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  • pg 1
									Minimizing Operational Risk
 & Optimizing Institutional
       Performance
Interest in Enterprise-wide Risk Assessments is
 being driven by Financial & Economic Realities

 • Global spotlight on risk and corporate governance
   – Sarbanes-Oxley Act of 2003 & COSO ERM Framework
 • Increased involvement from the Audit Committee of the
   Board of Directors with regard to risk management
   – NYSE listing requirements
 • Capital adequacy requirements and the need for efficient
   capital allocation
   – Basel Capital Accord
 • Need for alternative risk solutions due to the current
   insurance environment
 • Maximizing shareholder value
 • Sustaining a competitive advantage
                                                              1
Basel Committee’s Definition of Operational Risk



   “The risk of direct or indirect loss resulting from
   inadequate or failed internal processes, people and
           systems or from external events”

   Operational risk can result in increased write-offs,
         additional expenses or loss of revenue




                                                          2
         Operational Risk Management &
               Shareholder Value
Examples of how operational risk management
drives shareholder value?
• Improving operating efficiency and thus operating margins,
  by identifying and prioritising process improvement and de-
  risking opportunities
• Improving management effectiveness by enhancing the
  governance structure
• Enabling more effective capital usage by introducing
  processes to assess exposure & integrate this with an
  economic capital model
• Protecting assets by reducing losses through improved risk
  control environment and financing programme
• Enhanced organizational capabilities & subsequent
  competitive positioning through continuous improvement
                                                                3
  How to Reduce Operational Risks?

Understand Risks
• Benchmarking
• Scenario Analysis
• Key Risk Indicator’s (KRI)
De-Risking Operational Procedures
• Define, Measure, Analyze, Improve, & Control
Risk Finance & Transfer
• Mapping to Insurance Products
• Developing New Products
• Financing Retained Losses
• Transferring Risk to the Insurance & Capital Markets
                                                         4
       Op Risk/Lean Six Sigma Linkage

      Op Risk Needs            Six Sigma Can Provide
Identification of critical     Hierarchical, process view of
processes and activities       a business

Monitoring of key indicators   Process Management &
and warning of potential       Control
problems
Cure problems in existing      Process Improvement via
processes                      DMAIC & Lean

Prevention of problems for     Process Design via DFSS
new processes
                                                               5
             Six Sigma Defined

• A data driven approach to understanding and
  eliminating process variation and defects
• Three, universal, methodologies for process
  management
• A performance target of 3.4 defects per million
  opportunities




                                                    6
Risk Management: How Can Six Sigma Help?

 • Six Sigma provides three powerful methodologies
   for:
   – Designing robust processes
   – Fixing broken processes
   – Controlling processes on an ongoing basis (i.e.,
     keeping them from decaying and producing errors)




                                                        7
Risk Management: How Can Six Sigma Help?

 • Designing robust processes:
   – A structured methodology, DFSS (Design for Six
     Sigma), assures that:
     • New processes have high capability (satisfy customers
       and produce low defects) right from the start
     • New processes are designed to minimize the risk of
       failure




                                                               8
Risk Management: How Can Six Sigma Help?

 • Fixing broken processes:
   – A structured methodology, DMAIC (Define,
     Measure, Analyse, Improve, Control):
     • Uses powerful statistical (and non-statistical) tools to
       locate and eliminate the root causes of otherwise
       intractable problems
     • Focuses on removal and prevention of defects
     • Reduces process variability




                                                                  9
Risk Management: How Can Six Sigma Help?

 • Controlling processes, so that their behavior is
   predictable (within limits). Six Sigma provides:
   – Special tools and techniques including a framework:
     • For measuring and judging process variation
     • For detecting special causes
     • To providing early warning of process changes
   – The ability to calculate Process Sigma, an index of
     process performance




                                                           10
    Companies Pursue Six Sigma to …

• Accommodate customer demands
• Drive out waste, cycle time and variability
• Direct improvement resource to the most significant
  opportunities
• Establish a standard improvement methodology
• Develop leaders
• Reduce risk
• Grow the top-line
• Implement business strategy
• Increase product reliability
• Initiate cultural change
• Accelerate improvement

