when the wolf appeared, and he cried for help, analysis. The control review should focus on replacing
no villager turned up thinking that that the shepherd may or augmenting manual controls with ways of system-
again be lying leading to an eventual loss of goats. This driven detection using advanced analytics, algorithms
story teaches us not to lie since no one trusts a liar. In and automation.
professional language, these means that (i) resources are
10. This automation of controls generally in addition to
reducing false positives result in an increase in the
effectiveness of controls also and carry the scope to
reduce the probability of the controls failing. Increased
effectiveness will then result in rationalization of controls
which will manifest in reduction in unnecessary costs.
11. There is another bigger benefit to the society by virtue
of digitization. Efficient financial institutions can
undertake the intermediation functions efficiently. FSB
has in their assessment of potential benefits by adoption
of machine learning and automation listed that the
more efficient processing of information, for example
in credit decisions, financial markets, insurance
contracts, and customer interaction will lead to greater

28 | 2019 | APRIL | BANKING FINANCE