CHAPTER 3

Operational Risk

Operational risk is usually defined in the negative—it includes all of the risks that are not categorized as either market or credit risk. The industry does not yet have consensus on this terminology. Some firms use the term operational risk to cover a subset of the risks other than market and credit risk. For further discussion, see Jameson (1998a). Broadly speaking, these risks are the most difficult to quantify.

One attempt at a more positive definition that has been gaining some currency has been made by the Basel Committee on Banking Supervision: “the risk of direct or indirect loss resulting from inadequate or failed internal processes, people, or systems, or from external events.” Another attempt would be to break apart risk into three pieces. View a financial firm as the sum total of all the contracts it enters into. The firm can suffer losses on the contracts in one of three ways:

  1. Obligations in contracts may be performed exactly as expected, but changes in economic conditions might make the sum of all contracted actions an undesired outcome. This is market risk.
  2. The other parties to some of the contracts may fail to perform as specified. This is credit risk.
  3. The firm may be misled about what the contracted actions are or the consequences of these actions. This is operational risk.

Operational risk is virtually all risk that cannot be managed through the use of liquid markets, so, as argued in Chapter 1, it does not fall within the scope of ...

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