Operational Risk: A Guide to Basel II Capital Requirements, Models, and Analysis

CHAPTER 1

Operational Risk Is Not Just “Other” Risks

Until very recently, it has been believed that banks are exposed to two main risks. In the order of importance, they are credit risk (counterparty failure) and market risk (loss due to changes in market indicators, such as equity prices, interest rates, and exchange rates). Operational risk has been regarded as a mere part of “other” risks.

Operational risk is not a new concept for banks. Operational losses have been reflected in banks’ balance sheets for many decades. They occur in the banking industry every day. Operational risk affects the soundness and operating efficiency of all banking activities and all business units.

Most of the losses are relatively small in magnitude—the fact that these losses are frequent makes them predictable and often preventable. Examples of such operational losses include losses resulting from accidental accounting errors, minor credit card fraud, or equipment failures. Operational risk-related events that are often more severe in the magnitude of incurred loss include tax noncompliance, unauthorized trading activities, major internal fraudulent activities, business disruptions due to natural disasters, and vandalism.

Until around the 1990s, the latter events have been infrequent, and even if they did occur, banks were capable of sustaining the losses without major consequences. This is quite understandable because the operations within the banking industry until roughly 20 years ago have been ...