Operational Risk Management in Banking Sector: an Overview Essay Example

charge for this risk as part of the new capital adequacy framework (Basel II).

Operational risk has been defined by the Basel Committee on Banking Supervision as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition is based on the underlying causes of operational risk. It seeks to identify the causes of a loss event and at the broadest level includes the breakdown by four causes: people, processes, systems and external factors. Operational risk may materialise directly, e. g. , in electronic fund transfer (transfer of funds to the wrong person) or could result indirectly as a credit or market loss.

Since there is a close linkage of operational risk with other types of risks, it is very important for banks to first have a clear understanding of the concept of operational risk before designing the appropriate operational risk measurement and management framework. Different types of operational risk in Banking Sector The Basel Committee has identified the following types of operational risk events as having the potential to result in substantial losses for banks:

• Internal fraud. For example, intentional misreporting of positions, employee theft, and insider trading on an employee’s own account. External fraud. For example, robbery, forgery, cheque kiting, and damage from computer hacking.
• Employment practices and workplace safety. For example, workers compensation claims, violation of employee health and safety rules, organised labour activities, discrimination claims, and general liability.
• Clients, products and business practices. For example, fiduciary breaches, misuse of confidential customer information, improper trading activities on the bank’s account, money laundering, and sale of
  

unauthorized products. Damage to physical assets. For example, terrorism, vandalism, earthquakes, fires and floods.

Operational Risk

Management Process: Operational Risk management generally encompasses the process of identifying risks to the bank, measuring exposures to those risks, ensuring that an effective capital planning and monitoring program is in place, monitoring risk exposures and corresponding capital needs on an ongoing basis, taking steps to control or mitigate risk exposures.

Identification of Operational Risk

Banks should identify and assess the operational risk inherent in all products, services, activities, processes and systems. Effective risk identification should consider both internal factors (such as the bank’s structure, the nature of the bank’s activities, the quality of the bank’s human resources, organizational changes and employee turnover) and external factors (such as changes in the industry and technological advances) that could adversely affect the achievement of the bank’s objectives.

Assessment of Operational Risk

In addition to identifying the risk events, banks should assess their vulnerability to these risk events. Effective risk assessment allows a bank to better understand its risk profile and most effectively target risk management resources. Amongst the possible tools that may be used by banks for assessing operational risk are:

• Self Risk Assessment: A bank assesses its operations and activities against a menu of potential operational risk vulnerabilities. This process is internally driven
  

and often incorporates checklists and/or workshops to identify the strengths and weaknesses of the operational risk environment.

However, there is no clearly established, single method to measure operational risk on a bank-wide basis. Banks may develop risk assessment techniques that are appropriate to the size and complexities of their portfolio, their resources and data availability. A good assessment model must cover certain standard features. An example is the “matrix” approach in which losses are categorized according to the type of event and the business line in which the event occurred. Banks may quantify their exposure to operational risk using a variety of approaches.

For example, data on a bank’s historical loss experience could provide meaningful information for assessing the bank’s exposure to operational risk and developing a policy to mitigate/control the risk.

• Monitoring of Operational Risk. An effective monitoring process is essential for adequately managing operational risk. Banks should implement a process to regularly monitor operational risk profiles and material exposures to losses. In addition to monitoring operational loss events, banks should identify
  

appropriate indicators that provide early warning of an increased risk of future losses. Such indicators should be forward-looking and could reflect potential sources of operational risk such as rapid growth, the introduction of new products, employee turnover, transaction breaks, system downtime, and so on. There should be regular reporting of pertinent information to senior management and the Board o fDirectors that supports the proactive management of operational risk

Banks should periodically review their risk limitation and control strategies and should adjust their operational risk profile accordingly using appropriate strategies, in light of their overall risk appetite and profile. Investment in appropriate processing technology and information technology security are also important for risk mitigation. Banks should also have in place contingency and business continuity plans to ensure their ability to operate on an ongoing basis and limit losses in the event of severe business disruption.

