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Basel II: Measuring the Operational Risk |
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Manager, Pinnacle Research Group,
Pinnacle Systems, Inc.
Basel II: Measuring the Operational Risk?
The Oxford dictionary defines the word “risk” as “the possibility of something bad happening at sometime in the future; a situation that could be dangerous or have a bad result.” It is quite a well known fact that “where there is money there ought to be a certain amount of risk involved.” In the realm of the financial domain today, the term “risk” is getting more common and frequent. Managing this risk effectively has thus become the onus of one and all involved in the financial services sector.
The Basel Committee on Bank Supervision created the first Basel Accord in 1988 to ensure capital allocation by examining market risk and credit risk within banking institutions. The new version, the proposed Basel II, is set to modify its evaluation of credit risk, and more importantly, it seeks to assess “operational risk,” an area previously not clearly defined in the financial services marketplace.
Managerial practices in recent years are recognizing the importance of enterprise-wide risk management and trying to strategically analyze corporate activities. Organizations are realizing the need to correctly understand their risks due to various actions as well as the inter-relations within the firm.
Defining Operational Risk
Traditional risk management stresses upon insurance products to cover risk hazards, and to a certain extent, financial hedging to cover market risks. On the other hand, enterprise-wide risk management demands that managers re-define risk within the firm by identifying, measuring and managing risks as varied as accounting fraud, soft consumer demand and environmental requirements. These non-traditional risks are frequently labeled as “operational risk.”
The propounders of the Basel Capital Accord argue that Basel II is set to establish the financial services industry as a leader in risk management. Operational risk, in addition to credit and market risks, would be a determinant of minimum capital requirements. Firms in general are beginning to discuss the importance of operational risk more explicitly, keeping in line with the proposed Basel II accord, which out rightly mandates upon the financial services industry to manage this risk effectively.
The Basel Committee defines operational risk as “the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events.” The Basel Committee has observed through various surveys that the current measurement of operational risk by banks is relatively undefined and qualitative in nature.
The most important types of operational risk include breakdowns in internal controls and corporate governance. These kinds of breakdowns can lead to financial losses through slip-up, fraud or failure to carry out operations in a time-bound manner. It might lead to a situation where the interests of the bank had to be compromised in some ways say for example, by its dealers, lending officers or other staff exceeding their authority or conducting business in an unscrupulous or perilous manner. Other aspects of operational risk include major failure of information technology systems or events such as natural calamities, major fires or other disasters.
A New Frontier
Operational risk has been there ever since financial institutions evolved. However as a separate discipline, operational risk management has surfaced only in recent years. As such when Basel II is implemented as a regulation in individual countries, there surely will be a noteworthy movement toward the analysis of operational risk within financial services organizations.
It is a clear trend today that the financial-services industry is giving more attention to risk management. Regulators the world-over are working out a complicated set of rules for governing global banks, following the norms set by Basel II, which clearly indicates how much money banks must set aside in case of emergencies.
Measuring the risks intimately, executives are likely to look differently at the cost of technology-intensive investments in order to avoid those risks. Federal Reserve Vice Chairman Roger Ferguson in a recent report said, Supervisors expect the advanced measurement approach to provide the incentives to invest in new systems and practices that will reduce the potential for serious losses from operational risk.
Factors like globalization, consolidation and Basel II have taken real-time information into account, which has changed the risks in the financial services industry. The industry today is more dependent than ever before on electronic transactions and more inclined to real-time information. Over and above this, industry consolidation has left fewer banks in control of more money. Mr. Ferguson said, The operations of these banks are increasingly complex and sophisticated while at the same time, significant weaknesses in one of these entities, let alone failure, has the potential for severely adverse macro-economic consequences. Simply speaking if any bank undertakes a bad deal and loses, the fallout would be felt by the entire industry and thereby the entire global economy could get jeopardized.
According to a recent Gartner report, technology spending for risk management will account for 9% of the average IT budget in financial services. The report predicts that building risk-management infrastructures will remain an IT investment priority through 2005.
The Ifs and Buts
The move to label and compute operational risk has its skeptics as well. Mr. Ferguson notes that some bankers hold the opinion that the money spent on IT systems and procedures to measure operational risk would be better spent on high-tech systems to prevent such problems. Moreover the policy makers of Basel II face the challenge, which currently holds no foolproof standards for identifying and quantifying the risk.
However they stress upon the fact that operational-risk losses can ravage institutions. For example the case of Allied Irish Bank last year was an eye-opener. It lost nearly $750 million and shook its reputation when a trader at an US subsidiary forged records of options purchases, to perhaps conceal losses. More of this factor was clearly vivid when the September 11 disaster occurred, which made the biggest ever dent to the industry's disaster-recovery as well as business-continuity planning.
What protagonists of the operational-risk elements of Basel II propose is an advanced measurement approach (AMA), thereby allowing banks to develop their own methodologies in measuring operational risk and the capital they'll set aside to prepare for the same in accordance with certain guidelines proposed in Basel II. These will however be subjected to audit and regulatory oversight. But the result should be that banks that invest to reduce their risks would ultimately get the financial return of lower capital requirements. Under the AMA, “If a bank invests in improved contingency procedures and approaches, we would expect such an investment to be reflected in a reduction in the need for operational-risk capital, Mr. Ferguson added.
To make possible the adoption by large internationally active banks and banks with significant operational risk exposures of the more risk-sensitive AMA, the Basel Committee is prepared to allow for its partial adoption. Banks may use either the basic indicator approach or the standardized approach to operational risk for some parts of its operations and an AMA for others, provided that all material risks are captured within the banking organization on a global consolidated basis.
A bank will however not be allowed to revert to the simpler approaches once it has been approved to use one of the more advanced operational risk approaches, unless advised to do so by its supervisor. Another change to the AMA allows banks using this approach to recognize insurance as an operational risk mitigant when calculating regulatory capital. A bank may recognize insurance in an amount not to exceed 20% of its total operational risk capital requirement subject to minimum criteria outlined in the proposed Basel II accord.
The Road Ahead
With evolving risks, the need to uphold regulations and maintain competition, financial services organizations are set to be all the more reliant on business technology. If Basel II is implemented, it is set to affect about 20 of the largest financial institutions in the US, with another 20 to 30 likely to adopt the requirements since it will provide them superiority in competition and character. Thus, it will hasten the discussion on measuring and thereby provide a value on operational risks.
As one of the most heavily-regulated industries, financial services is often credited to set the ball rolling with regards to rules and guidelines, while other vertical industries follow suit. Stringent regulations and market pressures are likely to force every organization to adopt some essence of these policies in the near future. As Bits CEO Catherine Allen rightly points out in a report, This isn't just about Basel. This is about everyone.
About Pinnacle Systems, Inc.
Pinnacle Systems, Inc. is a technology consulting and solutions provider to Capital Markets firms.
For over seven years, Pinnacle has applied its in-depth domain expertise and off-shore development capabilities to the Capital Markets. Pinnacle’s Capital Markets Excellence Center (CMEC)TM and its Efficient Delivery Model (EDM)TM successfully deliver cost-effective project based solutions for leading global banks and financial institutions.
The company is headquartered in Piscataway, New Jersey, with offices in New York City, and development centers in Chennai, India.
For more information, you may contact Mark Engelhardt at 275, Madison Avenue, 6th Floor, New York, New York, 10016, USA. Tel: (212) 880 3737 or email him at: mark@pinnacle-sys.com
URL: www.pinnacle-sys.com
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