                                                        11
             Sigma is a Measure of
              Process Capability
                                     Performance    Process
                                     boundary       performance

                    Requirement                          6
Sigma DPMO                                          5
                                             4
 1    680,000
                                     3
 2    298,000                  2
 3     67,000
 4                       1
        6,000
 5        400
 6        3.4

  Six Sigma is a level of process capability such
  that less than 3.4 “defects” are produced for
  every million opportunities.
                                                                  12
        Estimating the Benefits of Six Sigma


 Sigma Level                               Defects Per Million                                      Cost of Quality

                3                                           66,807                                  20-30% of Sales

                4                                            6,210                                  15-20% of Sales

                5                                               233                                 10-15% of Sales

                6                                                3.4                                < 10% of Sales
Harry, Mikel J., Six Sigma: A Breakthrough Strategy for Profitability, Quality Progress, May 1998




                                                                                                                      13
          Process Sigma Advantages

 The Sigma Scale provides a common metric for comparison
  that includes the customer requirement and the degree of
          variation. Addresses multiple occurrences.

PROCESS               PERFORMANCE

Call servicing        32 seconds ASA vs goal of 35

Billing               98% accuracy, on time, right location

Accounts Receivable 33 days average aging vs goal of 40

Customer Service      82% rated 4 or 5 responsiveness

                                                              14
         The Antecedents of Six Sigma

• Six Sigma is the latest and most powerful in a long
  line of process management and process
  improvement methods, e.g.:
  –   Guilds
  –   The Scientific Method
  –   Quality Circles
  –   TQM
• Six Sigma has built on these ideas and added
  powerful tools
• It is specially useful for transactional processes
                                                        15
              Sound Practices in
         Operational Risk Management
Principle 1
The board of directors should be aware of the major aspects
of the bank’s operational risks as a distinct risk category that
should be managed, and it should approve and periodically
review the bank’s operational risk management framework.
The framework should provide a firm-wide definition of
operational risk and lay down the principles of how
operational risk is to be identified, assessed, monitored,
and controlled/mitigated.




Source: Sound Practices for the Management & Supervision
of Operational Risk (Basel Committee – July 2002)
                                                                   16
              Sound Practices in
         Operational Risk Management
Principle 2
The board of directors should ensure that the bank’s
operational risk management framework is subject to
effective and comprehensive internal audit by
operationally independent, appropriately trained and
competent staff. The internal audit function should not be
directly responsible for operational risk management.




Source: Sound Practices for the Management & Supervision
of Operational Risk (Basel Committee – July 2002)
                                                             17
              Sound Practices in
         Operational Risk Management
Principle 3
Senior management should have responsibility for implementing
the operational risk management framework approved by the
board of directors. The framework should be implemented
throughout the whole banking organization, and all levels of staff
should understand their responsibilities with respect to
operational risk management. Senior management should
also have responsibility for developing policies, processes
and procedures for managing operational risk in all of the
bank’s products, activities, processes and systems.



Source: Sound Practices for the Management & Supervision
of Operational Risk (Basel Committee – July 2002)
                                                                     18
              Sound Practices in
         Operational Risk Management
Principle 4
Banks should identify and assess the operational risk
inherent in all material products, activities, processes
and systems. Banks should also ensure that before
new products, activities, processes and systems are
introduced or undertaken, the operational risk
inherent in them is subject to adequate assessment
procedures.




Source: Sound Practices for the Management & Supervision
of Operational Risk (Basel Committee – July 2002)
                                                           19
              Sound Practices in
         Operational Risk Management

Principle 5
Banks should implement a process to regularly monitor
operational risk profiles and material exposure to
losses. There should be regular reporting of pertinent
information to senior management and the board of
directors that supports the proactive management of
operational risk.




