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Managing operational risk in banking: When crises occur, institutions must deal with not just the original event but also its impact on shareholders.

7 December 2004| IBM Edition
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Research in Brief
Managing operational risk in banking
When crises occur, institutions must deal with not just the original event
but also its impact on shareholders.
Robert S. Dunnett, Cindy B. Levy, and Antonio P. Simoes
The McKinsey Quarterly, 2005 Number 1

Most international banks are increasing their operational-risk cover to
comply with the new capital requirements in Basel II.1 Operational risk is
a financial institution's exposure to losses arising from mistakes (such
as computer failure and breach of regulations) and conspiracies (including
loan fraud and embezzlement) that affect its day-to-day business.
Banks generally calculate their operational-risk cover by estimating the
probability that a particular event might occur and the resulting
financial loss?such as the fine for breaking a rule or the sum pocketed by
an embezzler. But operational crises also upset shareholders and can lead
to a decline in market value.
Few institutions, however, factor such potential market losses into their
risk-cover calculations or operational-risk-management plans. New research
suggests that they should. The decline in market value following an
operational crisis can be far greater than the financial loss. The first
step for banks will be to measure and understand the full extent of their
operational risk.
We analyzed operational crises at European and North American institutions
for which the actual financial loss was more than $1 million.2 The average
actual loss for the sample was $65 million. In the short term, the decline
in shareholder value was, on average, about equal to the financial loss.
After 120 working days, however, the former figure had ballooned to 12
times the latter one, knocking almost 2 percent, on average, off an
institution's total returns to shareholders (TRS) (Exhibit 1). Even a
small financial loss can be followed by a significant drop in the share

enlarge exhibit
Different operational crises give rise to different degrees of market
loss. Looking across the range of events,3 we found that the most harmful
ones were embezzlement, loan fraud, deceptive sales practices, antitrust
violations, and noncompliance with industry regulations (Exhibit 2). Just
under half of the risk events in our sample fell into at least one of
these five categories.

enlarge exhibit
For European companies, the decrease in shareholder value was initially
higher but tended to tail off, whereas North American institutions
experienced smaller immediate losses that were still growing 100 days
later. The fallout from an event may last longer in North America because
of greater transparency: the market continues to receive details about a
crisis long after it first hits the headlines, while in Europe subsequent
findings are less likely to become public.
Losses also vary by subsector. Asset-management and corporate-finance
companies are vulnerable to any incident that undermines the customer's
faith in them and thus are heavily penalized for operational crises in
both the medium and long-term. For retail banks, an initial decline in
share price may persist for the same reason. Indeed, the market seems to
turn against these companies more during the second three-month period
following an event than in its immediate aftermath.
In contrast, businesses without such a customer franchise?sales, trading,
and, to some extent, retail brokerage?usually recover after an initial
loss. In these subsectors, we believe, stock prices are already discounted
because of the volatile nature of the companies' revenue streams.
What triggers a risk crisis? About half of the operational-risk events in
our sample arose from negligence, an unintentional failure to meet a
professional obligation, or a defect in the nature or design of a
product?problems that are largely within the institution's control. In
particular, these issues stemmed from improper business and market
practices, such as breaking antitrust rules, and from equally preventable
lapses, such as using deceptive sales practices or concealing a product's
characteristics. External and internal theft and fraud were responsible
for 20 percent and 14 percent of risk events, respectively, while 8
percent were caused by process failures, particularly in monitoring and
A company can soften the impact of a crisis on its market value by
communicating clearly with its shareholders. We compared two cases in
which unauthorized trading led to actual losses of several hundred million
dollars, for example. One institution issued a series of gloomy
statements, including upward revisions of the extent of the loss and news
of various resignations and reorganizations. The market penalized it
heavily in the six months following the incident. The other institution
was clear from the outset about the size of its loss, disclosed all of the
pertinent details, and issued no further bad news. This company suffered
no long-term damage to its market value, and within six months its TRS had
nearly returned to the estimated value had the event not occurred.
Operational crises can be unexpectedly costly and potentially catastrophic
events. Financial institutions need to understand the different kinds of
operational risk they face and the amount of their potential losses in
order to reduce their exposure. They can then apply the available
management tools for controlling risk4 in a more informed and systematic
About the Authors
Rob Dunnett and Antonio Simoes are consultants in McKinsey's London
office, where Cindy Levy is a principal.
1 Kevin S. Buehler, Vijay D'Silva, and Gunnar Pritsch, "The business case
for Basel II," The McKinsey Quarterly, 2004 Number 1, pp. 82?91.
2 The study assessed about 350 operational-risk events since 1990, with
help in the early stages from Professor Ron Anderson of the London School
of Economics. Fitch Risk Management's OpVar Loss database provided our
sample of events.
3 To categorize the types of events in our sample, we followed the Bank
for International Settlement's (BIS) three-level classification scheme for
actual losses stemming from operational-risk events.
4 Kevin S. Buehler and Gunnar Pritsch, "Running with risk," The McKinsey
Quarterly, 2003 Number 4, pp. 40?9.
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Architecture: New buildings use design and technology to reduce environmental impact, cut costs and provide better places to work

