Operational Risk Management in Indian Banks: Issues and Challenges

By Mehra, Yogieta S. | Indian Journal of Economics and Business, March 2012 | Go to article overview
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Operational Risk Management in Indian Banks: Issues and Challenges


Mehra, Yogieta S., Indian Journal of Economics and Business


Abstract

Basel II recommendations and Global crisis have definitely heightened importance given to operational risk by banks. The study explores the range of operational risk management practices used by cross--section of Indian Banks. The study also analyses the impact of size and ownership of banks on the range of operational risk management practices used by the banks through execution of survey comprising of a questionnaire. The paper evaluates the present status of risk management approaches, human resource and outsourcing policies and challenges in transition to advanced approaches amongst sample banks. Collection of external loss data, effectiveness of operational risk framework and internal controls, responsiveness of business to operational risk department is a concern with small and average sized public sector and old private sector banks. The human resource policies and outsourcing processes need restructuring to combat frauds and asset losses.

Reliability Analysis using Cronbach Alpha model has been used to test reliability of questionnaire. KMO Measure of Sampling Adequacy and Bartlett's test of sphericity have been used to justify the use of factor analysis as a data reduction technique. Thereafter Factor analysis has been performed to extract the most important variables in management of operational risk amongst Indian Banks.

JEL Classification: G21, G28

I. INTRODUCTION

The financial crisis has led to major structural changes being adopted by the banks and financial institutions to avert a similar crisis in future. One of them is the increased belief in management of operational risk. Though financial institutions have always been exposed to operational risk events since failure in people, processes, systems and external events are an inherent part of conducting financial services. However, firms now strongly believe that exposure to operational risks will increase in the future with systems, financial products and IT solutions becoming increasingly complex and interconnected.

One of the main reasons for the occurrence of the current crisis is the widespread use of complicated and non-transparent financial products that were developed during the last decade. Often they were structured as synthetic products that were bundled and resold several times to investors on a global scale. However, this has important consequences for the governance of operational risks. The key message is that when financial engineering increases in complexity, management needs to be focused on the management of operational risks. If top management neglects this task or accepts inefficient operational risks controls, this may lead to fatal consequences for any financial institution.

The identification and measurement of Operational Risk is still in evolutionary stage as compared to the maturity that market and credit risk measurements have achieved. Basel II (BCBS 2004) introduced capital charge for Operational Risk and provides three alternative methods in increasing order of complexity for calculating regulatory operational risk capital (the capital charge): (i) the Basic Indicator Approach (BIA), (ii) the Standardized Approach (TSA) and (iii) the Advanced Measurement Approach (AMA). BIA is the simplest approach for calculating operational risk capital. This is the default approach to be followed by every Basel II compliant bank irrespective of their size or sophistication. The Standardised Approach computes operational risk capital of banks by dividing their activities into eight business lines and taking a specific percentage of gross income of each business line and aggregating the same for a given year and use multiplier (Beta) of average gross income to compute capital charge. The Advanced Measurement Approach (AMA) is the most complicated of the three options where each firm calculates it own capital requirements, by developing and applying its own internal risk measurement system.

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