1. MEASURING
OPERATIONAL RISK
CHAPTER 11

2. Learning Objectives

Operational Risk Data
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Measuring Operational Risk
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Loss Events
Key Risk Indicators
Subjective Risk Assessments
Top Down Approaches
Bottom-up Approaches
Managing Operational Risk
Developing an appropriate risk management
environment
Risk identification, assessment, monitoring and
control
Management of Financial Institutions by Dr. Meera Sharma

3. OPERATIONAL RISK
 DEFINITION
A
wide definition of operational risk is that it
encompasses all risks that a bank faces other
than credit and market risks.
A
narrow definition, on the other hand, is that
operational risk is the risk associated with the
operations department of the bank.
Management of Financial Institutions by Dr. Meera Sharma

4. OPERATIONAL RISK

Incidents of Losses Owing to Operational Risk
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In May 2001, a dealer at Lehman Brothers in London traded
a £300 million lot instead of an intended £3 million. (Patel
2002).
In 1995 Daiwa Bank reported a $1.1 Billion loss as a result of
an internal fraud in its securities trading department.
Subsequent punishment by US regulators and loss of
reputation led to Daiwa bank having to quit the US market.
In 1995 Barings Bank, UK’s oldest merchant bank, was
purchased by Dutch bank ING for just 1 Pound Sterling after
sustaining $1 billion of unauthorized trading losses owing to
internal fraud by its trader Nick Leeson.
Management of Financial Institutions by Dr. Meera Sharma

5. OPERATIONAL RISK

Incidents of Losses Owing to Operational Risk
In
1998 LTCM (Long Term Capital Management) had to
be rescued by the Federal Reserve to prevent a systemic
crisis. One of the reasons for its failure was inadequate
stress testing of its valuation models.
Banker’s Trust, one of the leading banks in the business
of offering innovative financial products was sued by 4 of
its large clients in 1994 for having misled them about the
true risk profiles of its new products. The lawsuits were
settled at a loss to Banker’s Trust of $ 171 million.
Management of Financial Institutions by Dr. Meera Sharma

6. OPERATIONAL RISK
 The
New Basel Capital Accord (2003) defines
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.
Management of Financial Institutions by Dr. Meera Sharma

7. OPERATIONAL RISK
BANKING
RISKS
OPERATIONAL
MARKET
CONSEQUENTIAL
RISKS
CREDIT
CHOSEN RISKS
BUSINESS
MANAGEMENT RISKS
Management of Financial Institutions by Dr. Meera Sharma

8. OPERATIONAL RISK

DRIVERS OF INCREASING OPERATIONAL RISK
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CHANGING MARKETS;
CHANGING PRODUCTS AND SERVICES;
CHANGING TECHNOLOGIES,
CHANGING TECHNIQUES AND
UNEXPECTED EVENTS.
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Management of Financial Institutions by Dr. Meera Sharma

9. OPERATIONAL RISK
 GOALS
OF INVESTING IN OPERATIONAL
RISK MANAGEMENT
AVOIDANCE
OF
LARGE
UNEXPECTED
LOSSES - SEVERITY
 AVOIDANCE OF SMALL BUT LARGE NUMBER
OF LOSSES - FREQUENCY
 IMPROVED OPERATIONAL EFFICIENCY AND
RETURN ON CAPITAL

Management of Financial Institutions by Dr. Meera Sharma

10. OPERATIONAL RISK
SEVERITY
SECONDARY CHALLENGE
NOT RELEVANT
•NOT FIRM THREATENING
•CAN BE MANAGED WITH
EXPERIENCE
•CAN BE INCORPORATED INTO
PRICING
•GENERATE EFFICIENCY SAVINGS
DON’T MATTER
PRIMARY CHALLENGE
•CAN PUT BANKS OUT OF BUSINESS
•DIFFICULT TO PREDICT AND
MANAGE
•SIMILAR TO RISKS IN OTHER
INDUSTRIES SUCH AS CHEMICAL,
AVIATION, HEALTHCARE
Management of Financial Institutions by Dr. Meera Sharma
FREQUENCY

