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Risk Associated with Outsourcing of Activities

Risk Associated with Outsourcing of Activities ;

Further, the modern day banks make extensive use of outsourcing as a means of both reducing costs as well as making use of services of an expert not available internally. There are, however, a number of risks associated with outsourcing of activities by banks and therefore, it is quintessential for the banks to effectively manage those risks. RBI’s circular no. DBOD.BP.40/ 21.04.158/2006-07 dated November 3, 2006 contains extensive guidelines on managing the risks associated with the outsourcing of financial services by banks. The circular, however, also mandates that banks which choose to outsource financial services should not outsource core management functions including internal audit, compliance function and decision-making functions like, determining compliance with Know Your Customer (‘KYC’) norms for opening deposit accounts, according sanction for loans (including retail loans) and management of investment portfolio.

In addition to understanding the external factors that could indicate increased risk, the natures of risks arising from the bank’s operations are also of significant importance. Factors that contribute significantly to operational risk include the following:

(a) The need to process high volumes of transactions accurately within a short time through the large-scale use of IT.

(b) The need to use electronic funds transfer (EFT) or other telecommunication system to transfer ownership of large sums of money, with the resultant risk of exposure to loss arising from payments to incorrect parties through fraud or error.

(c) The conduct of operations in many locations with a resultant geographic dispersion of transaction processing and internal controls. As a result:

(i) there is a risk that the bank’s worldwide exposure, customer-wise and product-wise may not be adequately aggregated and monitored; and

(ii) control breakdowns may occur and remain undetected or uncorrected because of the physical separation between management and those who handle the transactions.

(d) The need to monitor and manage significant exposures that can arise over short time frames. The process of clearing transactions may cause a significant build-up of receivables and payables during a day, most of which are settled by the end of the day. This is ordinarily referred to as intra-day payment risk. These exposures arise from transactions with customers and counterparties and may include interest rate, currency and market risks.

(e) The handling of large volumes of monetary items, including cash, negotiable instruments and transferable customer balances, with the resultant risk of loss arising from theft and fraud by employees or other parties.

(f) The inherent complexity and volatility of the environment in which banks operate, resulting in the risk of inappropriate risk management strategies or accounting treatment, in relation to such matters as the development of new products and services.

(g) Overseas operations are subject to the laws and regulations of the countries in which they are based as well as those of the country in which the parent entity has its headquarters. This may result in the need to adhere to differing requirements, thereby, leading to risk that operating procedures that comply with regulations in some jurisdictions do not meet the requirements of others.