Operational risk

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Basel II

Bank for International Settlements Basel Accords - Basel I Basel II

Background

Banking Monetary policy - Central bank Risk - Risk management Regulatory capital Tier 1 - Tier 2

Pillar 1: Regulatory Capital

Credit risk Standardized - IRB Approach F-IRB - A-IRB PD - LGD - EAD Operational risk Basic - Standardized - AMA Market risk Duration - Value at risk

Pillar 2: Supervisory Review

Economic capital Liquidity risk - Legal risk

Pillar 3: Market Disclosure

Disclosure

Business and Economics Portal

An operational risk is, as the name suggests, a risk arising from execution of a company's business functions. It is a very broad concept which focuses on the risks arising from the people, systems and processes through which a company operates. It also includes other categories such as fraud risks, legal risks, physical or environmental risks.

A widely used definition of operational risk is the one contained in the Basel II [1] regulations. This definition states that operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.

The approach to managing operational risk differs from that applied to other types of risk, because it is not used to generate profit. In contrast, credit risk is exploited by lending institutions to create profit, market risk is exploited by traders and fund managers, and insurance risk is exploited by insurers. They all however manage operational risk to keep losses within their risk appetite - the amount of risk they are prepared to accept in pursuit of their objectives. What this means in practical terms is that organisations accept that their people, processes and systems are imperfect, and that losses will arise from errors and ineffective operations. The size of the loss they are prepared to accept, because the cost of correcting the errors or improving the systems is disproportionate to the benefit they will receive, determines their appetite for operational risk.

Determining appetite for operational risk is a discipline which is still in its infancy. Some of the issues and considerations around this process are outlined in this Sound Practice paper published by the Institute for Operational Risk in December 2009.[2]

Background

Since the mid-1990s, the topics of market risk and credit risk have been the subject of much debate and research, with the result that financial institutions have made significant progress in the identification, measurement and management of both these forms of risk. However, it is worth mentioning that the near collapse of the U.S. financial system in September 2008 is a clear indication that our ability to measure market and credit risk is far from perfect.

Globalization and deregulation in financial markets, combined with increased sophistication in financial technology, have introduced more complexities into the activities of banks and therefore their risk profiles. These reasons underscore banks' and supervisors' growing focus upon the identification and measurement of operational risk.

Events such as the September 11 terrorist attacks, rogue trading losses at Société Générale, Barings, AIB and National Australia Bank serve to highlight the fact that the scope of risk management extends beyond merely market and credit risk.

The list of risks (and, more importantly, the scale of these risks) faced by banks today includes fraud, system failures, terrorism and employee compensation claims. These types of risk are generally classified under the term 'operational risk'.

The identification and measurement of operational risk is a real and live issue for modern-day banks, particularly since the decision by the Basel Committee on Banking Supervision (BCBS) to introduce a capital charge for this risk as part of the new capital adequacy framework (Basel II).

Definition

The Basel Committee defines operational risk as:

"The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events."

However, the Basel Committee recognizes that operational risk is a term that has a variety of meanings and therefore, for internal purposes, banks are permitted to adopt their own definitions of operational risk, provided that the minimum elements in the Committee's definition are included.

Scope exclusions

The Basel II definition of operational risk excludes, for example, strategic risk - the risk of a loss arising from a poor strategic business decision.

Other risk terms are seen as potential consequences of operational risk events. For example, reputational risk (damage to an organization through loss of its reputation or standing) can arise as a consequence (or impact) of operational failures - as well as from other events.

Basel II event type categories

The following lists the official Basel II defined event types with some examples for each category:

1. Internal Fraud - misappropriation of assets, tax evasion, intentional mismarking of positions, bribery
2. External Fraud- theft of information, hacking damage, third-party theft and forgery
3. Employment Practices and Workplace Safety - discrimination, workers compensation, employee health and safety
4. Clients, Products, & Business Practice- market manipulation, antitrust, improper trade, product defects, fiduciary breaches, account churning
5. Damage to Physical Assets - natural disasters, terrorism, vandalism
6. Business Disruption & Systems Failures - utility disruptions, software failures, hardware failures
7. Execution, Delivery, & Process Management - data entry errors, accounting errors, failed mandatory reporting, negligent loss of client assets

Difficulties

It is relatively straightforward for an organization to set and observe specific, measurable levels of market risk and credit risk because models exist which attempt to predict the potential impact of market movements, or changes in the cost of credit. It should be noted however that these models are only as good as the underlying assumptions, and a large part of the recent financial crisis arose because the valuations generated by these models for particular types of investments were based on incorrect assumptions.

By contrast it is relatively difficult to identify or assess levels of operational risk and its many sources. Historically organizations have accepted operational risk as an unavoidable cost of doing business. Many now though collect data on operational losses - for example through system failure or fraud - and are using this data to model operational risk and to calculate a capital reserve against future operational losses. In addition to the Basel II requirement for banks, this is now a requirement for European insurance firms who are in the process of implementing Solvency II [3], the equivalent of Basel II for the banking sector.

Methods of operational risk management

Basel II and various Supervisory bodies of the countries have prescribed various soundness standards for Operational Risk Management for Banks and similar Financial Institutions. To complement these standards, Basel II has given guidance to 3 broad methods of Capital calculation for Operational Risk

• Basic Indicator Approach - based on annual revenue of the Financial Institution
• Standardized Approach - based on annual revenue of each of the broad business lines of the Financial Institution
• Advanced Measurement Approaches - based on the internally developed risk measurement framework of the bank adhering to the standards prescribed (methods include IMA, LDA, Scenario-based, Scorecard etc.)

The Operational Risk Management framework should include identification, measurement, monitoring, reporting, control and mitigation frameworks for Operational Risk.

See also

• Risk management
• Operational risk management
• Risk modeling
• Volatility
• Key risk indicators

External links

• Operational Risk in the Basel ii framework
• The Institute of Operational Risk The institute provides professional recognition and enables members to maintain competency in the discipline of operational risk.
• OpRisk & Regulation is the home page of the leading educational resource on operational risk, including a magazine, training, conferences, books, etc.
• Revised international capital framework is the text of the new Basel II Accord.
• Operational Risk Blog is a resource for operational risk content.
• Constraints of Consistent Operational Risk Measurement and Regulation: Data Collection and Loss Reporting, Andreas A. Jobst, 2007 (Journal of Financial Regulation and Compliance)
• The Credit Crisis and Operational Risk - Implications for Practitioners and Regulators, Andreas A. Jobst, 2010 (Journal of Operational Risk, Vol. 5, No. 2)
• The Risk Management Association - leading industry organization for operational risk professionals
• http://bis2information.org: Practical articles, on BIS2 and risk modeling, submitted by professionals to help create an industry standard.
• http://www.bos.frb.org/economic/wp/wp2006/wp0613.htm FRB Boston paper on measurement of operational risk.
• Operational Risk - The Sting is Still in the Tail But the Poison Depends on the Dose, Andreas A. Jobst, 2007 (Journal of Operational Risk)
• Convergence of Operational and Credit Risk, Tyson Macaulay 2008
• Operational Continuity and Additivity of Operational Risk, Tyson Macaulay 2008
• Metrics and Operational Continuity, Tyson Macaulay 2008
• Operational Risk Consortium is a consortium that collects and analyzes operational risk loss data for the insurance industry.