Islamic Finance: The New Regulatory Challenge, 2nd Edition

Chapter 15

Measuring Operational Risk

Sandeep Srivastava and Anand Balasubramanian

1. INTRODUCTION

Operational risk remained a fuzzy concept for a long time in the banking industry because it was hard to make a clear-cut distinction between operational risk and the “normal” uncertainties faced by the banks in their daily operations. Although everyone agreed that there was a risk other than the popularly known credit, market, and liquidity risks faced by a bank, the catastrophic nature of operational risk came into limelight in the wake of the huge losses incurred by Barings Bank and Daiwa Bank in the mid-1990s. The classical story of misclassification of operational risk continued for quite some time in the industry, with some of the operational risks getting misclassified as other risks. For example, no distinction was made in the losses caused by the deterioration in credit quality of the borrower and losses emanating from the fact that the credit officer did not correctly apply the credit policy. It was not uncommon to see both these losses getting lumped together under credit risk while it is quite clear that the losses in the latter case should be attributed to operational risk.

The Basel Committee for Banking Supervision (BCBS) defined operational risk as “the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk,1 but it excludes strategic and reputational risk.”2 As per the Basel ...