Operational Risk Management -Best Practices for Business Performance

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In the field of risk management, the focus so far has been on market risk and credit risk. Only recently have regulators begun to focus on the operational risk aspect, after a  series of  spectacular losses in the financial sector in the last two decades resulting from inadequate controls and processes. (The large loss events include the $750 million Allied Irish Bank loss resulting from lack of internal controls, the Barings Bank $1.6 billion loss on account of poor operational risk management, the Daiwa Bank and Orange County events resulting from poor management control and the recent Société Générale losses.)

The Basel Committee on Banking Supervision (BCBS) has defined operation risk as ‘the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events’. Operational risk is different from market risk and credit risk in terms of scope — operational risk cuts across various departments and functions of an organisation. Since it is not restricted to a particular department within  a bank, the traditional approaches to managing risk have not been satisfactory with regard to operational risk. 

 

Regulators are now looking at operational risk in a much more structured manner.

Exhibit 1-Traditional vs Enterprise Wide Approaches to Risk Management

 

Operational risk management is typically the responsibility of a risk function within the organisation. This  function defines the frameworks to manage operational risk. Once this framework is defined, individual departments would use it to identify areas of risk management, and conduct internal and external reviews and assessments. They could even have specialised units to handle operational risk within the department. Initiatives like setting up an operational risk portal could enable the much needed but hitherto neglected data sharing across departments within an organisation and across various organisations. Responding to these developments, banks have started to measure operational risk and are incorporating these measurements in their business decision making process. The Basel II Capital Accord requires all banks to allocate capital for operational risk but provides flexibility in the methods used for measurement. To measure operational risk, a standardised matrix comprising eight businesses and seven event type categories has been prescribed. The purpose of this classification is to provide the best practices and level playing fields to the banking institutions. Each regulatory prescription is supported by data collected during the four Quantitative Impact Study (QIS) events.

Risk measurement typically involves two types of operational risk losses — high frequency-low severity losses and low frequency-high severity losses. There is extensive data available for high frequency-low severity loss, so it is possible to analyse it within a loss distribution framework. However, for the more elusive low frequency high severity loss, one would require external data, scenario analysis and qualitative adjustments for business environments. Ultimately, loss distribution will differ from bank to bank and from business to business. Apart from direction regarding the measurement of operational risk, the BCBS has laid out in its publication ‘Sound Practices for the Management and Supervision of Operational Risk’, ten guidelines to enhance operational risk management. Operational risk management (ORM) from the Basel perspective can be divided into two distinct areas: data collection – involving work-flow and followup, and operational risk analytics to address the BCBSprescribed Advanced Measurement Approach (AMA).

There are four components of operational risk data: operational loss events, risk and control self-assessments, key risk indicators, and risk scenarios. 

Exhibit 2- Operational Risk Framework in a Nutshell

 Exhibit 2 sums up all the facets of the operational risk framework.

Recently, it has been recognised that management of losses and management of regulatory obligations are similar in approach. There are regulatory requirements pertaining to information security, anti money laundering, privacy, Sarbanes-Oxley Act compliance, central banking regulatory requirements, and so on. The compliance loop is completed when governance is put in place as this brings in accountability to stakeholders. So, organisations have started looking at operational risk and compliance together in a larger framework of governance. Organisations have also started asking for cost savings and return on investments for such initiatives.

Source-IIMB Management Review, September 2008 By Vijay Sharma

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