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					OperationalRisk
                                                                                               insurers don’t have any products to offer banks at this



Who’s buying?                                                                                  stage, and more suitable products won’t be emerging
                                                                                               in the near future,” he says.
                                                                                                 The result is a gaping hole in the banking industry’s
                                                                                               armour. Cruz estimates that up to 90% of banks’ op
                                                                                               risks are currently unhedged: “I just don’t see
                                                                                               insurance companies offering this kind of protection
Operational risk derivatives are being reconsidered as                                         with their current product line. There’s a gap that
                                                                                               needs to be sealed.”
a solution to banks’ distrust of op risk insurance                                               Op risk derivatives have long been touted as a way of
                                                                                               closing this gap. Cruz wrote an article for Risk
policies, but the market for these is yet to develop.                                          Magazine in the late 90s suggesting that op risk
                                                                                               quantification could one day provide the basis for a
By Duncan Wood                                                                                 suite of derivative products – a topic he revisited in a
                                                                                               book published in 2001. In the same year, this
                                                                                               publication carried an article written by Penny Cagan,

                                   HERE’S             a conundrum: banks don’t like the
                                                      insurance policies that are available
                                   to cover operational risk, and yet they keep buying
                                                                                               in which she argued that the then-fledgling credit
                                                                                               derivatives market might provide a model on which op
                                                                                               risk derivatives could be based.
                                   them. Why? Largely, it’s because of a scarcity of viable      Cagan, head of research for Algorithmics’ Algo
                                   alternatives – and this scarcity is now helping to revive   OpVantage product in New York, says, “five years on, a
                                   interest in the long-mooted but little-explored idea of     lot of the obstacles that existed then still exist today.”
                                   op risk derivatives.                                        Cruz concurs: “The subject hasn’t moved ahead.”
                                     Gripes with current insurance policies range from           The lack of progress hasn’t killed the idea off,
                                   their myriad exclusions (for example, many business         however – and some bank op risk managers are
                                   interruption policies won’t pay out unless the insured      convinced that it’s just a matter of time before they
                                   suffers property damage, which rules out claims             have the ability to transfer or shape portfolios of risk
                                   resulting from power outages) to uncertainties about        using derivative products.
                                   payouts and renewability.                                     “I am very confident that something will develop
       Dan Mudge, Algo OpVantage     These concerns reached the ears of the Basel              that will give financial institutions the opportunity to
                                   committee during the drafting of the new Accord, and        transfer risk in a commercially attractive manner,” says
                                   helped scupper the insurance industry’s hopes that          Joe Sabatini, managing director with JP Morgan
                                   regulators would give banks the freedom to substitute       Chase in New York and global head of the bank’s
                                   insurance cover for regulatory capital, which may have      corporate op risk team. “You could be an optimist or a
                                   created a big new market.                                   pessimist regarding the timing, and you could have
                                     A source close to the Basel committee says that           different views about the kind of products that will
                                   insurers “did not do a great job, frankly, of satisfying    develop, but I’ve no doubt that it will happen.”
                                   the committee that its products map well to op risk-          Various forms of derivative could conceivably be
                                   event types”. At the same time, banks were telling          used to transfer op risk – securitisation and swaps
                                   committee members that they have to fight tooth and         seem the most likely candidates. Cruz says that he
                                   nail to secure payments on claims they have made – a        expects the first transactions – if and when they arrive
                                   long, drawn-out process that can take months or even        – to take the securitisation route: “Bonds could be
                                   years. Says the source: “How could that ever be as          structured so that repayment of the principal was tied
                                   good as holding capital against risks?”                     to the risk of some kind of op risk event, like fraud.”
                                     But insurers did persuade the committee to allow          Investors would receive a standard Libor rate plus the
                                   banks some capital relief on the back of risk               credit spread, but would also be paid a premium to
                                                                                               bear the bank’s fraud risk. If the issuing bank was hit
                                                                                               by a fraud of a certain magnitude, he suggests, the
“I JUST DON’T SEE INSURANCE COMPANIES OFFERING THIS KIND OF                                    bank could then use some or all of the investors’
 PROTECTION WITH THEIR CURRENT PRODUCT LINE. THERE’S A GAP                                     principal to cover its own losses.
                   THAT NEEDS TO BE SEALED”                                                      This kind of structure might also be suitable for
                 Marcelo Cruz, Lehman Brothers                                                 securitising the risk of a group of institutions. Dan
                                                                                               Mudge, group managing director for Algo
                                                                                               OpVantage in New York, says that he recently heard
                                   mitigation. A bank can now use insurance to reduce          exactly this idea being floated by one insurance
                                   its op risk capital requirement by up to 20%, and a         industry executive. “The suggestion was that a
                                   recent seminar organised by Swiss Re in New                 number of banks could pool their rogue trading risk,
                                   York involved some discussion on how this could             for example. But it was all very vague. There was no
                                   be achieved.                                                elaboration on the specifics.”
                                     The bad news for both sides is that there’s no              One firm – US-based Giuffre Associates – is trying
                                   pipeline of blockbuster products ready to wow op risk       to turn these vague ideas into something more
                                   managers, says attendee Marcelo Cruz, global head of        concrete, according to Sandra Giuffre, one of the
                                   op risk at Lehman Brothers. “The conclusion was that        firm’s three principals and founder. Giuffre, a risk



