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Basel II |
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Bank for International Settlements |
| Background |
| Pillar 1: Regulatory Capital |
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Credit risk Operational risk |
| Pillar 2: Supervisory Review |
| Pillar 3: Market 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]
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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).
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.
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.
The following lists the official Basel II defined event types with some examples for each category:
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.
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
The Operational Risk Management framework should include identification, measurement, monitoring, reporting, control and mitigation frameworks for Operational Risk.
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