Managing Bank Capital: Capital Allocation and Performance Measurement, 2nd Edition

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Modelling Operational and Other Risks

The category of “operational and other risks” is not only the most difficult to model, it is also the least clearly defined (which explains at least part of the difficulty in building models). A recent survey by the Basel Committee noted that:

… there is no agreed upon definition of operational risk. Many banks have defined operational risk as any risk not categorised as market or credit risk and some have defined it as the risk of loss arising from various types of human or technical error.¹

Some components of operational risk, such as settlement risk, arguably cover more than one type of risk, showing a strong overlap between market and/or credit risk.

Some commentators like to distinguish between event risk (the risk that an operational event, such as a computer failure, human error or an earthquake, causes a loss through business disruption, erroneous payment etc.) and business risk (the risk of incurring a loss through a strategic error in the selection of business or the approach taken to manage a particular business). Other commentators like to further sub-divide operational risk into legal risk, reputational risk, environmental risk, tax risk, compliance risk and so forth. At times it seems that each consultant or advisor is competing to produce a longer list than his competitors. This is beside the point, and can become an intellectual exercise akin to the medieval argument as to how many angels can dance on the head of a pin ...