The rise of the green building
Dec 2nd 2004
From The Economist print edition

Architecture: New buildings use design and technology to reduce
environmental impact, cut costs and provide better places to work

IT IS officially known as the Swiss Re Tower, or 30 St Mary Axe. But
Londoners universally refer to the newest addition to their skyline as
?the Gherkin?, thanks to the 41-storey building's distinctive, curved
profile, which actually looks more like a pine cone (see right). What is
most remarkable about the building is not its name or its shape, however,
but its energy-efficiency. Thanks to its artful design and some fancy
technology, it is expected to consume up to 50% less energy than a
comparable conventional office building.
Most people are not used to thinking of large buildings as vast,
energy-guzzling machines. But that is what they are. In America, buildings
account for 65% of electricity consumption, 36% of total energy use and
30% of greenhouse-gas emissions. So making buildings more energy-efficient
could have a significant impact on energy policy, notes Rebecca Flora of
the Green Building Alliance, a group that promotes sustainable
architecture. That is a key goal of the ?green architecture? movement,
which is changing the way buildings are designed, built and run.
Proponents of green architecture argue that the approach has many
benefits. In the case of a large office, for example, the combination of
green design techniques and clever technology can not only reduce energy
consumption and environmental impact, but also reduce running costs,
create a more pleasant working environment, improve employees' health and
productivity, reduce legal liability, and boost property values and rental
The term ?green architecture? only came into use in the 1990s, but the
movement's roots can be traced back a long way. Crystal Palace in London
and Milan's Galleria Vittorio Emanuele II, for example, built in 1851 and
1877 respectively, used roof ventilators and underground air-cooling
chambers to regulate the indoor temperature. Today's enthusiasm for green
architecture has its origins in the energy crisis of the 1970s, when
architects began to question the wisdom of building enclosed
glass-and-steel boxes that required massive heating and cooling systems.
Early proponents of more energy-efficient architecture included William
McDonough, Bruce Fowle and Robert Fox in America, Thomas Herzog in
Germany, and Norman Foster and Richard Rogers in Britain.
These forward-thinking architects began to explore designs that focused on
the long-term environmental impact of maintaining and operating a
building, looking beyond the so-called ?first costs? of getting it built
in the first place. This approach has since been formalised in a number of
assessment and rating systems, such as the BREEAM standard introduced in
Britain in 1990, and the LEED (Leadership in Energy and Environmental
Design) standards developed by the United States Green Building Council
(USGBC) starting in 2000.
The LEED standards are intended to produce ?the world's greenest and best
buildings? by giving developers a straightforward checklist of criteria by
which the greenness of a building can be judged. Points are awarded in
various categories, from energy use (up to 17 points) to water-efficiency
(up to five points) to indoor environment quality (up to 15 points); the
total then determines the building's LEED rating. Extra points can be
earned by installing particular features, such as renewable-energy
generators or carbon-dioxide monitoring systems. A building that achieves
a score of 39 points earns a ?gold? rating; 52 points earns a ?platinum?
rating. A gold-rated building is estimated to have reduced its
environmental impact by 50% compared with an equivalent conventional
building, and a platinum-rated building by over 70%.
Rating buildings in this way reveals how inefficient traditional buildings
and building processes are. ?We can sometimes waste up to 30 cents on the
dollar,? says Phillip Bernstein, an architect and professor at Yale
University. ?It's not just the consumption of energy, it's the use of
materials, the waste of water, the incredibly inefficient strategies we
use for choosing the subsystems of our buildings. It's a scary thing.? In
part, he says, this is because the construction industry is so fragmented.
Designers, architects, engineers, developers and builders each make
decisions that serve their own interests, but create huge inefficiencies

