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

CHAPTER 2

Operational Risk: Definition, Classification, and Its Place among Other Risks

In Chapter 1 we provided a few examples of operational loss events, with the intention of giving the reader a feel for what operational risk is all about. We have assumed that the reader is familiar with the notions of credit and market risks, and we mentioned that operational risk has been loosely defined as part of “other” risks. In this chapter, we formalize the notion of operational risk and the place it takes among other financial risks.

WHAT IS RISK?

In finance risk is the fundamental element that affects financial behavior. There is no unique or uniform definition of risk, but this is not surprising: the definition depends on the context and the purpose for which one wishes to formulate the concept of risk. Broadly speaking, there are two ways to define risk:

1. Risk is a measure of uncertainty.

2. Risk is a measure to capture the potential of sustaining a loss.

The first definition, which is common in the economics literature, postulates that risk is a measure of uncertainty about the future outcomes, or, in other words, is a measure of dispersion of actual from expected future results. For example, in the context of an investment, risk is the volatility of expected future cash flows (measured, for example, by the standard deviation). Because of this uncertainty and because fluctuations in the underlying value may occur in either negative or positive direction, risk defined in this ...