Nyu – Leonard N. Stern School of Business Operations in Financial Service – B60. 2315. 030



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Operational Risk Issues


The Federal Reserve faces a multitude of risks which can permeate through the economy potentially affecting every financial institution in the World. The Federal Reserve must devote a disproportionate amount of resources into predicting and preventing such risks. The Federal Reserve publishes the Federal Reserve Policy on Payments System Risk outlining the key risks faced in its payment systems and how the plans to avoid and remedy such problems.

Service Disruptions


The biggest operational risk for check processing and settlement services is a disruption in the service. This may take a number of forms which have the Federal Reserve Banks have been actively trying to predict, simulate, and understand to develop an appropriate set of tools to counter such disruption. Since the financial disruption following the 2001 attack on the World Trade Center in downtown New York, the Federal Reserve along with
In general, the greatest damage to the financial markets inflicted by a disruption to financial markets will be to those up and down stream of the Federal Reserve attempting to settle transactions including checks and ACH. Federal Reserve regulations along with other federal law and regulation promulgated and monitored by entities such as the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation require financial institutions to maintain backup systems to deal with large-scale disruptions in service. Additionally, the individual Federal Reserve banks provide advice to account holders to assist in the event of a service disruption. For example, the Federal Reserve Bank of Boston advises the following courses of action to presenting and paying banks respectively in the case of a service disruption:

  • Presenting Banks


Sort Pattern FlexibilitySeparating high value, high priority, or separately processable instruments from others.
Return Processing – Implementing other alternate channels for return processing. Be prepared to separate local returns from Other Fed returns.

Deposit Records – Keeping backup information of presented and paid checks in the case of the destruction of the Fed’s electronic record of settlement transactions.

Deposit Holds – Disallowing deposits into checking accounts which will require transit through the Fed.

Courier Notification – Letting physical check couriers know about the problem and setting up backup delivery systems.

Account Management – Allowing flexibility in internal accounting methods allowing for delay in entries due to service disruption.
  • Paying Banks


No File Delivery – Ensuring that internal Bank systems do not require delivery of presentment files from the Federal Reserve.
Alternate Physical Presentment – If electronic delivery of check information is disrupted paying banks need to ensure that they are able to receive and process physical delivery of checks.
Later File Delivery – Ensuring the ability to receive check information later than usual, processing those instruments as quickly as possible.

Controlled Disbursement Accounts – Notifying customers of potential delays and disruptions to their services.


Return Processing – Allowing for non-standard formats for return checks. For example, image presentment may be substituted for MICR presentment.

Business Continuity and Disaster Planning


In addition to mitigating potential damage up and down the transactional chain, the Federal Reserve Banks must create a system of internal checks and balances to ensure that services remain up as much as possible.

Multiple energy and communications vendors – The Federal Reserve Banks cannot rely on a single vendor for system dependent resources such as energy or access to communications infrastructure. The Banks of the Fed use multiple vendors to provide such critical resources ensuring that distribution is maintained such that the loss of any single resource provider (or a concurrent loss of a reasonably foreseeable group of resource providers) would cause a service outage.

Security system with continuous monitoring – To prevent security incidents both through external forces such as terrorism or internal forces such as fraud, embezzlement or breach of private information, the Federal Reserve Banks maintain state of the art security systems to detect and protect against such attacks.

System physical and functional redundancy – Geographically separated systems are maintained and tested with key personnel. Every resources used in the system must be replicated to minimize risk of a large scale geographically distributed disaster rendering all systems, personnel, and resources of the primary site unavailable.




Balance Score-Card

Given this level of analysis and thought process, it will be important to set a strategic plan that not only addresses operational issues but encompasses financial and internal business practices.



Strategic Planning Processes


  • Reduce operational cost

By far one of the most important goals for the Federal Reserve would be to control and minimize operational costs associated with check processing as a whole but more specifically with respect to Check 21 integration activities.

  • Increase operational efficiency

An important step of cost containment is to achieve and sustain a high level of operational efficiency as quickly as possible.


  • Regenerate revenue streams

The decreasing volume of check usage in general is expected to have a direct affect on the fee-based pricing system introduced by the Monetary Control Act of 198010. This means that the Federal Reserve must look for new ways to generate new revenue streams while ensuring that adequate levels of competition is still maintained by not increasing prices
Objectives and Measures for Reducing Operational Costs


Fed’s Perspective

Objective

Measure

Financial

  • Reduce cost per activity and service

  • Cost by product/service

  • Cost per transaction

Customer

  • Maximize migration effort to lowest costs distribution channels

  • Percentage of depository institutions opting for electronic presentment

  • Percentage of checks in dollar and number terms presented electronically

  • Expand automated processing and self-help systems.

  • Number and percentage of transactions for which no electronic alternative exists

  • Reduce customer service expenses through minimizing customer errors

  • Number, length, and dollars spent on service calls to the Federal Reserve regarding electronic presentment.

  • Number of bank-created errors

Internal Business Process

  • Create value for the customer through operational efficiencies.