11. OPERATIONAL RISK

OPERATIONAL RISK DATA

Loss Events
An operational loss event is an occurrence that
results in a loss owing to operational reasons.
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Key Risk Indicators
Operational risk indicators are measures that can
signal the potential of loss owing to operational risk
Management of Financial Institutions by Dr. Meera Sharma

12. OPERATIONAL RISK
Operational Loss Events Types Identified
by the Basel Committee
 Internal
Fraud: Theft, position mis-reporting
and insider trading.
 External Fraud: Robbery, forgery, hacking.
 Employment Practices: Worker
compensation claims, fines for employee
health and safety violation.
Management of Financial Institutions by Dr. Meera Sharma

13. OPERATIONAL RISK
Operational Loss Events Types Identified by the
Basel Committee
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Clients, Products and Business Practices:
Fiduciary breaches, money laundering, unlawful
operations.
Damage to Physical Assets: Terrorism,
vandalism, natural disasters.
Systems Failure: Hardware and software failures.
Execution, Delivery and Process Management:
Data entry errors, incomplete documentation,
collateral management failure
Management of Financial Institutions by Dr. Meera Sharma

14. OPERATIONAL RISK
KEY RISK INDICATORS
 Employee sick days,
 Staff Turnover,
 Aggregate grading of employee reviews,
 Failed background checks on employees,
 Above market returns,
 Transaction volumes,
Management of Financial Institutions by Dr. Meera Sharma

15. OPERATIONAL RISK
KEY RISK INDICATORS
 Amount of overtime worked,
 Investments in technology,
 System downtime,
 Age of hardware,
 Capacity to usage ratio,
 Margin on a product,
 Level of training required by internal staff.
Management of Financial Institutions by Dr. Meera Sharma

16. OPERATIONAL RISK
CATEGORIES OF OPERATIONAL RISK
 Technology Risk
 Human risk
 Risk from external events
 Model risk
 Risk of failed processes
 Legal risk
Management of Financial Institutions by Dr. Meera Sharma

17. OPERATIONAL RISK
CATEGORIES OF OPERATIONAL RISK
Technology Risk:
The risk that banks face owing to advances in
technology arises from system breakdowns.
Failure of technology, hardware, software or
telecommunication systems is a major cause
of operational risk.
Management of Financial Institutions by Dr. Meera Sharma

18. OPERATIONAL RISK
CATEGORIES OF OPERATIONAL RISK
Human Risk:
The Basel committee (Working Paper on the
Regulatory Treatment of Operational Risk,
2001) defines internal fraud as, “losses due
to acts of a type intended to defraud,
misappropriate property or circumvent
regulations, the law or company policy,…”.
Management of Financial Institutions by Dr. Meera Sharma

19. OPERATIONAL RISK
CATEGORIES OF OPERATIONAL RISK
Risk from External Events:
This category includes risk owing to external fraud
defined by the Basel committee as, “Losses due to
acts of a type intended to defraud, misappropriate
property or circumvent the law, by a third party.”
It also includes loss arising from damage to physical
property arising from natural or manmade disasters.
Management of Financial Institutions by Dr. Meera Sharma

20. OPERATIONAL RISK
CATEGORIES OF OPERATIONAL RISK
Model Risk:
This risk arises from the breakdown of
assumptions underlying models of valuation
or risk calculation.
It also includes losses from faulty design of
products.
Management of Financial Institutions by Dr. Meera Sharma

21. OPERATIONAL RISK
CATEGORIES OF OPERATIONAL RISK
Process Failure Risk:
This risk category includes the risk of
inadequate or failed processes of execution
of transactions, maintenance of transactions
or delivery of products.
Management of Financial Institutions by Dr. Meera Sharma

22. OPERATIONAL RISK
CATEGORIES OF OPERATIONAL RISK
Legal Risk
Legal risk can arise when the bank breaches
contracts it has entered into.
Apart from situations where the bank breaches
a contract, legal risk can also arise when a
contract entered into by a bank cannot be
legally enforced.
Management of Financial Institutions by Dr. Meera Sharma

