Future options

Operational risk derivatives have been touted for a few years now, and interest in them moves in waves, but the current tide is high. Duncan Wood tests the water

If there's no smoke without fire, the dense clouds billowing around operational risk derivatives would suggest an almighty conflagration. "There is a huge amount of chatter about op risk derivatives," says Marcelo Cruz, head of operational risk at Lehman Brothers in New York. "A lot of people have become interested in more sophisticated hedging alternatives since they advanced on their measurement models and got more comfortable with the outcomes."

As an example, Swiss data-sharing association ORX set up a working group late last year, partly to discuss the possibility of derivatives based on an index of loss rates among ORX members - general hedges that would pay out when the index hit a certain point. Separately, derivatives dealers are zeroing-in on options, swaps and securitisations that would transfer op risk.

This kind of talk has got the industry excited. Bernd Rummel, a banking supervisor at Germany's financial supervisory authority, BaFin, says the first transactions should happen this year. Andrew Sheen, a manager in the operational risk policy team at the UK's Financial Services Authority (FSA), agrees interest has increased - advanced-measurement-approach (AMA) banks are putting the finishing touches to their models and have now begun to "focus attention on the potential for capital alleviation offered by risk-transfer mechanisms," he says. "In addition, derivatives providers are exploring the opportunities offered by these products."

But blow away the smoke and you'll find a small, fitful bonfire rather than a great blaze. There is some activity behind the scenes, but op risk derivatives have been talked about for years without anything concrete emerging, so any kind of activity represents a change. Rummel's expectation that op risk derivatives will be traded during 2007 is not widely shared.

"With AMA applied from 2008, the pressure on banks to be pro-active in transferring op risk will increase," says Mark Laycock, a director in the op risk team at Deutsche Bank in London. The German bank's op risk team has had a number of 'what-if' conversations with front-office colleagues - marketers and structurers - to get a feel for how the pricing on a derivative might compare to other means of transferring the risk, he says. Laycock has also spent time thinking about how the bank could use derivatives products strategically, as part of an arsenal of risk-transfer tools that would allow the institution to hold op risk selectively.

The potential of a new market would be significant, says Sebastian Fritz, global head of operational risk at Deutsche Bank. "If you look at the number of banks likely to have AMA capital requirements under Basel II, you get some sense of the potential demand for risk transfer above and beyond insurance," he says. "A lot of the structural components are there, and they will be applied to op risk."

Insurance company Aon has figures that sketch out the market's potential size. The company is working on a new type of op-risk-transfer solution that could end up bumping shoulders with derivatives-based products in the post-Basel world, says Daniel Butler, London-based head of operational risk in Aon's financial institutions global practice group. To estimate the market potential, Aon assumes that the $1.18 trillion currently held as tier I capital by the world's top 50 banks will end up being roughly equivalent to their capital stocks after Basel II has been implemented, and that op risk capital would account for around 12% of that total, or $142 billion.

Under the new capital regime, regulators will allow banks to use risk-transfer products in place of no more than 20% of their op risk capital - about $28 billion - but, crucially, only if the products provide a reliable, readily accessible payout. Butler says early conversations with regulators have suggested any risk-transfer cover would need to do more than just match capital on a dollar-for-dollar basis, with talk of a 20% buffer being added on to reflect the fact that such products cannot respond to every potential event. In total, then, the top 50 banks could produce demand for around $35 billion of risk transfer, he says.

A movable ceiling

The size of the market could also increase. If new risk-transfer products show they are an effective and reliable hedge, the FSA's Sheen doesn't rule out the possibility that the 20% capital relief ceiling might be increased - but he warns that "banks' early experiences with insurance and risk-transfer mechanisms will be subject to close review by regulators".

Even with the existing ceiling, there's plenty of room for insurance and derivatives-type transactions to co-exist and complement each other, says Butler - but there are a lot of unknowns. If a derivative were able to provide greater certainty than an insurance product - or if capital-market investors were willing to accept less compensation for the risk than insurers - then he accepts there would be "less opportunity for exotic insurance products".

Proponents of derivatives solutions believe these do have greater potential than insurance products. For one thing, derivatives can unlock a far greater store of risk-taking capacity via the international capital markets, says Lehman Brothers' Cruz. "Financial institutions realise we have to take this risk to the capital markets. The insurance industry has a total capitalisation of around $300 billion-400 billion, which is very small for what financial firms need," he says.

Derivatives are also touted as a more effective capital substitute than insurance. In other words, if a bank sustains a loss, it can be sure of rapid payment - a critical factor if regulators are to be satisfied.

Other pieces of the puzzle are also beginning to fall into place, says Vejen Stoilov of Deutsche Bank's op risk team in London. The arrival of Basel II, with its set loss types and business lines, means "we can now go to the market with standard terminology that has been determined by the regulator", he says. "Investors can be reassured that how one bank defines internal fraud is not down to some choice on the day. Basel II creates certainty and transparency with regard to major components of the loss categories."

A more vexed issue for potential investors could be moral hazard - the possibility that a bank, having rid itself of all exposure to fraud, might then be less than diligent when managing that risk. Stoilov says derivatives could tackle this issue by only transferring exposure over a certain magnitude of loss - or perhaps by retaining a percentage of the exposure on a sliding scale.

Yet some bankers have heard it all before. The head of op risk at one UK institution says: "People have been talking about this for years and years. I was told a year ago that several banks were about to issue a derivative but that didn't happen. There's a lot of talk and no action."

It certainly seems a little too early to expect anything to emerge from ORX. Simon Wills, the association's executive director in London, says an index is just one of the risk-transfer options under assessment. "We're looking at the potential for some sort of capital-market product to help banks transfer operational risk, but it's all in the very early stages of thinking and discussion," he says.

There are also questions about the potential effectiveness of index-based hedges as well. Any products written on the index would be triggered by the loss experiences of a group of banks rather than of a single bank, says one New York-based practitioner: "It might create an environment for people to play and trade op risk, but it's not clear how you'd use it to hedge losses at individual institutions." Another observer says there are concerns that the ORX data - probably the best in the industry - might still fall short of the quality needed to produce a robust index.

The UK bank's op risk head isn't waiting around. He argues that it makes most sense to try to tweak existing insurance policies rather than wait for a capital-market solution that might never arrive. Banks already have a patchwork of property cover and professional indemnity policies that could be used to offset a good chunk of capital, he says. Although the terms used in standard contracts don't typically match up with Basel loss events, and therefore might not be deemed effective hedges by regulators, he argues that it's possible to tailor the policies to achieve a better fit.

But not a good enough fit, say others. One former insurance executive, who has reviewed op risk-related policies for banks, says contracts that have been adjusted for Basel are "godawful". "They're worse than any contracts I've ever seen," he adds. "They're just written in a way that means it's not clear what's covered and what isn't." This kind of uncertainty tends to be resolved in lengthy legal wrangling. As a result, says one practitioner, insurance policies often boil down to "an option to go to court".

No substitute

Moreover, Aon's Butler is not convinced that standard insurance can be made to function as a capital substitute. "Some banks are looking to use existing products and think this will provide regulatory capital relief," he adds. "Such approaches fail to realise the potential for using insurance."

But this doesn't mean insurers have given up on op risk. Butler says Aon is already in discussion with several banks about arranging a form of insurance cover that would offer the clarity and certainty associated with derivatives products. Butler says these discussions should bear fruit within weeks: "It's too early to write off insurance products. We just haven't had a chance to show what we can do until now, because banks have still been getting to grips with their own op risk profiles."