  • Minimize time of transaction




  • Mean, median, maximum time spent per transaction in the Federal Reserve System.

  • Increase trust in the electronic presentment system

  • Number of errors per transactions.

  • Source of error – whether customer or Fed and what component caused the error.


Objectives and Measures for Increasing Operational Efficiency


Fed’s Perspective

Objective

Measure

Financial

  • Maximize operational efficiency to contain costs

  • Linear programming or DEA analysis to locate inefficiencies in the system.

  • Mean, Median, and maximum expense per transaction

  • Decrease cost of system errors

  • Cost of remedying all errors

  • Cost of remedying avoidable errors

  • External cost of Federal Reserve Errors

Customer

  • Minimize errors created by customers

  • Mean, variance, and maximum number of customer created/caused errors

  • Source of error

Internal Business Process

  • Minimize time per transaction




  • Mean, median, and maximum time per transaction

  • Minimize Federal Reserve errors

  • Errors per time period

  • Source/ process creating error

  • Mean errors per period

  • Error variance

  • Maximum errors per period



Objectives and Measures for Generating Revenue Streams


Fed’s Perspective

Objective

Measure

Financial

  • Increase number of transactions sent through the Federal Reserve Electronic Services

  • Number of transactions using electronic presentment as a percentage of all Federal Reserve Transactions.

  • Number of transaction using electronic presentment as a total of all industry-wise clearing transactions

  • Increase Revenue from electronic presentment

  • Dollars revenue gained from electronic presentment

Customer

  • Increase customer trust in the electronic presentment system




  • Number of errors per transactions.

  • Source of error – whether customer or Fed and what component caused the error.

  • Non-check related clearing transactions sent through the Federal Reserve as gross by number and percentage of industry.

  • Percentage of client banks using Fed for majority of clearing transactions.

Internal Business Process

Create and Diversity Product Lines creating expanded revenue streams

  • Number of product lines

  • Client subscription to new or expanded products


Conclusion and Challenges

This analysis has focused on the relative efficiencies of the introduction of the substitute check system vis-à-vis Federal Reserve processes. Much of the analysis is not surprising insofar as it details the tradeoff between upfront, fixed costs including equipment, training, and short-term increases in error raters and longer term savings generated from greater efficiency through lower variable costs including time savings, long-term quality increases, less human labor, and lower transportation and other costs. This consideration is basically an analysis of future value creation through operational benefits of change versus the costs of investments today. This trade-off makes the predictive value of the estimation tools of operational efficiency critical to the choices made by the Federal Reserve and in turn other market players. These analyses made prior to passage of Check 21 as well as those made in enacting the legislation will affect the direction of the industry.



A second consideration further complicating this analysis is the time horizon of checking and the replacement other financial services. The reduction of check use by financial customers is forcing the Federal Reserve to choose between continuing the less efficient processes of paper checks and large investments in electronic processing which may have a relatively quickly approaching terminal point. This is exacerbated by rapidly changing technology and an even quicker consumer integration of existing technologies. These characteristics combine to create an amorphous and constantly changing demand structure which puts industry players in the position of reacting to potentially short-term demand trends through inherently long-term investments.
A final consideration is the complex treble role as a market participant, a regulator, and a technical innovator. The Federal Reserve must push forward industry-wide standards in a market in which it competes, and must enforce market norms against competitors. Added to this complicated mix is a lack of profit maximization motive by Federal Reserve coupled with Congressional directive to use fee-based services to compensate federal expenses used to service financial transaction systems. As detailed above, this duality creates a system in which the Federal Reserve is incentivized to increase operational efficiencies above those achieved by market competitors while pushing the financial transactional system as a whole towards industry-wide efficiency maximization.








1 See H. R. 7837. (Dec. 23, 1913), 12 USC Sec. 221 et seq.



2 See “Check Clearing for the 21st Century Act” at http://www.federalreserve.gov/paymentsystems/truncation/default.htm (November 16th, 2004).


3 The twelve Federal Reserve districts are represented by Federal Reserve Banks in (1)Boston, (2) New York, (3) Philadelphia, (4) Cleveland, (5) Richmond, (6) Atlanta, (7) Chicago, (8) St. Louis, (9) Minneapolis, (10) Kansas City, (11) Dallas, and (12) San Francisco.

4 http://www.frbservices.org/Retail/FedImageCapture.html

5 http://www.frbservices.org/Retail/FedImageArchive.html

6 http://www.frbservices.org/Retail/FedImageRetrieval.html

7 http://www.frbservices.org/Retail/FedImageDelivery.html

8 See Wheelock, David C. and Paul W. Wilson, “Trends in the Efficiency of Federal Reserve Check Processing Operations” Federal Reserve Bank of St. Louis Review September/October 2004.


9 Please see United States Federal Reserve Annual Report to Congress, 2001, 2002, 2003, & 2004 available at:

http://www.federalreserve.gov/boarddocs/rptcongress/annual04/default.htm (May, 2005).

10 http://www.federalreserve.gov/paymentsystems/pricing/principles.htm




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