23. OPERATIONAL RISK
MEASURING OPERATIONAL RISK
-the top down approach
-the bottom up approach.
Management of Financial Institutions by Dr. Meera Sharma

24. OPERATIONAL RISK
MEASURING OPERATIONAL RISK
Top-Down Approaches
 The top down approach involves first
estimating the risk and the capital required
for the bank as a whole
 The basic indicator approach
 The standardized approach in the New Basel
Capital Accord.
Management of Financial Institutions by Dr. Meera Sharma

25. OPERATIONAL RISK
The Basic Indicator Approach calculates the
operational risk capital charge as 15% of the
bank’s average annual gross income over
past three years
Management of Financial Institutions by Dr. Meera Sharma

26. OPERATIONAL RISK
Gross income is defined as
Gross income = Net profit + provisions and contingencies + operating
expenses –
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reversal during the year in respect of provisions and write-offs made
during the previous year(s);
income recognised from the disposal of items of movable and
immovable property;
realised profits/losses from the sale of securities in the “held to
maturity” category;
income from legal settlements in favour of the bank;
other extraordinary or irregular items of income and expenditure; and
income derived from insurance activities (i.e. income derived by writing
insurance policies) and insurance claims in favour of the bank.
Management of Financial Institutions by Dr. Meera Sharma

27. OPERATIONAL RISK
The standardized approach involves dividing
the bank’s activities into eight business lines
The total capital charge is calculated by
summing the capital charge for each
business line.
The capital charge for each business line is
calculated by multiplying the gross income of
that business line by a factor ranging from 12
to 18%.
Management of Financial Institutions by Dr. Meera Sharma

28. OPERATIONAL RISK
Business Lines
Multiplication Factors
Corporate Finance
18%
Trading and Sales
18%
Retail Banking
12%
Commercial Banking
15%
Payment and Settlement
18%
Agency Services
15%
Asset Management
12%
Retail Brokerage
12%
Management of Financial Institutions by Dr. Meera Sharma

29. Management of Financial Institutions by Dr. Meera Sharma

30. OPERATIONAL RISK
MEASURING OPERATIONAL RISK
Bottom-Up Approaches – CHALLENGES
Lack of position equivalence;
Incompleteness of portfolio;
Context dependence and
Irrelevance of past data; and
Validation difficulties.
Management of Financial Institutions by Dr. Meera Sharma

31. Ca
De usal
y M pe nd
od enc
el
y
al nc
u s de
Ca pen l
D e od e
M
Historical Database
Loss
Event
Frequencies
Historical Database
of Loss Event
Impact
Historical Database
of
Key
Risk
Indicators
Causal Dependency
Model
Estimates of Loss
Event frequencies
over a future Horizon
Forecasting
Model
Estimates of Key Risk
Indicators over a future
Horizon
Aggregate Loss Data over
a future Time Horizon
Management of Financial Institutions by Dr. Meera Sharma
Causal Dependency
Model
Estimates of Loss
Event Impact over a
Future Horizon

32. OPERATIONAL RISK
MEASURING OPERATIONAL RISK
Bottom-Up Approaches
Guidelines from Basel Committee – New Accord
It allows banks to use an internal operational risk
measurement system provided some qualitative
and quantitative criteria are met.
One of these is that the bank should be able to
demonstrate that its model captures potentially
severe “tail” loss events.
Management of Financial Institutions by Dr. Meera Sharma

33. OPERATIONAL RISK
MEASURING OPERATIONAL RISK
Bottom-Up Approaches
Guidelines from Basel Committee – New Accord
It should be able to capture loss comparable to a oneyear horizon and 99.9% confidence interval.
Its historical loss database should be at least three
years long, extendable to five years.
In addition to loss data banks should also capture key
business environment and internal control factors
that can change its operational risk profile to make
risk assessments forward looking.
Management of Financial Institutions by Dr. Meera Sharma