Operational risk and its relationship with institution size in the Hungarian banking sector

In addition to credit, market and liquidity risk, measuring and managing operational risk (risk associated with people, systems, processes and external events) is a great challenge for banks. In 2010, around HUF 35 billion in operational risk losses were reported in the banking sector overall, which is significant relative to the pre-tax profits of the banking sector. To a large extent, banks’ operational risk measurement methods rely on loss events which have already occurred. If an individual institution has insufficient data for modelling or wishes to include the experiences of extreme events, it should use external data or transpose the risk exposure of the banking sector onto itself. The empirical analysis of the Hungarian banking sector’s operational risk data confirms that, similarly to foreign banking sectors and banking groups (which have been already analysed in the relevant literature), there is a significant relationship in the Hungarian banking sector between institution size as defined by gross income and total operational risk losses recorded during the specific period. However, the most significant correlation can be observed between institution size and the frequency of operational risk losses. This result could provide basis for the systemic analysis of operational risk and support simpler operational risk capital allocation methods. Nonetheless, due to the relatively short time series and the significant dispersion of data, we could not robustly assess the sufficiency of the capital already allocated for operational risk.banks, financial risk, risk management, operational risk

The impact of the capital requirements for operational risk in the Hungarian banking system

The capital adequacy regulation which came into force on 1 January 2008 for the Hungarian banking sector, in line with the Basel II directives and generally applied in the European Union, brought the novelty of distinct management of operational risk. Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, personnel and systems or from external events, which, similarly to financial risk, may result in substantial losses. The regulation allows for various methods of calculating the capital requirement. Financial institutions may opt for simpler approaches based on income indicators, or for more complex ones based on actual measures of risk. Based on the past oneyear period, it appears that the Hungarian banking system’s operational risk capital charge is significant compared to the total capital charge, with the operational risk capital charge for 2009 Q1 amounting to HUF 120 billion, equivalent to nearly 8% of the total capital requirements. The reported realised losses are lower than the capital requirement (approximately HUF 13 billion in 2008), but the capital charge must provide a buffer in extreme, unexpected situations, and conclusions on extreme values cannot be drawn based merely on one year of observation, therefore this discrepancy could be completely justified. Regarding institutions’ choice of approach, it can be established that larger institutions prefer more complex methods in both foreign and Hungarian practice. This is due to the fact that the introduction of more advanced approaches comes with a higher fixed cost, which larger institutions can absorb more easily over the short term, and moreover, they can take better advantage of the benefits offered. Overall, the conscious management of operational risk and application of more developed methods aimed at managing such risks can contribute to the stability of the financial system.operational risk, Basel II, capital requirements, CRD, Hungarian banking sector.

Analysis of operational risk of banks – catastrophe modelling

Nowadays financial institutions due to regulation and internal motivations care more intensively on their risks. Besides previously dominating market and credit risk new trend is to handle operational risk systematically. Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. First we show the basic features of operational risk and its modelling and regulatory approaches, and after we will analyse operational risk in an own developed simulation model framework. Our approach is based on the analysis of latent risk process instead of manifest risk process, which widely popular in risk literature. In our model the latent risk process is a stochastic risk process, so called Ornstein- Uhlenbeck process, which is a mean reversion process. In the model framework we define catastrophe as breach of a critical barrier by the process. We analyse the distributions of catastrophe frequency, severity and first time to hit, not only for single process, but for dual process as well. Based on our first results we could not falsify the Poisson feature of frequency, and long tail feature of severity. Distribution of “first time to hit” requires more sophisticated analysis. At the end of paper we examine advantages of simulation based forecasting, and finally we concluding with the possible, further research directions to be done in the future