Source: Sound Practices for the Management & Supervision
of Operational Risk (Basel Committee – July 2002)
                                                           20
                            The 6s Process

                            Establish                   Operational Risk
                            Controls                  Assessment & Analysis
      Key Risk Indicators
        (Dashboards)
                                                                         Project
      Measurement                                                       Selection
    System Validation
                                                                          SIPOC
New Process
 Capability
                                                                           Capability
New Process                                                                Baseline
   Pilot                    IMPROVE
                                                                        Measurement
 New Policies                                                         System Validation
 & Procedures
                                                                 Process Risk
        Process                                                    Mapping
      Specifications    Confirm                        Identify Key
                        Impact          Correlation    Risk Drivers
                                         Analysis
                                                                                          21
       Mapping 6s to Operational Risk Framework




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                                              Operational Risk




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 Level 2 & Activity Groups




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                             Creating Management Awareness         
                             Identification & Risk Mapping                                                            
                             Quantification & Modelling                                                               
                             Risk Profiling                                  
                             Risk Solutions                                                                              
                             Monitoring & Updating                                                         

                                              Operational Risk Definition & Analysis


• Natural Linkage to Operational Risk Management Framework
• Operates at Level 1, Level 2 and Activity Group Level (All Business Lines)
• Linked to All Products, Activities, Processes, and Systems
• DMAIC Employed to Improve Existing Policies, Procedures, and
  Processes….DFSS Leveraged to Design New Ones
       Operational Risk Management Using 6s
                             Operational Risk Internal Measurement Analysis (ORIMA)
                                                                                                                            Loss
                                                                                             Business Line
                                                                                                             Probability   Given
                                Potential Risk   Potential Failure   Potential   Current          Risk                              Expected
    Business Line Description                                                                                 of Loss      Event
                                   Factors           Effects         Causes      Controls      (Exposure                            Loss (EL)
                                                                                                             Event (PE)    Occurs
                                                                                             Indicator - EI)
                                                                                                                           (LGE)

1 Corporate Finance                   -                  -               -          -             0.50          0.10        100       5.00

2   Trading and Sales                 -                  -               -          -              -              -          -          -

3   Retail Banking                    -                  -               -          -              -              -          -          -

4   Commercial Banking                -                  -               -          -              -              -          -          -

5   Payment and Settlement       Six Sigma Focus
                                   -        -                            -          -              -              -          -          -

6   Agency Services              • Identify Risks
                                     -         -      -      -                                     -              -          -          -

7   Asset Management             • Describe Outcome of Failure
                                     -         -      -      -                                     -              -          -          -

8   Retail Brokerage             • Determine Cause & -Effect -
                                     -         -                                                   -              -          -          -