Green is good
But things are now changing, as green architecture moves into the
mainstream. In the spring of 2003, Toyota completed a 624,000-square-foot
office complex in Torrance, California, that received a LEED gold rating,
thanks to the inclusion of features such as solar cells to provide up to
20% of the building's energy needs. Also last year, Pittsburgh opened the
doors on its 1.5m-square-foot convention centre, the largest building to
be awarded a gold LEED rating so far. The USGBC says nearly 1,700
buildings in 50 states are now seeking LEED certification and 137 have
been constructed and certified so far. And America's General Services
Administration, which oversees all non-military government construction,
recently decreed that all new projects and renovations must meet the
minimum LEED standards.
In Britain, meanwhile, 70 office buildings constructed during 2003,
representing 25% of the total by floor area, met the BREEAM standard.
Similar standards have been adopted in New Zealand, Australia and Canada.
In China, the Beijing Organising Committee of the Olympic Games aims to
host the first zero-net-emissions games, which will include constructing
all buildings and sports venues using green-architecture principles.

?Going green saves money by reducing energy and maintenance costs, and may
boost productivity.?

There are many ways to reduce a building's environmental impact. Consider
the 48-storey Condé Nast Building at 4 Times Square in New York, for
example, which was designed by Fox & Fowle Architects. It was one of the
first examples in which green-architecture principles were applied to a
large urban office building, and informed the drawing up of the LEED
points system, since it uses almost every energy-saving technique
Special glass allows daylight in to reduce the need for interior lighting,
keeps heat and ultraviolet rays out, and minimises heat loss in winter.
Two natural-gas-powered fuel cells provide 400 kilowatts of power, enough
to provide all the electricity needed at night, and 5% of the building's
needs during the day. The hot-water exhaust produced by the fuel cells is
used to help heat the building and provide hot water. The heating and
cooling systems, located on the roof, are gas-powered rather than
electric, which reduces energy losses associated with electrical power
transmission. Photovoltaic panels on the building's exterior provide up to
an additional 15 kilowatts of power. Inside the building, motion sensors
control fans and switch off lights in seldom-occupied areas such as
stairwells. Exit signs are illuminated by low-power light-emitting diodes.
The result is that the building's energy consumption is 35-40% lower than
that of a comparable conventional building.
30 St Mary Axe, designed by Foster and Partners, is also packed with
energy-saving features. In particular, it uses natural lighting and
ventilation wherever possible. The façade consists of two layers of glass
(the outer one double-glazed) enclosing a ventilated cavity with
computer-controlled blinds. A system of weather sensors on the outside of
the building monitors the temperature, wind speed and level of sunlight,
closing blinds and opening window panels as necessary. The building's
shape maximises the use of natural daylight, reducing the need for
artificial lighting and providing impressive long-distance views even from
deep inside the building.

Clockwise from bottom left: Pittsburgh's convention centre, Toyota's
building at Torrance, and New York's future Freedom Tower

The highest-profile green building currently on the drawing board is the
Freedom Tower, which will be built on the site of the World Trade Centre
in New York. The architects, Skidmore, Owings & Merrill and Studio Daniel
Libeskind, have incorporated environmental design features throughout the
huge complex. The main tower, which will rise 1,776 feet, will include
solar panels and a wind farm, the turbines of which are expected to
deliver around one megawatt of power, enough to provide up to 20% of the
building's expected demand. Like other green buildings, it will rely on
natural light and ventilation, and energy-efficient lighting.
High energy costs, environmental concerns and anxiety about the ?sick
building syndrome? associated with the sealed-box structures of the 1970s
all helped to jump-start the green-architecture movement. But now
economics is driving the shift towards greener design, as new materials
and techniques fall in price, argues Michael Crosbie, an architect at
Steven Winter Associates, a consultancy based in Norwalk, Connecticut. He
says his clients ?are much more demanding because they see the incredible
amount of money it takes to get something constructed, and they want a
return on that investment.?