Backtesting the efficiency of MNB’s Lending Survey

This article briefly presents the general practice of lending surveys aimed at revealing loan supply behaviour, as well as the literature analysing their usability. The focus of our analysis is the so-called Lending Survey (SLO), conducted by the MNB since 2003. In the context of our backtesting based on data available up to December 2008, we examined whether there were any contradictions in banks’ responses and how usable the results were from the perspective of lending and growth forecasts. Based on the results, it can be established that banks are consistent in their answers, so there is a strong relationship between their forward-looking and subsequent, retrospective answers. The correlation between the changes in lending standards and the volume of loan portfolios is weak. This is due to the fact that in the Hungarian banking sector the increase in loan portfolios over the past five years may have been influenced not only by supply-side behaviour, but also by demand for loans and economic growth to a great extent. We also examined the correlation between changes in corporate lending standards and GDP growth, which proved to be significant. Nevertheless, we cannot draw conclusions about the direction of the cause and effect relationship based solely on the establishment of correlation, in other words about whether banks act procyclically or whether corporate lending behaviour plays a decisive role in economic growth. The strength of our analysis is limited by the brevity of the available time series and by the fact that we were unable to observe the entire loan cycle during the period under review. Later, with the expansion of the Lending Survey’s data series, it will be worthwhile to pursue our examination.lending survey, Hungary, loan supply behaviour,lending standards.

A bankok által alkalmazott működési kockázatkezelési módszerek és az intézményméret viszonya

A működési kockázat tudatos kezelése a 2007–2008-ban bevezetett Bázel II-es kockázatkezelési és tőkeallokációs keretrendszer fontos újdonsága. A szabályozás lehetőséget ad egyszerűbb és fejlettebb módszerek alkalmazására. A fejlettebb működési kockázati tőkemeghatározási módszerek bevezetésének előfeltétele nemcsak a kockázatmérés fejlettsége, hanem a kockázatkezelés tudatosságának megerősítése, megfelelő folyamatok kiépítése és az üzleti döntésekbe való beépítése. Tanulmányomban nemzetközi és hazai banki mintára is azt vizsgálom, hogy milyen kapcsolat van eredményesség, intézményméret, illetve a választott szabályozói működési kockázati módszertan között. Elemzésem alapján az rajzolódik ki, hogy mind a nemzetközi, mind a hazai bankok között a nagyobb intézmények hajlamosabbak fejlettebb működési kockázatkezelési módszereket alkalmazni, miközben ennek a nyereségességgel nincsen szignifikáns kapcsolata. Mindez az eredmény a működési kockázathoz kapcsolódó rendszerkockázati szempontból kedvező, mivel fontos, hogy a potenciálisan nagyobb rendszerkockázati hatással bíró, nagyobb intézmények tudatosabb kockázatkezelést alkalmazzanak

Banki működési kockázat és intézményméret = Operational risk of banks and firm size

