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Financial Engineering: The Evolution of a Profession by Cara M. Marshall, Tanya Beder

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Chapter 25

Operational Risk

Monique Miller

WR Managed Accounts LLC

INTRODUCTION AND CURRENT STATE OF KNOWLEDGE

An appropriate definition of operational risk has been debated in the financial community for decades. In the past, many have used an all-inclusive definition that classifies operational risk as any risk that is not categorized as market risk or credit risk. The Basel Committee on Banking Supervision came out with a definition of operational risk several years ago that has been generally adopted by the financial services industry, although its comprehensiveness continues to be debated. The Basel Committee, in consultation with the banking community, crafted the following definition: “Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk but excludes strategic and reputational risk.”1

No matter how it is defined, insufficient management of operational risk can be devastating to every type of organization. The highly publicized corporate scandals that led to the bankruptcies of Enron and WorldCom can be attributed in part to operational risk. Banks and trading firms spend tens of millions of dollars every year to manage and measure operational risk, and buy-side investors are demanding tighter controls and increased transparency from their investment managers in order to avoid fraud and other operations-related losses.

The emergence of more sophisticated ...

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