Applying op risk and probabilistic networks to corporate actions processing

CORPORATE ACTIONS PROCESSING

Bayesian belief networks may provide a solution for arriving at loss estimates for Basel II. By Shilpa Ramamurthy, Harpreet Arora and Anirbid Ghosh

WITH the Basel deadlines fast approaching, most affected banks are scrambling to get their operational risk management act together. Among many factors that are impeding the development of stable operational risk management infrastructures, unavailability of loss data is probably the most common. Without a credible internal loss history database, most of the advanced risk analysis and measurement techniques (for example, the loss distribution approach) cannot be implemented. The Basel-defined requirements for loss history are fairly stringent – to use any one of the actuarial approaches, organisations would need to have at least three years (preferably five) of operational loss history. Most banks and financial institutions, if not all, will not have this historical data, especially for some business lines – risk category combinations as shown in table A.

One way to get around this limitation is to use qualitative approaches such as scorecards or key risk indicators. However, these approaches depend on purely qualitative risk assessments and hence do not involve the same amount of rigour as actuarial approaches such as the loss distribution approach.

Bayesian belief networks (BBNs) provide an elegant solution to this problem. They combine both qualitative and quantitative information for arriving at loss estimates. They are particularly appropriate for modeling operational risks with little or no historical losses – most low-frequency/high-severity operational losses fall in this category. Moreover, BBN's are causal networks, unlike other approaches such as simulations, and are particularly useful for analysing causes that contribute to operational risk.

This article provides a reference implementation of a BBN with an application to corporate actions (CA) processing. It tries to model operational losses from 'missed CA announcements', a fairly prevalent problem in the custody business. Though the implementation is for a specific risk category, the technique can easily be extended to any other category.

Bayesian networks – a brief overview

A BBN, also known as qualitative or causal probabilistic network, is a technique that helps model, measure and manage operational risk using prior knowledge of the causal risk factors and probabilistic reasoning. It is represented in the form of an acyclic graph consisting of nodes and directed arcs. Each node represents a variable that affects or determines operational risk. The arcs denote causal or influential relationships between variables. Each variable in the network is assigned an underlying probability distribution based on subjective prior beliefs. The Bayesian analysis involves improving the prior estimates in the light of additional information about one or more variables in the network.

Application to CA processing

CA processing is one of the most risky and labour-intensive back-office processes in the securities industry. A CA is defined as any action taken by the issuer of a security that affects the structure or financial status of the security.

About 1 million CAs take place every year worldwide over and above the 3 million fixed-rate interest payments and redemptions. Each of these face high operational risks because CA processing is, to a large extent, non-standardised and manual. Failure in handling a single CA has the potential to result in huge losses running into millions of dollars. The global fund management industry alone incurs actual losses of approximately $400 million–900 million every year due to CA processing failures. Indirect losses, arising from incorrect interpretation of CA information, can be significantly larger – such losses cost the securities industry between $2 billion and $9.6 billion annually, according to DTCC (the largest processor of corporate actions and securities clearing, settlement and servicing organisation in the world) and Oxera (one of the largest independent economic consultancies in Europe).

Our article constructs a BBN to model operational loss arising from missed CA announcements (sent by an issuer/vendor). Announcements are typically sent in multiple formats by data vendors and collected by financial organisations for further processing. Since it is largely a manual and non-standardised process, there are chances of missing an announcement, which can result in missed notifications and subsequent settlements, thereby leading to an opportunity/cash loss.

Modelling the network

The first step in the Bayesian process is construction of the operational loss model by identifying the key variables and their cause-effect relationship. The key BBN variables for a missed CA announcement are given below. These variables, in combination, determine operational loss from a missed announcement.

• Data sources. A number of sources including registrar, custodian/sub-custodian and data vendors provide CA announcement data in multiple formats using multiple delivery methods. Further, there is no standard way in which the events are announced by issuers, there is no single securities identification system that is universally accepted and the processing terms and details are often specific to the particular market or financial instrument. Data sources may, therefore, be considered as good or bad.

• CA volumes. Many CAs are announced every year on both equity and debt instruments. Volumes tend to surge during the corporate earnings season, thereby straining the efficiency of the CA staff and increasing the risk of operational loss. The volume of CA announcements to be processed may be low or high.

• CA type complexity. In general, voluntary CAs and mandatory actions with options are considered to be more complex than mandatory actions as they are deadline driven and require processing investor responses. CA type complexity may be in either of the two states – low or high.

• CA processing system. The amount of automation in CA processing varies among organisations. Even the more successful organisations have not managed to automate the entire life cycle. The CA processing system may be assumed to be good or bad.

• Staff efficiency. CA processing continues to be labour-intensive and requires a high degree of manual intervention to resolve exceptions. Staff efficiency may be considered to be in either of the two states – low or high.

The network in figure 1 shows the links between all the BBN variables. The nodes for data sources, CA volumes, CA processing system, CA complexity and staff efficiency represent the causal risk factors or parameters.

The node for 'Loss of missed CA announcement' shows the evidence of operational loss. The magnitude of operational loss due to a missed CA announcement is affected by the data source quality, CA system maturity, staff efficiency and CA volumes.

Assigning probability distributions to BBN variables

The next step in the Bayesian process involves assigning probability distributions to each of the variables in the network. The probability distributions of the variables are provided on the basis of prior knowledge about the behaviour of parameters before operational loss data is observed. (For the sake of simplicity, discrete distributions are considered; however, the technique for assigning continuous distributions is very similar.) In practice, this would involve gathering inputs from the operations staff.

Based on the probability distribution of the causal variables, likelihood estimates for the operational loss are calculated. The results are provided in table C. It should be noted that the probability distribution of 'staff efficiency' is recalculated since it is dependent on two other variables – CA complexity and CA volumes.