Dolgozatomban a bankokat érintő működési kockázatokat és kockázatkezelési módszereket vizsgáltam. A működési kockázat alatt az emberek, rendszerek, folyamatok nem megfelelő, esetleg hibás működéséből, vagy külső eseményekből fakadó veszteségek kockázatát értjük. Egyrészt megállapítottam, hogy a szimulációval vizsgált, stilizált modellkeretben a működési kockázati veszteségek gyakorisági eloszlása a Poisson-eloszlással jól közelíthető; míg a súlyossági eloszlásra a lognormális eloszlás nem mutat megfelelő illeszkedést, de a vastag eloszlásszéllel rendelkező Pareto-eloszlás jó illeszkedéssel rendelkezik. Másrészt empirikus elemzésem alátámasztja azt, hogy hasonlóan a szakirodalom eredményeihez a hazai bankrendszerben is szignifikáns a bruttó jövedelemalapú intézményméret és az adott időszakban elszenvedett működési kockázati összveszteség közötti kapcsolat, de leginkább az intézményméret gyakorisági paraméterrel való összefüggése tekinthető erősnek, a veszteségmérettel kevésbé. A következtetéseinket korlátozza a vizsgálható intézményminta kis mérete. Harmadikként pedig azt állapítottam meg, hogy mind a nemzetközi, mind a hazai bankok között a nagyobb intézmények hajlamosabbak fejlettebb működési kockázatkezelési módszereket alkalmazni, miközben a nyereségességgel nincsen szignifikáns kapcsolat. A dolgozat eredményeit és azok kapcsolatát összegezve a legfontosabb eredményünk az, hogy az intézményméret fontos befolyással bír a működési kockázati kitettségre, a módszerválasztásra. Mindez a működési kockázathoz kapcsolódó rendszerkockázati szempontból kedvező tendencia, mivel fontos, hogy a potenciálisan nagyobb rendszerkockázati hatással bíró intézmények tudatosabb kockázatkezelést alkalmazzanak. ――――――――――――――――――――――――――――――――――――――――――――――― In my thesis, I analysed the operational risks and risk management methods related to the activity of banks. By operational risk we mean the risk of loss resulting from inadequate or failed operation of people, systems, and processes or from external events. Firstly in a stylised model framework analysed by simulation methods I concluded that the frequency distribution of operational risk losses can be properly approximated by the Poisson distribution; while in the case of loss severity distribution, lognormal distribution did not show appropriate fit, while the more fat tailed Pareto distribution provided appropriate goodness of fit. Secondly my empirical analysis supports the following similarly to the literature, the correlation between gross income-based institution size and the total operational risk losses incurred in a given period is significant in the Hungarian banking sector as well, the relationship between the institution size and the frequency parameter can be regarded as strong, and that with the loss size as less strong. The small sample of institutions limits the possibility to draw solid conclusions from the presented analysis. Thirdly I concluded that amongst both the international and the domestic banks, the larger institutions are more inclined to use more advanced operational risk management methods, while there is no significant relationship with profitability. Summarising the results of the thesis and the connections thereof, our most important result is that institution size has an important effect on operational risk exposure and method selection. This is a favourable tendency from an operational-risk-related system risk point of view, since it is important that institutions with potentially higher systemic risk influence apply more conscious risk management

Környezeti kockázatok felmérése. Paraméterek bizonytalanságának hatása a kockázatkezelési döntéshozatalra = Assessment of environmental risks – effects of parameter uncertainty to the risk management decisions

A környezeti kockázatok megfelelő felmérése és kezelése napjaink egyik legfontosabb kérdése, nemcsak a szakmai, hanem a széles értelemben vett közvélemény számára. A szerző cikkében azt vizsgálja, hogy a környezeti kockázatok felmérésének milyen megközelítései vannak. Kulcskérdésként pedig arra koncentrál, hogy a kockázatkezelési döntéseket hogyan befolyásolja a becslések bizonytalansága. Először a környezeti kockázat definícióját adja meg, majd azt mutatja be, hogy a környezeti kockázatok kezelésére vonatkozó megközelítések milyen párhuzamban állnak a pénzügyi rendszerrel, mint komplex rendszerre vonatkozó megközelítésekkel. Végül a jelenleg legnagyobb kockázatoknak tartott környezeti kockázatokat ismerteti röviden. A cikk második részében kockázatkezelési alternatívákat mutat be, és azt, hogy a kockázatkezelési lépések kiválasztását befolyásolja a bizonytalanság. Ezt illusztrálandó Brouwer-Blois (2008) modelljét használva a soklépéses szimulációt és alternatív döntési kritériumot – a kritikus (extrém) költség-hatás mutatót – alkalmazza. _____________ Adequate assessment and management of environmental risks is a key question nowadays also for professional experts and also for the overall public. In this article the author examines the different approaches concerning environmental risks. He concentrates as a key question the influence on risk management decisions of uncertainties raised by our estimations. First he analyses the definition of environmental risks, and he shows the similarities and differences between approaches concerning environmental risks and risks threatening financial system, and finally he gives short overview on the most current environmental risks. In the second part of the paper he presents risk management alternatives and analyses the influential power of uncertainty on risk management decisions. In order to illustrate this phenomenon the author applies the model of Brouwer-Blois (2008) with multistep simulation and an alternative decisive criterion, the ranking based on critical (extreme) cost to effect measure

