CHAPTER
5
Operational Risk and Business Risk
While market and credit risks are clearly at the heart of bank activity, operational risk
and business risk play an important role as well. Operational risk has gained increasing
attention since the mid-1990s not only because of banking crises (e.g., Barings), which
were driven mostly by fraud, human error, and missing controls, but also because the
Basel Committee made clear since 1999 the intention to introduce a new regulatory capital
requirement for operational risk in addition to market and credit risk. The Basel Com-
mittee also proposed a regulatory defi nition of operational risk, whose boundaries often
used to vary signi cantly from bank to bank. Operational risk is de ned as “the risk of
loss resulting from inadequate or failed internal processes, people and systems or from
external events. This defi nition includes legal risk, but excludes strategic and reputational
risk” (Basel Committee 2006a, §644).
Business risk, on the other hand, has not been assigned an MRCR by supervisors, but
it is still very important for a bank. Business risk is defi ned here as the risk of losses
deriving from profi t volatility for fee-based businesses (such as advisory services in either
corporate fi nance or private banking businesses, asset management, and payment ser-
vices, among many others). While its impact on book capital may often be limited, its
impact on the bank’s market capitalization may be much larger. Hence, for business risk
the concept of “capital” that is considered (according to the distinctions set out in Chapter
2) is particularly relevant.
This chapter is structured as follows. Section 5.1 summarizes how requirements for
operational risk are defi ned in the Basel II Accord; Sections 5.2–5.4 discuss the practical
issues to be tackled when developing an internal risk measure for operational risk. Section
5.5, by Patrick de Fontnouvelle and Victoria Garrity from the Federal Reserve Bank of
Boston, presents an interesting case study on recent U.S. banks progress in operational
risk measurement. The chapter then turns to business risk. Sections 5.6 and 5.7 analyze
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