Why it pays to be green
Going green saves money by reducing long-term energy costs: a survey of 99
green buildings in America found that on average, they use 30% less energy
than comparable conventional buildings. So any additional building costs
can be recovered quickly: according to the USGBC, the 2% increase in
construction costs required to achieve a LEED gold rating typically pays
for itself in lower running costs within two years. The traditional
approach of trying to minimise construction costs, by contrast, can lead
to higher energy bills and wasted materials.
Energy-saving techniques need not all be as exotic as installing coated
glass, computer-controlled blinds or photovoltaic cells. Mr Crosbie says
builders are now insulating buildings more effectively, in some cases
using materials such as recycled paper and fabrics, including old,
shredded jeans. It is more effective than traditional insulation, he says,
saves money and is easier on the environment.
Green buildings can also have less obvious economic benefits. The use of
natural daylight in office buildings, for example, as well as reducing
energy costs, also seems to make workers more productive. Studies
conducted by Rachel and Stephen Kaplan, environmental psychologists at the
University of Michigan, found that employees with views of a natural
landscape report greater job satisfaction, less stress and fewer
illnesses. Lockheed Martin, an aerospace firm, found that absenteeism fell
by 15% after it moved 2,500 employees into a new green building in
Sunnyvale, California. The increase in productivity paid for the
building's higher construction costs within a year.
Similarly, the use of daylight in shopping complexes appears to increase
sales. The Heschong Mahone Group, a California-based consultancy that
specialises in energy-efficient building technologies, found that sales
were as much as 40% higher in stores lit with skylights. It also found
that students in naturally lit classrooms performed up to 20% better.
Green buildings can also reduce legal liabilities for their owners, since
they are less likely to give rise to ?sick building? lawsuits. But more
studies are needed, says Caren Glotfelty, director of the environmental
programme at the Heinz Endowments, a non-profit foundation run by Teresa
Heinz Kerry that funds sustainable initiatives.
Despite its benefits and its growing popularity, green architecture is
still the exception, not the rule, however. The main problem is
co-ordination, says Mr Bernstein, who is also vice-president of the
building solutions division at Autodesk, a software company. Green
buildings require much more planning by architects, engineers, builders
and developers than traditional buildings. ?The building industry is very
disaggregated,? he says, ?so adoption patterns are really, really slow.?
But new software is now improving planning by simulating how a building
will perform before it is built.
Autodesk's software can create a three-dimensional model of a building and
then work out how much energy it will use, taking into account its shape,
heating and cooling systems, orientation to the sun and geographic
location. Other such tools abound: the designers of 4 Times Square
calculated its energy consumption using a free package called DOE-2,
developed by James J. Hirsch & Associates together with the Lawrence
Berkeley National Laboratory, with funding from America's Department of

Greener by design

In the old days, says Mr Bernstein, assessing a building's environmental
impact had to be done with spreadsheets, calculators and informed
guessing, and three-dimensional modelling was primarily used to prepare
presentations. But now the three-dimensional computer models are being
used with sophisticated analytical tools. ?We are getting to the next
phase where you can analyse rather than simply represent,? he says. It is
then possible to predict how much energy and water a building will
consume, how much material will be needed, and other parameters that
determine its LEED certification. All of this is old hat for the airline
and automobile industries, where computer models have long been used to
trim costs and streamline design before construction begins. Now the same
technology is being applied by architects.
Computers also make possible entirely new designs. 30 St Mary Axe, for
example, could not have been built without a computer model to specify the
exact shape of every one of its 5,500 glass panels, or to model the
airflow in and around it. Similarly, computer modelling made possible the
Avax office building completed in Athens, Greece, in 1998. It has sheaves
of glass which open and close automatically, depending on the intensity
and angle of the sun, to provide sunlight while preventing the building
from overheating. The ventilation system in Pittsburgh's convention centre
uses the natural ?chimney effect? created by its sweeping roof to draw air
through vents by the river below, cooling the building without using a
single fan.
This is more than a mere fad, or the use of technology for the sake of it,
says Mr Bernstein. Green architecture will, he suggests, help to reshape
the construction industry over the next five years, with ever more
innovative, energy-efficient and environmentally friendly buildings. ?No
one is doing this for fun,? he says. ?There's too much at stake.?