A Constructive Review of Basel's Proposals on Operational Risk

Risk and loss are common words that need to be clearly defined when embarking on the task of assessing operational risks. Financial institutions may rush into implementing the methodologies proposed by Basel in the hope of achieving better risk management - or simply to satisfy a regulatory request - but without giving enough thoughts to this enterprise. We show that the methodologies proposed by Basel to assess risks and calculate capital requirements are indeed poorly defined and, as far as they can be understood, misconceived. When restricting our attention to operational risks we find that their impact in the vast majority of cases is negligible compared to other risks, be they credit, market or general business risks. A few truly exceptional operational risks may, of course, lead to catastrophic consequences, but then the answer is not in an extra capital buffer that would have to be enormous to be of any use. An attempt to aggregate purely operational risks, as proposed by Basel in the so-called Advanced Measurement Approaches, is as futile as it is difficult. What matters in risk management is balancing all risks, whatever they are, against costs and revenues. And risks do not add up; it is the interaction between operational risks and other risks and the risk/reward trade-off that is of interest. Basel recognises this broader aspect of operational risk management in its guidance notes for the development of an operational risk management framework and the supervision of risk management. Recent redrafting of these notes suggest a change of emphasis from loss data collection towards more forward-looking risk assessment and comprehensive risk management.