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Measuring Operational Risk: Part Science, Part Art

May 4, 2011
By Chris Kentouris

Each day small and large financial institutions alike face various amounts and types of risk.

These have historically been divided in two broad categories: the credit risk associated with the trustworthiness of a counterparty and the market risk related to the volatility of the prices of the securities or contracts purchased or sold.

But there is yet another type of risk – operational risk – that has now come to the forefront. This is due to a combination of regulatory requirements and the financial crisis when firms realized the costs involved with errors valuing non-exchange traded instruments, trading with financially unsound counterparties and simply not keeping track of. The catch-all phrase encompasses everything from employee errors to systems failures, fires and floods or other cause of loss to physical assets, as well as fraud and other illegal business activities.

The range of risks is so broad that eliminating all of them would be far too costly, say risk management experts.

Besides, there’s a natural tug of war going on. Financial firms want to ensure they can be reduced as much as possible. Yet they also want to spend as little as possible so they can maximize the use of their regulatory capital and operating budget.

The Basel II and pending Basel III Capital Accords do require financial firms to set aside regulatory capital to account for projected future operational risk and provides some guidelines for how to do so. While the new U.S. Dodd-Frank Wall Street Reform Act, passed in July 2010, doesn’t mandate that financial firms measure their operational risk it will require them to have tighter controls around payment, clearing and settlement activities, say regulatory experts.

To accurately measure their operational risk, financial firms are now trying to understand just how much the potential errors, natural disasters or fraud will cost them and how well their current procedures work through a combination of qualitative and quantitative means. Those procedures involve a combination of sufficient manpower, automation and correct business processes.

“Operational risk can really never be accurately quantified because the actual amount of exposures is unknown,” explains Jaidev Iyer, director of J-Risk, a New York based operational risk consultancy. “You can base your analysis on historical risk and make estimates but not for 100 percent of the time.”

The reasons: Unlike market or credit risk, operational risk is not transaction-based. “There is no bottoms-up simple mechanism to aggregate exposure and risk so at best it is statistical or scenario-based,” says Iyer. “In addition, it is quite possible that an operational risk event such as a regulatory fine or litigation isn’t limited; a firm could lose more than its entire capital including reputation and operating franchise.”

Among the most common – and unintentional -- operational mistakes: failed settlement of trades, incorrect valuation of securities, unreconciled transactions with counterparties and service providers such as custodian banks and prime brokers; and erroneous processing of corporate action notifications and decisions from investors.

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