OPERATIONAL RISK Operational risk refers to the possibility that operating

Operational risk operational risk refers to the

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OPERATIONAL RISK Operational risk refers to the possibility that operating expenses might vary significantly from what is expected, producing a decline in net income and firm value. The Basel Committee defines operational risk as: The risk of loss resulting from inadequate or failed internal processes, people, and systems, or ]rom external events.41 A new focus of the Basel II Accord is operational risk (see Chapter 12 for more details on capital requirements). Starting in 2006, the proposed Basel capital requirements will require a bank to make capital allocations for operational risk. The focus is on the optimum use of capital in the technology and business process operations of a fmancial institution. The events of September 11, 2001, tragically demonstrated the need for banks to protect themselves against operational risk to their systems and people. From a capital adequacy point of view, this covers technology risks, management-and people-related operational risks, and legal risks. There are many causes of earnings variability in an institution's operating poliCies. Some banks are relatively inefficient in controlling direct costs and employee processing errors. Banks must also absorb losses due to employee and customer theft and fraud. A bank's operating risk is closely related to its operating policies and processes and whether it has adequate controls. Losses from external events, such as an electrical outage, are easy to identify but difficult to forecast because they are not tied to specific tasks or products within the bank. Operational risk is difficult to measure directly but is likely greater for higher numbers of divisions or subsidiaries, employees, and loans to insiders. Historically, measures of operational risk were limited to measures of operational efficiency and expense control or productivity, and included ratios such as total assets per employee and total personnel expense per employee. More recently, banks and other firms have come to realize that operational risk is much greater than this. Operational risk also arises from the more difficult-to-measure, unexpected loss or risk that might occur as the result of the following: 1. Business interruptions from loss or damage to assets, facilities, systems, or people 2. Transaction processing from failed, late, or incorrect settlements 41 See "What is Operational Risk?" by Jose Lopez. Economic Letter, Federal Reserve Bank of San Francisco, January 25, 2002. C HAP T E R 3 Analyzing Bank Performance 3. Inadequate information systems in which the security of data or systems is compromised 4. Breaches in internal controls resulting in fraud, theft, or unauthorized activities 5. Client liability resulting in restitution payments or reputation losses Unfortunately, there is no concrete way to estimate from published data the likelihood of these contingencies. The key is to have strong internal audit procedures with follow-up to reduce exposures and for management. to meticulously identify and quantify potential losses by type of event and the lme of
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