Using the above loss estimates, an organisation can estimate the expected loss arising from missing a CA announcement. The expected loss is:

(0.5 × 0.3432) + (1.5 × 0.4349) + (2.5 × 0.2219) = 0.1716 + 0.6524 + 0.5548 = 1.3787 million

Analysis

There are two common techniques of analysing a Bayesian network – scenario analysis and causal analysis.

Scenario analysis involves calibrating one or more causal risk factors in the network and analysing its impact on the loss estimate. For example, an operations manager might be interested in estimating operational losses under heavy processing volumes (all other conditions remaining unchanged). In such a situation, the estimated operational loss is given in table D. It can be seen that, according to the model, processing volumes do not have a significant impact on operational losses. The expected loss given high CA volumes is:

(0.5 × 0.3042) + (1.5 × 0.4606) + (2.5 × 0.2353) = 0.1521 + 0.6909 + 0.5884 = 1.4314 million

Conceptually, causal analysis is the exact opposite of scenario analysis. Under causal analysis, new evidence of operational losses is used to calculate updated probabilities (also referred to as posterior probabilities) of all the causal factors. In other words, additional loss information is propagated to all the nodes in the network. This technique of evidence propagation is extremely useful for analysing the causes of operational losses.

Table E clarifies this concept. If an operations manager is most concerned with large losses ($2 million–3 million) and wants to mitigate this risk, understanding the causes that typically contribute to such losses is important to design a better control infrastructure. From the results in table E, it is evident that the quality of data sources has the maximum impact on operational losses. Consequently, an operations manager, on the basis of these results, might strive to improve the quality of source data – probably by subscribing to more automated feeds.

Refining the network

A BBN may be extended to include decision nodes and utility nodes to facilitate the management of operational risk. A decision node represents a variable controlled by a risk manager to manage operational risk. In the above example, the risk manager may decide to train his staff in order to improve their efficiency. Since the decisions are controlled by the risk manager, they do not have conditional probability tables.

A utility node represents the expected utility from the decision. For instance, the utility node, cost, gives information about the cost associated with training while the utility node, payoff, represents the payoff from increased staff efficiency.

Conclusion

As has been highlighted throughout this article, BBNs provide an effective technique for modelling operational losses. Though they can be used to model almost all operational risk types, they are more appropriate for situations where loss data availability is low. Unlike many statistical techniques, BBNs are investigative in nature – they try to analyse the causes rather than focus solely on the effects. In that respect, it is a forward-looking technique and does not depend entirely on historical losses. This feature makes BBNs particularly effective when the past is not the best predictor of the future.

On the downside, BBNs are somewhat subjective in nature. They are a modeller's view of reality and hence there can be multiple models representing the same operational loss type. Moreover, since business landscapes are dynamic in nature, BBNs involve some amount of maintenance – they need to be regularly updated to incorporate changes in the business. OpRisk

Shilpa Ramamurthy, Harpreet Arora and Anirbid Ghosh work in banking and capital markets solutions consulting at Infosys Technologies. All examples in this paper have been developed using a BBN modelling tool (Hugin Lite) from Hugin Expert A/S. We would like to extend our thanks to Hugin for making this tool freely available for educational purposes

References

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Modeling, measuring and hedging operational risk
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Application of Bayesian inference to operational risk management
Doctoral theses

1. BBN for a missed CA announcement
1. BBN for a missed CA announcement

A. Frequency and severity of Basel defined operational risk categories
Risk category
Frequency
Severity
Internal fraud
Low
High
External fraud
Low
High
Employment practices and workplace safety
Low
Low
Clients, products and business practices
Low/medium
High/medium
Damage to physical assets
Low
Low/medium
Business disruption and system failures
Low/medium
Low/medium
Execution, delivery and process management
High
Low

B. Prior probability distributions of BBN variables

Data sources
Probability
CA complexity
Probability
CA volumes
Probability
Good
70
Low
80
Low
30
Bad
30
High
20
High
70

CA processing system
Probability
CA complexity
Low
High
Good
60
CA volumes
Low
High
Low
High
Bad
40
Efficiency - Low
25
40
40
55
- High
75
60
60
45

Volumes
Low
Processing
Good
Bad
Staff efficiency
Low
High
Low
High
Data sources
Good
Bad
Good
Bad
Good
Bad
Good
Bad
Loss $0–1 million
50
20
60
30
30
10
50
20
1–2 million
30
50
30
40
40
50
40
50
2–3 million
20
30
10
30
30
40
10
30
 
Volumes
High
Processing
Good
Bad
Staff efficiency
Low
High
Low
High
Data sources
Good
Bad
Good
Bad
Good
Bad
Good
Bad
Loss $0–1 million
40
10
50
20
20
10
30
10
1–2 million
40
60
40
50
50
40
50
50
2–3 million
20
30
10
30
30
50
20
40

C. Bayesian inference
Staff efficiency
Probability
Low
38.5
High
61.5
Op loss US$
Probability
0–1 million
34.32
1–2 million
43.49
2–3 million
22.19

D.Scenario analysis
CA volumes
Probability
Low
0
High
100
Op loss US$
Probability
0–1 million
30.42
1–2 million
46.06
2–3 million
23.53

E. Causal analysis: maximum operational loss
Op loss US$
Probability
Data sources
Probability
CA complexity
Probability
0–1 million
0
Good
53.58
Low
79.02
1–2 million
0
Bad
46.42
High
20.98
2–3 million
100

CA volumes
Probability
Staff efficiency
Probability
CA
system
Probability
Low
25.79
Low
48.47
Good
50.54
High
74.21
High
51.53
Bad
49.46

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