# Operational risk

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Operational risk is "the risk of a change in value caused by the fact that actual losses, incurred for inadequate or failed internal processes, people and systems, or from external events (including legal risk), differ from the expected losses". This definition, adopted by the European Solvency II Directive for insurers, is a variation from that adopted in the Basel II regulations for banks. [1] [2] In October 2014, the Basel Committee on Banking Supervision proposed a revision to its operational risk capital framework that sets out a new standardized approach to replace the basic indicator approach and the standardized approach for calculating operational risk capital. [3]

## Contents

It can also include other classes of risks, such as fraud, security, privacy protection, legal risks, physical (e.g. infrastructure shutdown) or environmental risks.

The study of operational risk is a broad discipline, close to good management and quality management. [4]

In similar fashion, operational risks affect client satisfaction, reputation and shareholder value, all while increasing business volatility.

Contrary to other risks (e.g. credit risk, market risk, insurance risk) operational risks are usually not willingly incurred nor are they revenue driven. Moreover, they are not diversifiable and cannot be laid off. This means that as long as people, systems, and processes remain imperfect, operational risk cannot be fully eliminated.

Operational risk is, nonetheless, manageable as to keep losses within some level of risk tolerance (i.e. the amount of risk one is prepared to accept in pursuit of his objectives), determined by balancing the costs of improvement against the expected benefits.

Wider trends such as globalization, the expansion of the internet and the rise of social media, as well as the increasing demands for greater corporate accountability worldwide, reinforce the need for proper operational risk management.

## Background

Until Basel II reforms to banking supervision, operational risk was a residual category reserved for risks and uncertainties which were difficult to quantify and manage in traditional ways [5] – the "other risks" basket.

Such regulations institutionalized operational risk as a category of regulatory and managerial attention and connected operational risk management with good corporate governance.

Of course, businesses in general, and other institutions such as the military, have been aware, for many years, of hazards arising from operational factors, internal or external. The primary goal of the military is to fight and win wars in quick and decisive fashion, and with minimal losses. For the military, and the businesses of the world alike, operational risk management is an effective process for preserving resources by anticipation.

Two decades (from 1980 to the early 2000s) of globalization and deregulation (e.g. Big Bang (financial markets)), combined with the increased sophistication of financial services around the world, have introduced additional complexities into the activities of banks, insurers and firms in general and therefore their risk profiles.

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, the near collapse of the U.S. financial system in September 2008 [6] [7] is an indication that our ability to measure market and credit risk is far from perfect and eventually led to the introduction of new regulatory requirements worldwide, including Basel III regulations for banks and Solvency II regulations for insurers.

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

These reasons underscore banks' and supervisors' growing focus upon the identification and measurement of operational 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 in Basel II and Basel III as:

The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk. [8]

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 seven event type categories

The following lists the seven official Basel II 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, and 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 and Systems Failures – utility disruptions, software failures, hardware failures
7. Execution, Delivery, and 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. 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, the equivalent of Basel II for the insurance sector. [9]

## Methods for calculating operational risk capital

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.

There are a number of methodologies to choose from when modeling operational risk, each with its advantages and target applications. The ultimate choice of the methodology/methodologies to use in your institution depends on a number of factors, including:

• Time sensitivity for analysis;
• Resources desired and/or available for the task;
• Approaches used for other risk measures;
• Expected use of results (e.g., allocating capital to business units, prioritizing control improvement projects, satisfying regulators that your institution is measuring risk, providing an incentive for better management of operational risk, etc.);
• Senior management understanding and commitment; and
• Existing complementary processes, such as self-assessment [10]

### Standardised Measurement Approach (Basel III)

The Basel Committee on Banking Supervision (BCBS) has proposed the "Standardised Measurement Approach" (SMA) as a method of assessing operational risk as a replacement for all existing approaches, including AMA. The objective is to provide stable, comparable and risk-sensitive estimates for the operational risk exposure and is effective January 1, 2022. [11] The SMA puts weight on the internal loss history (losses of the last 10 years must be considered). It is possible to consider net losses (after recoveries and insurance).

The marginal coefficient (α) increases with the size of the BI as shown in the table below.

BucketBI range (in €bn)BI marginal coefficients (αi)
1≤112%
21 < BI ≤3015%
3> 3018%

The ILM is defined as:

${\displaystyle ILM=\ln(\exp(1)-1+(LC/BIC)^{0}.8)}$

where the Loss Component (LC) is equal to 15 times average annual operational risk losses incurred over the previous 10 years. [11]

## Related Research Articles

Bank regulation is a form of government regulation which subjects banks to certain requirements, restrictions and guidelines, designed to create market transparency between banking institutions and the individuals and corporations with whom they conduct business, among other things. As regulation focusing on key actors in the financial markets, it forms one of the three components of financial law, the other two being case law and self-regulating market practices.

Basel II is the second of the Basel Accords,, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision.

