Operational Risk Essay Example | Topics and Well Written Essays - 1750 words

Operational Risk - Essay Example (Dictionary of Accounting, 1999). Most of the prior studies on operational risk have focused on estimating operational risk in a financial institution. Frachot et al. (2001) explored the Loss Distribution Approach (LDA) for computing the capital charge of a bank for operational risk where LDA refers to statistical/actuarial methods for modelling the loss distribution. In this framework, the capital charge is calculated using a Value-at-Risk measure. Frachot et al. (2001) show how to compute the aggregate loss distribution by compounding the loss severity distribution and the loss frequency distribution, how to compute the total Capital-at-Risk using copulas, how to control the upper tail of the loss severity distribution with order statistics. Fachot et al. (2001) also compare LDA with the Internal Measurement Approach (IMA) proposed by the Basel Committee on Banking Supervision to calculate regulatory capital for operational risk. The results show that LDA and IMA are bottom - up internal measurement models which a re apparently different. (Frachot et al., 2001). As earlier mentioned, much of the Literature has focused on operational risk in financial institutions with a particular emphasis on the Basel II accord and the quantification of operational risks. Kuritzkes (2002) notes that the Basel II Accord definition of operational risk considers only a subset of operational risks. According to Kuritzkes (2002) the term "operational risk" commonly refers to all non-financial risks whereas the Basel II Accord definition considers only a subset of non-financial risks including those resulting from failure of "internal processes, people, or systems or from external events". Mainelli (2002) suggests that operational risk has many pseudo-standard sub-taxonomies, such as people (e.g. workforce disruption, fraud), process (e.g., documentation risk, settlement failure), systems (e.g. failure, security) and external risks (e.g., suppliers, disasters, infrastructure utilities failures). However, day-to-da y operational risk management involves decisions about opening times, cleaning standards, rodent controls in dealing rooms, secure electricity supply, security controls and other management decisions not suitable to real-time spreadsheet analysis. (Mainelli, 2002). Mainelli (2002) further suggests that there is a tension between the top-down imposition of a change and the bottom-up nature of these detailed decisions. If the purpose of risk-based capital allocation is to reflect differences across banks in business mix and risk profile, then operational risk measurement will need to be supported bottom-up within individual institutions. (Kuritzkes, 2002) Figure 1: Taxonomy of Operational Risk. Source: Kuritzkes (2002) As shown in figure 1 above risks can be divided into financial and non-financial risk components. The financial risk components include market risk, credit risks and ALM insurance and other risks whereas the nonfinancial risk component includes internal event risk, external event risk and business risk. As the figure indicates, the Basel II Accord only considers a subset (internal event risk and external event risk) as the nonfinancial risk. It fails to take into consideration a very important aspect of the risks - business risks.