Risk Management

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CHAPTER 1: INTRODUCTION

1.1. Introduction

Operational risk is defined as “the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.” Financial markets in the last two decades have been highlighted by large-scale financial failures due to incompetence and fraud, such as Barings, Daiwa, Allied Irish Banks, Orange County, Enron, along with man-made and natural disasters, such as “9/11,” Hurricanes Andrew and Katrina. As a consequence, operational risk has been acknowledged to overweigh the importance of credit and market risks.

Since 2001, the Basel Committee for the Banking Supervision of the Bank of International Settlements has been requiring banks to set aside regulatory capital amount that would cover potential operational loss. The capital amount must be evaluated on a one-year aggregated basis at a sufficiently high confidence level. Statistical tools are required to accurately assess the frequency and severity distributions.

The presence of so-called “low frequency/ high severity” events poses problems for the modeling of operational risk and calls for models capable of capturing excessive heavy-tailedness in the data.

Operational risk is one of the important arms of the risk management triangle – the other two being Credit Risk and Market (Treasury) Risk. Any organization, particularly in the banking sector, is squarely exposed to operational risks emanating within or outside the organization.

Risk Management Triangle

Credit Risk Market (Treasury) Risk.

Operational risk

Operational risk capital charge is a mandatory requirement in global banking sector. This puts in a lot of stress and strain on a bank’s management.

Operational Risk is also known as Transaction Risk in some countries.
In order to efficiently face this new challenge of operational risk in risk management, the prerequisites for efficiently facing the operational risk are enumerated as follows :
Ø creation of risk culture ;
Ø enterprise wide operational ;
Ø risk awareness.
Proactive steps at all the levels of operation should operate as a safety valve and in the process, may in turn facilitate lower risk capital charge.

1.2. Background

Risk mapping is often mentioned both in describing various approaches to operational risk management and, in an audit context, in formulating the key steps to control self-assessment, as the cornerstone of the risk identification process. Yet there is little published guidance on how to perform it effectively and on how to ensure that the resulting map is indeed complete and consistent. In other words, although the term is widely used by bankers, auditors, regulators and consultants alike, and although all these professionals

may even agree on what constitutes an acceptable final product, they will most likely give widely different explanations on how to get such product, the resources needed and the costs involved.

Risk mapping is difficult for a number of reasons, all of which can be summarized by reminding ourselves that ‘the map is not the territory’.

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