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OperationalRisk

 www.operationalriskonline.com

HERE’Sa conundrum: banks don’t like the

insurance policies that are available

to cover operational risk, and yet they keep buying

them. Why? Largely, it’s because of a scarcity of viablealternatives – and this scarcity is now helping to revive

interest in the long-mooted but little-explored idea of 

op risk derivatives.

Gripes with current insurance policies range from

their myriad exclusions (for example, many business

interruption policies won’t pay out unless the insured

suffers property damage, which rules out claims

resulting from power outages) to uncertainties about

payouts and renewability.

These concerns reached the ears of the Basel

committee during the drafting of the new Accord, and

helped scupper the insurance industry’s hopes that

regulators would give banks the freedom to substitute

insurance cover for regulatory capital, which may have

created a big new market. A source close to the Basel committee says that

insurers “did not do a great job, frankly, of satisfying

the committee that its products map well to op risk-

event types”. At the same time, banks were telling

committee members that they have to fight tooth and

nail to secure payments on claims they have made – a

long, drawn-out process that can take months or even

 years. Says the source: “How could that ever be as

good as holding capital against risks?”

But insurers did persuade the committee to allow 

banks some capital relief on the back of risk 

mitigation. A bank can now use insurance to reduce

its op risk capital requirement by up to 20%, and a

recent seminar organised by Swiss Re in New 

 York involved some discussion on how this could

be achieved.

The bad news for both sides is that there’s no

pipeline of blockbuster products ready to wow op risk 

managers, says attendee Marcelo Cruz, global head of 

op risk at Lehman Brothers. “The conclusion was that

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

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 seeinsurance companies offering this kind of protection

 with their current product line. There’s a gap that

needs to be sealed.”

Op risk derivatives have long been touted as a way of 

closing this gap. Cruz wrote an article for Risk 

Magazine in the late 90s suggesting that op risk 

quantification could one day provide the basis for a

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,

in which she argued that the then-fledgling credit

derivatives market might provide a model on which op

risk derivatives could be based.

Cagan, head of research for Algorithmics’ AlgoOpVantage product in New York, says, “five years on, a

lot of the obstacles that existed then still exist today.”

Cruz concurs: “The subject hasn’t moved ahead.”

The lack of progress hasn’t killed the idea off,

however – and some bank op risk managers are

convinced that it’s just a matter of time before they 

have the ability to transfer or shape portfolios of risk 

using derivative products.

“I am very confident that something will develop

that will give financial institutions the opportunity to

transfer risk in a commercially attractive manner,” says

Joe Sabatini, managing director with JP Morgan

Chase in New York and global head of the bank’s

corporate op risk team. “You could be an optimist or a

pessimist regarding the timing, and you could havedifferent views about the kind of products that will

develop, but I’ve no doubt that it will happen.”

 Various forms of derivative could conceivably be

used to transfer op risk – securitisation and swaps

seem the most likely candidates. Cruz says that he

expects the first transactions – if and when they arrive

– to take the securitisation route: “Bonds could be

structured so that repayment of the principal was tied

to the risk of some kind of op risk event, like fraud.”

Investors would receive a standard Libor rate plus the

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 cer tain magnitude, he suggests, the

bank could then use some or all of the investors’principal to cover its own losses.

This kind of structure might also be suitable for

securitising the risk of a group of institutions. Dan

Mudge, group managing director for Algo

OpVantage in New York, says that he recently heard

exactly this idea being floated by one insurance

industry executive. “The suggestion was that a

number of banks could pool their rogue trading risk,

for example. But it was all very vague. There was no

elaboration on the specifics.”

One firm – US-based Giuffre Associates – is trying

to turn these vague ideas into something more

concrete, according to Sandra Giuffre, one of the

firm’s three principals and founder. Giuffre, a risk 

Who’s buying?Operational risk derivatives are being reconsidered as

a solution to banks’ distrust of op risk insurance

policies, but the market for these is yet to develop.

By Duncan Wood

Dan Mudge, Algo OpVantage

“I JUST DON’T SEE INSURANCE COMPANIES OFFERING THIS KIND OFPROTECTION WITH THEIR CURRENT PRODUCT LINE. THERE’S A GAP

THAT NEEDS TO BE SEALED”

Marcelo Cruz, Lehman Brothers 

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specialist and formerly a managing director with

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 

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 hasmandates 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.”

THEadvantage that op risk derivatives have over

insurance cover (in theory) is that the

derivatives can be better aligned with the actual risk 

faced by the bank. The length of the contract and the

definition of the trigger event could be customised –and it shouldn’t take two years to get paid either.

“For example,” says Charles Beach, a partner in the

derivatives team with PricewaterhouseCoopers in

London, “if you were going to switch to a new trading

platform, and knew you were facing increased exposure

to rogue trading over the transition period, you could

go out and do a six-month swap that would mitigate

the risk. You can’t do that with an insurance policy.”

Despite these supposed advantages, a market for op

risk derivatives has not yet sprung into being – so

 what’s the catch?

First, there’s the problem of fixing a fair price for

risks that banks are still struggling to quantify.

Implementation of Basel II will require the mostsophisticated banks to demonstrate that they can

accurately quantify their op risks – but even thereafter,

derivative products are unlikely to spring up like

daisies in the lawn, warns Cruz. He says it will

probably take a couple of years before banks become

fully comfortable with the figures their op risk systems

are generating. And if it’s tough for the seller to judge

the price, it’s even more difficult for the buyer, who

has no public data from which to decide whether the

seller’s assessment of the risk is correct.

The second big problem is the fact that Basel II does

not allow the possibility of capital relief for banks that

use derivatives as an op risk mitigant, despite the best

efforts of would-be op risk derivatives dealers to

convince regulators otherwise.

 A source close to the Basel committee says that

regulatory scepticism about the benefits of insurance

 was “magnified when people started talking about

products that don’t even exist.” He says that some

investment banks argued that op risk derivativesshould be given the committee’s seal of approval,

claiming that they would be able to develop an

effective product, but adds that “there was no way 

that the committee was going to go out on a limb for

something that had not been tried and tested.”

Sabatini denies that this is an insuperable problem.

He notes that many of the largest banks will be

running two somewhat separate risk and capital

systems, even after Basel II is introduced – the

regulatory capital system for Basel, as well as the

economic capital systems that sprang up prior to the

regulatory overhaul. For these banks, he says, the

primary driver for op risk mitigation will be economic,

not regulatory – in other words, if a bank believes thatit can reduce op risk by using an derivative it will go

ahead, whether it attracts capital relief or not.

But no bank is going to be so desperate to

reduce its exposure to a given risk that it will

pay any price to do so – and highly customised,

painstakingly arranged transactions are rarely 

cheap. Giuffre Associates is betting that it can keep

the costs of risk transfer

down by making its transactions highly specific.

“We’re really trying to understand a very specific risk 

and to arrange a transaction that transfers that risk 

away,” says Sathe.

It shouldn’t be too long before risk managers find

out whether that’s just a pipe dream.OpRisk 

December 2005

Op risk Derivatives

New and improved:

The idea of op riskderivatives

hasa certain amountof cache

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