The Basel Committee on Banking Supervision (BCBS) is a committee of banking supervisory authorities that was established by the central bank governors of the Group of Ten countries in 1974. The committee expanded its membership in 2009 and then again in 2014. In 2019, the BCBS has 45 members from 28 Jurisdictions, consisting of Central Banks and authorities with responsibility of banking regulation. It provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. The Committee frames guidelines and standards in different areas – some of the better known among them are the international standards on capital adequacy, the Core Principles for Effective Banking Supervision and the Concordat on cross-border banking supervision. The Committee's Secretariat is located at the Bank for International Settlements (BIS) in Basel, Switzerland. The Bank for International Settlements (BIS) hosts and supports a number of international institutions engaged in standard setting and financial stability, one of which is BCBS. Yet like the other committees, BCBS has its own governance arrangements, reporting lines and agendas, guided by the central bank governors of the Group of Ten (G10) countries.

Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital, which consists primarily of common stock and disclosed reserves, but may also include non-redeemable non-cumulative preferred stock. The Basel Committee also observed that banks have used innovative instruments over the years to generate Tier 1 capital; these are subject to stringent conditions and are limited to a maximum of 15% of total Tier 1 capital. This part of the Tier 1 capital will be phased out during the implementation of Basel III.

Advanced measurement approach (AMA) is one of three possible operational risk methods that can be used under Basel II by a bank or other financial institution. The other two are the Basic Indicator Approach and the Standardised Approach. The methods increase in sophistication and risk sensitivity with AMA being the most advanced of the three.

The basic approach or basic indicator approach is a set of operational risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions.

The term Advanced IRB or A-IRB is an abbreviation of advanced internal ratings-based approach, and it refers to a set of credit risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions.

The term Foundation IRB or F-IRB is an abbreviation of foundation internal ratings-based approach, and it refers to a set of credit risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions.

Probability of default (PD) is a financial term describing the likelihood of a default over a particular time horizon. It provides an estimate of the likelihood that a borrower will be unable to meet its debt obligations.

The term standardized approach refers to a set of credit risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions.

In the context of operational risk, the standardized approach or standardised approach is a set of operational risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions.

Loss given default or LGD is the share of an asset that is lost if a borrower defaults.

Exposure at default or (EAD) is a parameter used in the calculation of economic capital or regulatory capital under Basel II for a banking institution. It can be defined as the gross exposure under a facility upon default of an obligor.

The Capital Requirements Directives (CRD) for the financial services industry have introduced a supervisory framework in the European Union which reflects the Basel II and Basel III rules on capital measurement and capital standards.

The Solvency II Directive is a Directive in European Union law that codifies and harmonises the EU insurance regulation. Primarily this concerns the amount of capital that EU insurance companies must hold to reduce the risk of insolvency.

Basel III is a global, voluntary regulatory framework on bank capital adequacy, stress testing, and market liquidity risk. This third installment of the Basel Accords was developed in response to the deficiencies in financial regulation revealed by the financial crisis of 2007–08. It is intended to strengthen bank capital requirements by increasing bank liquidity and decreasing bank leverage.

The ORRF Risk Research Forum a forum on risk research organised by the ORRF, a recognised internationally as a leading risk research foundation. It was established, in April 1999, as an independent think tank, with tacit support from the Financial Services Authority (FSA) and the Science Research Council.

A systemically important financial institution (SIFI) or systemically important bank (SIB) is a bank, insurance company, or other financial institution whose failure might trigger a financial crisis. They are colloquially referred to as "too big to fail".

Basel IV is a contested term for the changes agreed in 2016 and 2017 to the international banking standards known as the Basel Accords. Regulators argue that these changes are simply completing the Basel III reforms, agreed in principle in 2010–11, although most of the Basel III reforms were agreed in detail at that time. The Basel Committee (BCBS) itself calls them simply "finalised reforms" and the UK Government has called them "Basel 3.1". Critics of the reform, in particular those from the banking industry, argue that Basel IV require a significant increase in capital and should be treated as a distinct round of reforms.

The Capital Requirements Regulation(EU) No. 575/2013 is an EU law that aims to decrease the likelihood that banks go insolvent. With the Credit Institutions Directive 2013 the Capital Requirements Regulation 2013 reflects Basel III rules on capital measurement and capital standards.

## References

1. "Basel II: Revised international capital framework". Bis.org. 2004-06-10. Retrieved 2013-06-06.
2. "Solvency II Glossary – European Commission" (PDF). CEA – Groupe Consultatif. Retrieved 2014-04-29.
3. "Operational risk capital: Nowhere to hide" (PDF). PwC Financial Services Regulatory Practice, November, 2014.
4. "Operational Risks in Financial Services: An Old Challenge in a New Environment" (PDF). Credit Suisse Group. Retrieved 2014-04-29.
5. "The Invention of Operational Risk" (PDF). CARR – ESRC Center for Analysis of Risk and Regulation. Retrieved 2014-04-30.
6. International Convergence of Capital Measurement and Capital Standards. https://www.bis.org/publ/bcbs128.pdf: Bank for International Settlements. p. 144. ISBN   92-9197-720-9.CS1 maint: location (link)
7. "Solvency – European Commission". Ec.europa.eu. 2012-11-26. Retrieved 2013-06-06.
8. Sanchez, Luis; Ceske, Robert; Hernandez, Jose (1 December 2000). "Quantifying Event Risk: The Next Convergence". Journal of Risk Finance (Spring 2000). CiteSeerX  .
9. Basel III: Finalising post-crisis reforms. https://www.bis.org/bcbs/publ/d424.pdf: Bank for International Settlements. 2017. ISBN   978-92-9259-022-2.CS1 maint: location (link)