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According to §644 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.
Examples
Examples of operational risk include:
- technology failure
- business premises becoming unavailable
- inadequate document retention or record-keeping
- poor management, lack of supervision, accountability and control
- errors in financial models and reports
- attempts to conceal losses or make personal gains (rogue trading)
- third party fraud
In short risk associated with non-availability of environment to function.
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
- Risk management
- Credit risk
- Legal risk
- Liquidity risk
- Market risk
- Volatility
- Operational risk management
- Risk modeling
External links
- Operational Risk is a detailed article on operational risk.
- Revised international capital framework is the text of the new Basel II Accord.
- Operational Risk Management Blog is a resource for operational risk management content.
"Operational risk"