Commercial bank operational risk

Author: Alexander
Publisher:
Publish Date: 2005-01-01
Features: For financial institutions and commercial banks, operational risk is an important and vivid topic in practical work. The Basel Committee on Banking Supervision proposed the recommendation to allocate capital for operational risk when setting minimum capital requirements for internationally active banks in Group of Ten countries, which sparked extensive debate in the industry. These debates discussed many viewpoints, such as the pre-importance of operational risk, how to measure and extract operational risk capital, and so on. This book will focus on exploring these issues. Fraud and some operational risks have led to significant losses and even the collapse of major companies—such as Drexel and Barings. However, any bank faces severe challenges when calculating operational risk because most operational risk events do not occur frequently. Financial data is mostly composed of high-frequency, low-loss event data, so it is crucial for the industry to share data when assessing operational risk. Unlike the exogenous nature of a company's credit risk and market risk, operational risk is endogenous, depending on the structure, efficiency, and control capabilities of the company's system. The first line of defense is the company's system design and incentive mechanisms, while the second line of defense is capital requirements. However, can the size of capital determined by regulatory requirements meet the requirements for withstanding operational risk? Some banks with higher operational risk (e.g., those engaged in custody and payment businesses) may have lower credit risk and market risk, so allocating capital based on their corresponding credit and market risk exposure may not be appropriate. Even for banks with higher credit risk and market risk, it cannot be assumed that operational risk is unrelated to these risks. In the early stages of an operational risk event, the relationship may not be apparent, but once the bank faces pressure, losses will be exposed (e.g., when fraud incidents cannot be concealed). Some operational risks are directly related to the problems faced by the bank. For example, a bank with a high number of non-performing loans may find that its mortgage disposal process is overly complex, creating space for potential fraud risks. As a result, the bank will have to bear the losses incurred. A complex issue is how to define different types of risks. For instance, when a borrower defaults, if process flaws cause the loss (LGD) from the default event to be larger—i.e., the bank fails to maximize the value of collateral or guarantees—then is it operational risk or credit risk? Furthermore, to ensure the quality of credit risk data, it is important not to change the definition of credit risk losses (by excluding operational risk) during collection. Additionally, regulatory oversight of operational risk will encourage commercial banks to design better systems to control and measure losses from such risks. Therefore, any changes in regulation must be evaluated. One currently debated issue is how to recognize the role of insurance in mitigating risk in capital allocation. Commercial banks need to study operational risk control issues as soon as possible. From past large loss cases, it can be seen that although the system design was well done, it was not fully effectively implemented. In other cases, even when flaws in systems and controls were identified, timely action was not taken (which ultimately led to losses). As an important part of the Basel II capital adequacy framework, the Basel Committee on Banking Supervision will propose clear capital requirements for operational risk in 2006, so many issues need further discussion. This book will provide an important foundation for these discussions. Patricia Jackson, Head of the Financial and Regulatory Department, Bank of England