Encyclopedia of Financial Models III

Operational Risk

ANNA CHERNOBAI, PhD

Assistant Professor of Finance, M J. Whitman School of Management, Syracuse University

SVETLOZAR T. RACHEV, PhD, DrSci

Frey Family Foundation Chair-Professor, Department of Applied Mathematics and Statistics, Stony Brook University, and Chief Scientist, FinAnalytica

FRANK J. FABOZZI, PhD, CFA, CPA

Professor of Finance, EDHEC Business School

Abstract: At one time the belief was that financial institutions are exposed to two main risks. Operational risk was regarded as a mere part of “other” risks. That view has changed. This risk is now viewed as a major risk faced by financial institutions as the world financial system has been shaken by a number of banking failures since the mid 1980s, and the risks—that internationally active banks, in particular, have had to deal with—have become more complex and challenging. More than 100 operational losses exceeding $100 million in value each and a number of losses exceeding $1 billion have impacted financial firms globally since the end of the 1980s. There is no question that the cause is unrelated to market or credit risks. Such large-scale losses have resulted in bankruptcies, mergers, or substantial equity price declines of a large number of highly recognized financial institutions.

A long-held belief is that credit risk and market risk have been considered the two largest contributors to the risks faced by financial entities such as banks, insurance companies, and asset management firms. Credit ...