                                                                                                                        www.operationalriskonline.com
                                                                                                                        Op risk Derivatives


specialist and formerly a managing director with




                                                                                                                                                                 Photo: Masterfile
insurance firm Marsh, has teamed up with Sanjay
Sathe, previously the head of the global swap business
at Chase Manhattan, to look for ways to transfer op
risks using a combination of insurance and capital
markets techniques.
  Given that there aren’t many firms focusing on this
space, Giuffre says that “a lot of painstaking work is
needed to make potential clients comfortable with the
techniques involved. You also have to bring the buy
side and the sell side along together, moving at a pace
that they’re comfortable with.”
  The firm’s approach is work in collaboration with
organisations that are exposed to some form of risk and
are either uninsured or unhappy with the cover they



                                                                                                                    Derivatives
currently have, developing structures and solutions and
then looking for companies and markets that are better
placed to bear that risk.
  Giuffre is coy about the kind of structures that the
firm plans to use, but she says the firm currently has
mandates to try and place $100 million worth of fraud
risk, as well as separate exposures to related supply
chain and anti-trust issues.
  Will the firm be able to find a buyer for the risk?
Giuffre sees no reason why not: “These are all
transferable risks. There’s nothing in the way we have
the trigger organised that should be a problem.
They’re all do-able. It’s just a matter of pricing and
finding the right market for it.”
                                                             convince regulators otherwise.                                              New and improved:


THE         advantage that op risk derivatives have over
            insurance cover (in theory) is that the
derivatives can be better aligned with the actual risk
                                                               A source close to the Basel committee says that
                                                             regulatory scepticism about the benefits of insurance
                                                             was “magnified when people started talking about
                                                                                                                               The idea of op risk derivatives
                                                                                                                               has a certain amount of cache


faced by the bank. The length of the contract and the        products that don’t even exist.” He says that some
definition of the trigger event could be customised –        investment banks argued that op risk derivatives
and it shouldn’t take two years to get paid either.          should be given the committee’s seal of approval,
  “For example,” says Charles Beach, a partner in the        claiming that they would be able to develop an
derivatives team with PricewaterhouseCoopers in              effective product, but adds that “there was no way
London, “if you were going to switch to a new trading        that the committee was going to go out on a limb for
platform, and knew you were facing increased exposure        something that had not been tried and tested.”
to rogue trading over the transition period, you could         Sabatini denies that this is an insuperable problem.
go out and do a six-month swap that would mitigate           He notes that many of the largest banks will be
the risk. You can’t do that with an insurance policy.”       running two somewhat separate risk and capital
  Despite these supposed advantages, a market for op         systems, even after Basel II is introduced – the
risk derivatives has not yet sprung into being – so          regulatory capital system for Basel, as well as the
what’s the catch?                                            economic capital systems that sprang up prior to the
  First, there’s the problem of fixing a fair price for      regulatory overhaul. For these banks, he says, the
risks that banks are still struggling to quantify.           primary driver for op risk mitigation will be economic,
Implementation of Basel II will require the most             not regulatory – in other words, if a bank believes that
sophisticated banks to demonstrate that they can             it can reduce op risk by using an derivative it will go
accurately quantify their op risks – but even thereafter,    ahead, whether it attracts capital relief or not.
derivative products are unlikely to spring up like             But no bank is going to be so desperate to
daisies in the lawn, warns Cruz. He says it will             reduce its exposure to a given risk that it will
probably take a couple of years before banks become          pay any price to do so – and highly customised,
fully comfortable with the figures their op risk systems     painstakingly arranged transactions are rarely
are generating. And if it’s tough for the seller to judge    cheap. Giuffre Associates is betting that it can keep
the price, it’s even more difficult for the buyer, who       the costs of risk transfer
has no public data from which to decide whether the            down by making its transactions highly specific.
seller’s assessment of the risk is correct.                  “We’re really trying to understand a very specific risk
  The second big problem is the fact that Basel II does      and to arrange a transaction that transfers that risk
not allow the possibility of capital relief for banks that   away,” says Sathe.
use derivatives as an op risk mitigant, despite the best       It shouldn’t be too long before risk managers find
efforts of would-be op risk derivatives dealers to           out whether that’s just a pipe dream. OpRisk



December 2005

				
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