Risk management, as described by the Insurance Institute of America, is the process of making and implementing decisions that will minimize the adverse effects of accidental business losses of an organization. Throughout the past few decades, different industries experienced quicker globalization, deregulation, and a boost of activity surrounding new products, instruments, and services. An inevitable outcome has been an elevated exposure of various sources of risk for trading, construction, insurance and financial institutions. Results of risks occurring in corporations lead to damages and ultimately to financial consequences. The resulting value reduction, or losses can be characterized as financial risk. A large portion of these financial risks is attributed neither to market nor to credit risk, but rather to operational risk.
Operational risk is largely a firm-specific non-systematic risk. According to the Bank of International Settlements (1998), ‘operational’ risk factors are largely internal (Bank for International Settlements). This paper will focus on the means by which the application of risk management principles can minimize operational risk factors in the financial sector. The following paragraphs will provide a descriptive introduction to the classification of operational risk, as defined by the Basil II Capital Accord and the Bank of International Settlements.
The Basel II Capital Accord is an initiative of the Basel Committee on Banking Supervision, which is comprised of sets of recommendations on banking laws and regulation, in an aim to create an international standard for banking regulators to protect banks from financial and operational risk.
The Basel II classifies operational risk into 6 operational loss types, 7 event type groups, and 8 business lines. These classifications are used in unison to produce risk management strategies which in turn further loss control mechanisms throughout the financial industry (Tarullo). The 6 operational loss types describe various categories of means by which an institution is chanced to encounter accidental losses through operations.
The 6 operational losses include:
- loss of recourse,
- legal liability,
- regulatory and compliance,
- loss of or damage to assets.
These losses require certain events to occur for them to materialize.
The Basel II lists the 7 event types that can lead to these loss types as follows:
- internal fraud,
- external fraud,
- employee relations and workplace safety,
- clients, products and business practices,
- damage to physical assets,
- business disruption and system failure, and
- execution, delivery, and process management.
These event types can occur throughout institutions’ various strategic business units (SBUs). An SBU or a business line is a fundamentally different product or service that an institution offers its customers through its business practices. A financial institution can have multiple business lines at the same time, each of which require a different set of regulations, marketing strategies, and management processes. The Basel II includes 8 business lines to which the aforementioned loss types and event types apply.
These business lines are as follows:
- corporate finance,
- trading and sales,
- retail banking,
- commercial banking,
- payment and settlement,
- agency services,
- asset management,
- retail brokerage (Bank for International Settlements).
After considering these three classifications (loss types, event types, and business lines) managers are able to analyze risk and apply various qualitative and quantitative risk management techniques more effectively. The rest of this paper will describe these classifications in greater detail and explore risk management principles as they apply in relation to banking and the financial industry.
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Works Cited Bank for International Settlements. "Basel II: International Convergence of Capital Measurement and Capital Standards: a Revised Framework." Bank for International Settlements. Bank for International Settlements Press & Communications, Jun 2004. Web. 22 May 2011. http://www.bis.org/publ/bcbs107.htm Tarullo, Daniel. Banking on Basel: the future of international financial regulation. 1st. Washington: Peterson Institute, 2008. Print.