Effective risk management is crucial to the survival of an institu-
tion in rapidly moving financial markets. Derivatives have become
an indispensable tool for managing and transferring the traditional
market and credit risks. Whist derivatives do not create any new
types of risks, the leveraged nature of the products that makes
them so cost-effective when covering existing exposures, means
that the effects of the market movements can be magnified both in
terms of profits and losses. It therefore becomes imperative that the
management understands the nature of the exposure and has effec-
tive operational controls in place to effectively monitor it.
The spectrum of risks outlined in this book include market risk
(i.e. risk due to the movements in the market having an adverse
effect on the portfolio), credit risk (i.e. risk that a counterparty
will fail to perform on a financial obligation), and operational
risk. Operational risk has been defined in its broadest sense as
including organizational structure and culture, corporate strategy,
people, processes, systems and controls. This inclusive nature of
operational risk means that market and credit risks can only be
managed effectively if the required infrastructure, including tech-
nology and business expertise, is in place.
At its broadest, operational risk can be defined as everything that
is not market or credit risk. However, effective management of
market and credit risks relies on systems, controls and people – all
of which are components of operational risk. In looking at oper-
ational risk, the management need to consider the risk that losses
will be incurred as a result of inappropriate management structure
or culture, inadequate systems and internal controls, legal or reg-
ulatory issues, inadequate disaster or contingency planning,
human error, or management failure.
Entering into complex financial transactions without adequate
systems for measuring, monitoring, and controlling market or
credit risk is an example of operational risk. An aspect of opera-
tional risk that has received significant attention in the recent
years is the internal controls and oversight process. A failure at
any point in the risk management chain constitutes operational
risk and can result in significant losses. Many of the major finan-
cial disasters over the last few years (e.g. the collapse of Barings,
losses at Sumitomo, Daiwa etc.) have not been examples straight
market or credit risk. They are all examples of a lack of proce-
dures, systems or managerial control, that is to say they are all
issues associated with operational risk.
While there are many cultural and structural differences between
institutions, research has shown that the operational structure
within investment banks is still predominately rather bureaucratic
with work being co-ordinated from the top and individuals having
little input in the type or scope of their daily activities. There is
still a substantial amount of manual clerical activity within the
back office. Despite tremendous advances in technology, the
majority of the core back office or operational systems within
investment banks still rely on 1980s technology. The staff within
operations tend to be young and inexperienced with limited
knowledge of the business or technology. All these issues perpetu-
ate the current operations paradigm and this has made it difficult
to define a new role for the operations function within a modern
financial institution.
In order to effectively manage operational risk, there needs to be
a paradigm shift in the role of the operations department or the
back office. Risk management is not something that can be
imposed on an organization but it needs to be ‘embedded’ into the
culture. Investment banks, particularly within the operations
departments, need to move away from a bureaucratic culture to a
more people-based culture. The nature of a bureaucratic culture is
that while it provides the cohesion that an organization needs, it
15 Conclusions

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