                                 • Evaluate Current Controls

                                                                                             Expected
      ORIMA Drills-Down From Top Level                                                      Loss Factors
       Business Line to the Processes
         Within Each Activity Group
                                                                                                                                                23
                     Operational Risk Management Using 6s
                                                                                                                                                                                                                                                                                                                                  Methods                                                          Material
                             Operational Risk Internal Measurement Analysis (ORIMA)
                                                                                                                                   Loss
                                                                                               Business Line
                                                                                                               Probability        Given
                                                                                                                                                                                                                   Establish                         Operational Risk                                                                                Processor Review
                                Potential Risk    Potential Failure   Potential     Current         Risk                                   Expected                                                                Controls                        Assessment & Analysis                                                                                                                                                            Easy to understand instructions
    Business Line Description                                                                                   of Loss           Event
                                   Factors            Effects         Causes        Controls     (Exposure                                 Loss (EL)                                                                                                                                                                                                                    Loan amount
                                                                                                               Event (PE)         Occurs                                                  Key Risk Indicators
                                                                                               Indicator - EI)
                                                                                                                                  (LGE)                                                     (Dashboards)
                                                                                                                                                                                                                                                                                                                     Manager approval
1 Corporate Finance                   -                   -               -               -         0.50              0.10         100       5.00                                                                                                                                          Project
                                                                                                                                                                                      Measurement System                                                                                  Selection                                                                                    Disclosures
2   Trading and Sales                 -                   -               -               -          -                 -            -          -
                                                                                                                                                                                          Validation
                                                                                                                                                                                                                                                                                                                                                                                                                                                                  Application
3   Retail Banking                    -                   -               -               -          -                 -            -          -
                                                                                                                                                                             New Process                                                                                                    SIPOC
4   Commercial Banking                -                   -               -               -          -                 -            -          -                                                                                                                                                                              Create approval letter
                                                                                                                                                                              Capability
5   Payment and Settlement            -                   -               -               -          -                 -            -          -
                                                                                                                                                                                                                                                                                             Capability                                                                                                                                                                                                      Fast Loan
6   Agency Services                   -                   -               -               -          -                 -            -          -
                                                                                                                                                                              New Process                                                                                                    Baseline                                                                                                                                                                                                        Approval
    Asset Management                  -                   -               -               -          -                 -            -          -                                 Pilot
7
                                                                                                                                                                                                                  IMPROVE
8   Retail Brokerage                  -                   -               -               -          -                 -            -          -                                                                                                                                        Measurement
                                                                                                                                                                                                                                                                                                                                                                        Remote Printing                                                                                                  # of underwriters
                                                                                                                                                                                                                                                                                      System Validation
                                                                                                                                                                                  New Policies &                                                                                                                                        Credit Score
                                                                                                                                                                                   Procedures
                                                                                                                                                                                                                                                                                                                                                                                                                                                                        # of loan processors
                                                                                                                                                                                                                                                                               Process Risk
                                                                                                                                                                                           Process                                                                               Mapping                                       Internet capability
                                                                                                                                                                                         Specifications
                                                                                                                                                                                                                   Confirm                            Identify Key
                                                                                                                                                                                                                                 Approval
                                                                                                                                                                                                 Process Capability Analysis for Risk Drivers CT_
                                                                                                                                                                                                           Impact    Correlation                                                                                                               Machine                                                                          Environment
                                                                                                                                  NO                                                                                                Analysis
                                                                                                                                             Notify Bank
       Receive Loan                          Review                            Enter in                            Loan
                                                                                                                                             Manager &
        Application                         Application                        System                             Approval                                                                                                                       UB                                                                                                                                    Pareto Chart for Loan Amount
                                                                                                                                              Customer
                                                                                                                                                            Process Data
                                                                                                                            YES                      Upper Bound      120.000
                                                                                                                                                                                                                                                                                                 Within
                                                                                                                                                     Target                  *
                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              100
                                                                                                                                                     LSL                     *                                                                                                                   Overall                                                 500
                                                                                                                                                     Mean               98.126                                                                                                                                                                                                                                                                                                                                80
                                                                                                                                                     Sample N              530                                                                                                                                                                           400
                                          Notify Bank &                        Prepare                     Approve Loan




                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    Percent
                                                                                                                                                     StDev (Within)   19.2991




                                                                                                                                                                                                                                                                                                                                                 Count
                                           Customer                           Documents                       Amount                                                                                                                                                                                                                                     300                                                                                                                                                  60
                                                                                                                                                     StDev (Overall)  19.5817

                                                                                                                                                                                                                                                                                                                                                         200                                                                                                                                                  40
                                                                                                                                                     Potential (Within) Capability
                                                                                                                                                     Cp                          *                                                                                                                                                                       100                                                                                                                                                  20

