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Information about Operational Risk

Basel II
Bank for International Settlements
Basel Accord - 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 - 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


According to ยง644 of International Convergence of Capital Measurement and Capital Standards, known as Basel II, operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. Although the risks apply to any organisation in business it is of particular relevance to the banking regime where regulators are responsible for establishing safeguards to protect against systemic failure of the banking system and the economy. The Basel II definition includes legal risk, but excludes strategic risk: i.e. the risk of a loss arising from a poor strategic business decision. This definition also excludes reputational risk (damage to an organisation through loss of its reputation or standing) although it is understood that a significant but non-catastrophic operational loss could still affect its reputation possibly leading to a further collapse of its business and organisational failure.

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.

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 Barings, AIB and National Australia Bank, and the Y2K scare 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

Operational risk was initially defined in the negative as any form of risk that is not market or credit risk. This negative definition is rather vague as it does not tell us much about the exact types of operational risks faced by banks today, nor does it provide banks with a proper basis for measuring risk and calculating capital requirements.

A better definition is provided by the Basel Committee, who define operational risk 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. 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 the minimum elements in the Committee's definition are included.

Although the definition has gained some acceptability in the banking industry, there are also some analysts who believe it to be flawed, describing it as opaque, open-ended and leaving many unanswered questions regarding the exact type of events that can be attributed to operational losses.

In particular, the somewhat abrupt manner in which legal risk is incorporated into the definition and then left undeveloped has been the subject of criticism, as has the decision to exclude certain risks (reputational and strategic).

Basel II Event Type Categories

The following lists the official Basel II defined event types with some examples for each category:
  • Internal Fraud - misappropriation of assets, tax evasion, intentional mismarking of positions, bribery
  • External Fraud - theft of information, hacking damage, third-party theft and forgery
  • Employment Practices and Workplace Safety - discrimination, workers compensation, employee health and safety
  • Clients, Products, & Business Practice - market manipulation, antitrust, improper trade, product defects, fiduciary breaches, account churning
  • Damage to Physical Assets - natural disasters, terrorism, vandalism
  • Business Disruption & Systems Failures - utility disruptions, software failures, hardware failures
  • Execution, Delivery, & Process Management - data entry errors, accounting errors, failed mandatory reporting, negligent loss of client assets

Difficulties

It is relatively straightforward for an organisation to set and observe specific, measurable levels of market risk and credit risk. By contrast it is relatively difficult to identify or assess levels of operational risk and its many sources. Historically organisations have accepted operational risk as an unavoidable cost of doing business.

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
  • Standardised 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

External links


Economic policy
Monetary policy
Central bank   Money supply
Fiscal policy
Spending   Deficit   Debt
Trade policy
Tariff   Trade agreement

Finance
Financial market
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The Basel Accord(s) or Basle Accord(s) (see spelling section below) refers to the banking supervision Accords (recommendations on banking laws and regulations), Basel I and Basel II issued by the Basel Committee on Banking Supervision (BCBS).
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Basel I is the term which refers to a round of deliberations by central bankers from around the world, and in 1988, the Basel Committee (BCBS) in Basel, Switzerland, published a set of minimal capital requirements for banks.
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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 purpose of Basel II is to create an international standard that banking regulators can use when creating
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bank is a commercial or state institution that provides financial services , including issuing money in various forms, receiving deposits of money, lending money and processing transactions and the creating of credit.
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Economic policy
Monetary policy
Central bank   Money supply
Fiscal policy
Spending   Deficit   Debt
Trade policy
Tariff   Trade agreement

Finance
Financial market
..... Click the link for more information.

Economic policy
Monetary policy
Central bank   Money supply
Fiscal policy
Spending   Deficit   Debt
Trade policy
Tariff   Trade agreement

Finance
Financial market
..... Click the link for more information.
For the Parker Brothers board game, see risk (game)

Risk is a concept that denotes a potential negative impact to an asset or some characteristic of value that may arise from some present process or future event.
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Risk management is the human activity which integrates recognition of risk, risk assessment, developing strategies to manage it, and mitigation of risk using managerial resources.
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The capital requirement is a bank regulation, which sets a framework on how banks and depository institutions must handle their capital. The categorization of assets and capital is highly standardized so that it can be risk weighted.
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Credit risk is the risk of loss due to a debtor's non-payment of a loan or other line of credit (either the principal or interest (coupon) or both).

Faced by lenders to consumers

Main article: Consumer credit risk

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The term standardized approach (or standardised approach) refers to a set of credit risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions.
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Probability of default (PD) is a parameter used in the calculation of economic capital or regulatory capital under Basel II for a banking institution. This is an attribute of bank's client.
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Loss Given Default or LGD is a common parameter in Risk Models and also a parameter used in the calculation of Economic Capital or Regulatory Capital under Basel II for a banking institution. This is an attribute of any exposure on bank's client.
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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.

Basel II requires all banking institutions to set aside capital for operational risk.
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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.
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Market risk is the risk that the value of an investment will decrease due to moves in market factors. The four standard market risk factors are:
  • Equity risk, or the risk that stock prices will change.

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For other meanings of duration, see Duration (disambiguation).
A duration is an amount of time or a particular time interval. For example, an event in the common sense has a duration greater than zero (but not very long), but in certain specialized senses
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Value at Risk (VaR) is the maximum loss not exceeded with a given probability defined as the confidence level, over a given period of time. It is commonly used by security houses or investment banks to measure the market risk of their asset portfolios (market value at risk
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In finance, mainly for financial services firms, economic capital is the amount of risk capital, assessed on a realistic basis, which a firm requires to cover the risks that it is running or collecting.
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Liquidity risk arises from situations in which a party interested in trading an asset cannot do it because nobody in the market wants to trade that asset. Liquidity risk becomes particularly important to parties who are about to hold or currently hold an asset, since it affects
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Legal and regulatory risk: Sometimes governments change the law in a way that adversely affects a bank's position.

The Risk Principle

The Risk Principle is an area of law closely tied to legal causation in negligence.
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Disclosure means the giving out of information, either voluntarily or to be in compliance with legal regulations or workplace rules.

Information

  • In Computer security, full disclosure means disclosing full information about vulnerabilities.

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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 purpose of Basel II is to create an international standard that banking regulators can use when creating
..... Click the link for more information.
Criminal law
Part of the common law series
Elements of crimes
Actus reus  · Causation  · Concurrence
Mens rea  · Intention (general)
Intention in English law  · Recklessness
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Risk management is the human activity which integrates recognition of risk, risk assessment, developing strategies to manage it, and mitigation of risk using managerial resources.
..... Click the link for more information.
Credit risk is the risk of loss due to a debtor's non-payment of a loan or other line of credit (either the principal or interest (coupon) or both).

Faced by lenders to consumers

Main article: Consumer credit risk

..... Click the link for more information.
Legal and regulatory risk: Sometimes governments change the law in a way that adversely affects a bank's position.

The Risk Principle

The Risk Principle is an area of law closely tied to legal causation in negligence.
..... Click the link for more information.
Liquidity risk arises from situations in which a party interested in trading an asset cannot do it because nobody in the market wants to trade that asset. Liquidity risk becomes particularly important to parties who are about to hold or currently hold an asset, since it affects
..... Click the link for more information.
Market risk is the risk that the value of an investment will decrease due to moves in market factors. The four standard market risk factors are:
  • Equity risk, or the risk that stock prices will change.

..... Click the link for more information.


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