Operational Risks in Banks

“Operational Risk is defined as the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and system or from external events.”

Generally, operational risk is defined as any risk, which is not categorized as market or credit risk, or the risk of loss arising from various types of human or technical error. It is also synonymous with settlement or payments risk and business interruption, administrative and legal risks. Operational risk has some form of link between credit and market risks. An operational problem with a business transaction could trigger a credit or market risk.

Indeed, so significant has operational risk become that the Bank for International Settlement (BIS) has proposed that, as of 2006, banks should be made to carry a Capital cushion against losses from this risk.

Managing operational risk is becoming an important feature of sound risk management practices in modern financial markets in the wake of phenomenal increase in the volume of transactions, high degree of structural changes and complex support systems. The most important type of operational risk involves breakdowns in internal controls and corporate governance. Such breakdowns can lead to financial loss through error, fraud, or failure to perform in a timely manner or cause the interest of the bank to be compromised.

The objectives of Operational Risk Management is to reduce the expected operational losses that focuses on systematic removal of operational risk sources and uses a set of key risk indicators to measure and control risk on continuous basis. The ultimate objective of operational risk management is to enhance the shareholder’s value by being ready for risk based capital allocation. There is no uniformity of approach in measurement of Operational Risk in the banking system at present.

The bank’s operational risks can be classified into following six exposure classes

  • People
  • Process
  • Management
  • System
  • Business and
  • External

Bank has also identified 5 business lines viz…..

  • Corporate finance
  • Retail banking
  • Commercial banking
  • Payment and Settlement and
  • Trading and Sales (Treasury operations) also

To each of this exposure classes within each business line are attached certain risk categories under which the bank can incur losses or potential losses.

Bank collected information at first instance for a 5 year period and is being updated on a six monthly basis June and December. These date help in qualifying the overall potential / actual loss on account of Operational Risk and initiate measure for plugging these risk areas.

Bank may suitably at a latter date move to appropriate models for measuring and managing Operational Risk also after receipt of RBIs Guidance Note.

Measurement of Operational Risk

There is no uniformity of approach in measurement of operational risk in the banking system. Besides, the existing methods are relatively simple and experimental, although some of the international banks have made considerable progress in developing more advanced techniques for allocating capital with regard to operational risk.

Measuring operational risk requires both estimating the probability of an operational loss event and the potential size of the loss. It relies on risk factor that provides some indication of the likelihood of an operational loss event occurring. The process of operational risk assessment needs to address the likelihood (or frequency) of a particular operational risk occurring, the magnitude (or severity) of the effect of the operational risk on business objectives and the options available to manage and initiate actions to reduce/mitigate operational risk. The set of risk factors that measure risk in each business unit such as audit ratings, operational data such as volume, turnover and complexity and data on quality of operations such as error rate or measure of business risks such as revenue volatility, could be related to historical loss experience. Banks can also use different analytical or judgmental techniques to arrive at an overall operational risk level. Some of the international banks have already developed operational risk rating matrix, similar to bond credit rating. The operational risk assessment should be bank-wide basis and it should be reviewed at regular intervals. Banks, over a period, should develop internal systems to evaluate the risk profile and assign economic capital within the RAROC framnework.

Indian Banks have so far not evolved any scientific methods for quantifying operational risk. In the absence any sophisticated models, banks could evolve simple benchmark based on an aggregate measure of business activity such as gross revenue, fee income, operating costs, managed assets or total assets adjusted for off-balance sheet exposures or a combination of these variables.

At present, scientific measurement of operational risk has not been evolved. Hence, 20% charge on the Capital Funds is earmarked for operational risk.

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