                                                                                                                                                     CPU                         *
                                                                                                                                                                                                                                                                                                                                                          0                                                                                                                                                   0
                                            Customer                                                                                                 CPL                         *                                                                                                                                                                                                                                         0
                                                                               Enter in                          Disperse                                                                                                                                                                                                                                                                                            ,00                                  01                              ,00
                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              2
                                                                                                                                                                                                                                                                                                                                                                                   0                            99                                  9,0                                99
                                              Signs                                                                                                  Cpk                         *                                                                                                                                                                                      60
                                                                                                                                                                                                                                                                                                                                                                             ,00                          -$1                               0-$
                                                                                                                                                                                                                                                                                                                                                                                                                                               29                                -$4                   ers
                                                                               System                             Funds
                                                                                                                                                             Regression Plot                                                                                                                                                                   Defect            <$
                                                                                                                                                                                                                                                                                                                                                                    1                             ,00
                                                                                                                                                                                                                                                                                                                                                                                                      0
                                                                                                                                                                                                                                                                                                                                                                                                                                      ,00                             0,0
                                                                                                                                                                                                                                                                                                                                                                                                                                                                            00                      Oth
                                            Paperwork                                                                                                                                                                                                                                                                                                                                     $1
                                                                                                                                                                                                                                                                                                                                                                                               60
                                                                                                                                                                                                                                                                                                                                                                                                                               $2
                                                                                                                                                                                                                                                                                                                                                                                                                                    00
                                                                                                                                                                                                                                                                                                                                                                                                                                                               $3
                                                                                                                                                                                                                                                                                                                                                                                                                                                                  0
                                                                                                                                                                          30
                                                                                                                                                     Cpm PLT.YLD. = 68371.0 -*19042.9 pH
                                                                                                                                                                                                       50         70           90          110         130              150                170
                                                                                                                                                                                                                                                                                                             I Chart for Approval               Count             254                             164                                  53                               38                           21
                                                                                                                                                                    + 1327.06 pH**2                                                                                                                                                            Percent           47.9                            30.9                                10.0                              7.2                          4.0
                                                                                                                                                                  Capability
                                                                                                                                                           OverallR-Sq = 42.5 %                                                                                                                                                                Cum %             47.9                            78.9                                88.9                             96.0                        100.0
                                                                                                                                                   S = 18.7123                        R-Sq(adj) Observed Performance
                                                                                                                                                                                                = 40.0 %                        Exp. "Within" Performance         Exp. "Overall" Performance
                                                                                                                                                     Pp                           *        PPM < LSL                  *        PPM < LSL                  *      PPM < LSL                   *                                                                 UCL=156.0
                                                                                                                      150
                                                                                                                                                     PPU                                                                                                              150
                                                                                                                                                                              *    PPM
                                                                                                                                                                             Quadratic > UB
                                                                                                                                                                                       Model                  133962.26        PPM > UB                   *      PPM > UB                    *
                                                                                                                                                     PPL                          *        PPM Total          133962.26        PPM Total                  *      PPM Total                             *
                                                                                                                                                     Ppk                          *




                                                                                                                                                                                                                                                                 Individual Value
                                                                                                           PLT.YLD.




                                                                                                                      100
                                                                                                                                                                                                                                                                                    100                                                                        Mean=98.13




                                                                                                                                                                                                                                                                                    50
                                                                                                                      50                                                                                                                                                                                                                                       LCL=40.23
                                                                                                                                                                                                                                                                                                                                                         1

                                                                                                                                                                                                                                                                                             0        100      200     300         400           500
                                                                                                                                            7.0                             7.1                             7.2
                                                                                                                                                                                                                                                                                                            Observation Number
                                                                                                                                                                    pH




                                                                                                                        The Discipline and Its Approach,
                                                                                                                      Combined With a Rich Set of Analysis
                                                                                                                      Tools, Makes Six Sigma a Perfect Fit
                                                                                                                       for Operational Risk Management
                   A Way Forward

Outside In or Inside Out
• Outside In:
  1. Review statistics for comparable businesses and identify risk
     by type
  2. Identify the processes that lie behind the risk (hierarchy)
  3. Perform risk analysis on the key processes (FMEA)
  4. Identify key measures inside and outside of the process
  5. Collect data
  6. Monitor, using dashboards and control charts. Search for
     signals
  7. Take action as required (DMAIC, Lean, DFSS or other)
                                                                     25
                   A Way Forward

• Inside Out:
  1. Inventory all processes
  2. Identify those presenting the greatest risk
  3. Identify the sub-processes that lie behind the risk (process
     hierarchy)
  4. Perform risk analysis on the key processes and sub-
     processes (FMEA)
  5. Identify key measures inside and outside of the process
  6. Collect data
  7. Monitor, using dashboards and control charts. Search for
     signals
  8. Take action as required (DMAIC, Lean, DFSS or other)

                                                                    26
         Questions?




Further Questions / Information:


                  Lori Marin
         Telephone: 312-381-4420
       Email: lori_marin@ars.aon.com




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