Operational Risk

Introduction• operational risk has proved to be an important cause of

financial losses.• Indeed, most financial disasters can be attributed to a

combination of exposure to market or credit risks along with some failure of controls that is a form of operational risk

• For the first time, the Basle Committee is proposing to establish capital charges for operational risks, that is about 20% of the overall capital requirements

• Problem: operational risk is much harder to identify thanmarket and credit risks. Even, the definition of operationalrisk is still vague ...

Definition of Operational Risk• There are still no consensus on exact definition the broadest operational

risk is any financial other than market and credit risk. too broad, include also business risk, ...

• the narrowest operational risk as risk arising from operations. includes back office problems, failure in transactions and systems,

... but does not include internal fraud, improper sales practices, ...• Intermediate definition the risk of direct or indirect loss resulting from

inadequate or failed internal process, people or systems or from external events.

• exclude business risk, strategic and reputational risks. but include external events such as external fraud, regulatory effects, natural disasters legal risks, ...

• It is now the Basle II definition ...• Daniel HERLEMONT

Examples of Operational Risks

Breakdown of Financial Risks

Operational Risk Classifications

Model Risk

• Among operational risk, a notable risk for complex products is Model Risk which is due to using the wrong models for valuing and hedging products

• Internal risks that combines lack of knowledge (people) product complexity, valuation errors , programming errors

Approaches to Operational Risks

• Models Top DownBottom up

• Tools– Audit – Critical self assessment– Key risk indicators– Earnings volatility– Causal Networks – Actuarial models

Managing Operational Risks

• Like market VAR, the distribution of operational losses can be used to estimate expected losses as well as the amount of capital required

Regulatory requirements

• The new Basle Accord introduce charge against operational risk

• 3 Methods– Basic Indicator Method – Standardized approach– Internal measurement approach (IMA)

Preventing Operational Risk• Straight Through Processing (STP)• Internal control:

– clear separation of functions– dual entries– Reconciliations– Tickler Systems– Confirmations– Verification of prices– Authorization– Settlement– Internal / External Audits