Lending to local governments: Risks and behaviour of Hungarian banks

Over the past one and a half years, the amount of credit granted by banks to Hungarian local governments has doubled, and the gap between their cash deficit and net additional indebtness has increased. This borrowing boom is not the result of a drastic change in the financial management of local governments, but stems primarily of the fear of statutory tightening of borrowing conditions and their propensity to hold reserves. As the current statutory regulation does not represent an effective restriction on debt, indebtedness in the sector is limited only by the market – i.e. banks’ lending propensity. Although it is not unprecedented in international practice that this kind of market coordination may – with minor fluctuations – be able to keep indebtedness at an acceptable level, the uncertainties in the financial management of local governments and the weak transparency related to their long-term or contingent liabilities mean that the conditions for this kind of coordination are not fully in place in Hungary. Our survey of banks underpins this assumption, revealing that due to the sharp competition between banks, local governments are in a strong bargaining position vis-a-vis credit institutions, as – due to the lack of information and a high level of uncertainty – credit institutions are limited in the use of more sophisticated risk assessment techniques generally used in the corporate sector, and thus their lending is based on the expected continuity of local government operations.banks, state and local borrowing, bankruptcy; liquidation.

On the optimal design of operational risk data consortiums

To manage operational risk banks increasingly use data coming from data consortia formed by peer institutions. Although existing data consor- tia seem to work appropriately, it is worth examining why banks report properly (that is, thoroughly and truthfully), since in several countries where new data consortia are planned to be set up, there are fears that banks may choose to report untruthfully or hide information (what we call misreporting). We show that if misreporting cannot be detected, then even in an inÖnitely repeated setup the game has multiple equilibria, so proper reporting is not the unique outcome. Then we analyze two types of sanctions. When the punishment is non-monetary (e.g. exclusion from the consortium for a given number of periods), then for some parameter values even the harshest punishment cannot bring about proper reporting as the unique outcome. Nonetheless, a numerical example suggests that by designing adequately the data consortium, proper reporting can be ad- vanced, without overly compromising anonymity. When a monetary Öne is imposed on misreporting banks, then a su¢ ciently sever punishment results in proper reporting, even if anonymity is maintained in the limit

Risks of the indebtedness of the Hungarian local government sector from a financial stability point of view

Our paper explores the risks that arise due to indebtedness of Hungarian local governments. Our analysis relies on interviews conducted with the heads of the local government business branches of the credit institutions most important in terms of local government financing and on the related data collections, as well as on data from the Hungarian State Treasury regarding the financial management of local governments and on data from banks. Until 2011, the repayment of the bonds issued during the bond issue boom experienced in the local government sector in 2007–2008 started only in the case of one third of the bonds outstanding. However, by the end of 2011 year nearly 50 per cent and by end-2013 90 per cent of total bonds outstanding will reach the principal repayment period. Due to the considerable foreign exchange exposure of total loans and bonds outstanding (60 per cent, 80 per cent of which is Swiss franc exposure) as well as to the declining revenues of local governments and the deteriorating economic prospects, it is doubtful that local governments will be able to repay their debts to the banking sector in line with the original maturities. Therefore local governments financing may have an effect not only on the fiscal position but on the whole financial system as well. Nevertheless, our partial analysis establishes that the risks related to the debt of the local government sector have increased significantly in the recent period, but these risks could be managed by the banks. The comprehensive restructuring of the local government system as a whole and a further changing of debt settlement procedures by the government may influence the financial position of the local government system. In parallel with the regrouping of tasks, transferring of a portion of local government debt (primarily from the county local governments) to the central budget may result in a clear picture