Operational Risk - A Primer

The Basle 2 Accord, first drafted in 1999, has just undergone its' final revision. The Act will have widespread ramifications on all institutions. One of the most notable changes from the original Basle Accord of 1988 is the introduction of a Capital Charge for Operational Risk. In respect of a charge being levied for losses (in excess of balance sheet reserves for doubtful debts) the Financial Services market is unique. One does not see Capital Charges being applied to poor controls in manufacturing where margins are small and where errors of 1 in 1,000,000 can often be deemed excessive!

The need to include a Capital Charge specifically for Operational Risk has raised the ire of many in the industry who state that processes are in place to minimize these effects, specifically as it relates to Operational Resilience and Systemic failures.

Indeed many in the Industry are of the opinion that Ops Risk should be relegated to a Pillar 2 charge, determined by each country's own regulators and that a combination of balance sheet reserves and other instruments such as

1) Insurance policies
2) Commission charges
3) Surplus APRs on Credit Cards

As a result of the internal industry conflicts and the nascent nature of Ops Risk as a risk category many institutions are taking a wait and see approach. However a more immediate regulatory issue has pushed it to the fore, Sarbanes-Oxley.

One of the emerging trends is that, in Financial Institutions, Sarbanes-Oxley is seen as a subset of Operational Risk and that many firms has merged the two together.

Financial Institutions have spent relatively little on external Operational Risk solutions, when compared to the spend on Market and Credit Risk, due to the relevant simplicity of market offerings. Many vendor offerings are centered on controlled self assessments (CSA) and loss data capture tools, all of which can be developed internally. Whilst Self-Assessment is the right first step to take, it is just that, a first step.

As the market matures there is strong evidence that the current offerings for Ops Risk will be superceded by the need for automation, integration, visualization etc and an increase in focus away from CSA and the recording of losses to loss prevention.

Survey results indicate that there is a substantial gap between expectations and reality when it comes to the short-term benefits of putting a risk management framework in place. Many industry participants expect a reduction in losses and loss events of over 20% for minimal investment!

The Bank of International Settlements (BIS) has used the Basel Accord to force Financial Institutions to adopt the process quality control lessons that the manufacturing sector have learnt over the past 30 years.

It is the authors' contention that the BIS intention in introducing an Operational Risk Capital Charge is to focus senior management attention on the issue of Operational Inefficiency and jump start an improvement process.

The Spirit behind Basle 2 is to

1) Place focus of management on maximizing operational effectiveness and resilience whilst minimizing risk

2) Highlight that the real purpose of operational risk management programs, including loss data collection and capital modeling, is just to understand and better manage business better

In essence "Sound operational risk management is just good business management practice".