Operational Risk Management Approaches in Basel II

The Basel framework (2004) proposes

a range of approaches for setting aside regulatory capital for operational risk under Pillar 1: The Basic Indicator Approach (BIA), The Standardised Approach(TSA) and the Advanced Measurement Approach (AMA). All the three approaches differ in their complexity and the banks are encouraged to move along the spectrum of approaches as they obtain more sophistication in their risk management practices.

The Basic Indicator Approach is the simplest approach for estimating regulatory capital, where in banks are required to set apart an amount equal to the average over the previous three years of 15% of positive annual gross income. In The Standardised Approach, banks’ activities are divided into eight business lines: Corporate finance, Trading & Sales, Retail Banking, Commercial Banking, Payment & Settlement, Agency Services, Asset Management and Retail Brokerage.

While gross income continues to be the main indicator of operational risk as under the Basic Indicator Approach, the specific amount to be set apart as a percentage of the gross income varies between business lines, ranging from 12 to 18% , as compared to the 15% overall under the Basic Indicator Approach. This approach is more refined than the Basic Indicator Approach as it takes into the account the fact that some business lines are riskier than others and therefore a higher proportion of capital has to be set apart for those business lines.

The Advanced MeasurementApproach(AMA) is based on the banks’ internal models to quantify operational risk. The framework gives flexibility to the banks in the characteristics of the choice of internal models, though it requires banks to demonstrate that the operational risk measures meet a soundness standard comparable to a one-year

holding period and a 99. 9% confidence level, which means that a bank’s capital charge should be equal to at least 99. 9% quantile of their annual aggregate loss distribution.

Banks are required to factor in four key elementsindesigningtheirAdvancedMeasurementApproach framework: internal loss data, external loss data, scenario analysis and bank specific business environmental and internal control factors. The methodologies under the advanced approach are evolving and there are a range of methods in practice in banks internationally.

Operational Risk Management in the Context of Indian Banking Sector

The Reserve Bank of India is the regulator and supervisor of the banking system in India and is entrusted with the task of framing the capital adequacy guidelines for banks in India under Basel II.

Public sector banks, where the Government of India is the major shareholder, dominate the Indian banking system, accounting for nearly three-fourths of total assets and income. These banks are large and very old banks, operating through thousands of branches spread all over the country. The new private sector banks are fully automated from day-one and operate like other high-tech foreign banks. The private sector banks have grown rapidly since the onset of reforms and have increased their share in total assets of the banking industry, whereas the public sector banks have witnessed shrinkage in their market share.

The public sector banks have only recently started automating their processes and operations. This transition has posed significant challenges in the management of operational risk to the banks as introduction of new technology and complete overhauling of the existing systems requires a re-engineering of business processes, training of manpower, audit in

a computerized environment and other related operational risk challenges. The new generation private sector banks on the other hand have to deal with the risks arising from growth at a scorching pace.

With the reforms in the Indian banking sector and banks being allowed to access new markets and sophisticated products, the Reserve Bank of India has also been repeatedly advising the banks to have in place an effective and resilient control framework in place to manage operational risks. Specific guidance on management of operational risk has also been issued as per which some banks; especially the larger and internationally active banks are expected to move along the range towards more sophisticated approaches as they develop more sophisticated operational risk management systems and practices that meet the prescribed qualifying criteria.

Conclusion

Managing Operational Risk is emerging as an important element of sound risk management practice in modern day banks in the wake of phenomenal increase in volume of transactions, high degree of structural changes and complex technological support systems. RBI expects all Indian banks to strengthen their operation risk management system and in readiness to graduate to more sophisticated approaches of operational risk management under Basel norms. In order to derive maximum gains banks need to gear up efforts for speedy and effective implementation of comprehensive operational risk management frameworks and thereby bring more efficiency, transparency, profitability and sustainability into their operations.

Reference

1. Reserve Bank of India, Department of Banking Operations and Development, Central Office, Mumbai, (2005), “Draft guidance note on management of operational risk”,
2. Basel Committee on Banking Supervision (August, 2003) “The Joint Forum Operational risk
   

transfer across financial sectors”,