Basel's Brushstrokes: Implications for Managing Operating Risk: Operational Risk Management Has Emerged as One of the Hottest Topics in the Financial Services Industry, Especially since the Basel Committee on Banking Supervision Released Its Second Round of Proposed Reforms to Bank Capital Rules. (on the Cutting Edge)

By O'Connell, Bryan | Journal of Banking and Financial Services, December 2001 | Go to article overview

Basel's Brushstrokes: Implications for Managing Operating Risk: Operational Risk Management Has Emerged as One of the Hottest Topics in the Financial Services Industry, Especially since the Basel Committee on Banking Supervision Released Its Second Round of Proposed Reforms to Bank Capital Rules. (on the Cutting Edge)


O'Connell, Bryan, Journal of Banking and Financial Services


One of the most controversial aspects of the vaunted reforms focuses on banks and financial institutions for the first time being required to reserve capital to cover their operational risk exposure.

The proposed reform of the accord will directly affect all authorised deposit taking institutions (ADIs) in Australia: banks, building societies and credit unions.

The proposal comes at a time when there has been an increasing focus on operational risk. This is due to factors including electronic disintermediation, a closer network between banks globally which increases systemic risk; and an increased reliance on internet and ebusiness technology, raising security concerns.

Operating risks are real -- not just potential -- dangers. While not only due to operating risk issues, the National Australia Bank's disastrous $3 billion HomeSide write-off demonstrates a major warning.

There are a number of implications for Australian banks and financial institutions, including how the reforms will affect capital requirements.

An old but growing problem

Operational risk in banking is not new. It can stem from computer failures, lax procedures, fraud, errors, theft and accounting mix-ups, to name a few. However the problem areas seem to be growing and becoming more complex, raising heightened concern in the industry.

IBM's global head of risk management and financial market strategist, Francis Lacan, says that, regulatory pressures aside, a number of issues are driving an increased focus on operational risk. These include process inefficiencies, day to day mistakes and failures which have resulted in significant losses for a number of banks globally.

A particular concern has been security breaches, piracy, fraud, major system failures and computer viruses.

"As you move into wide area networks and the internet systems you need more and more protection against intrusion," Lacan says. "This in turn requires more focus on, and investment in, the technology related to major operational risk issues."

A further reason banks are turning their attention to risk is the complex nature of today's financial structures. There are more counter-parties involved in dealmaking and more custodians and agents who carry messages. The sheer complexity and sophistication of some types of transactions have increased operational risk concerns.

According to Brad Gravell, the ANZ Bank's head of group operating risk measurement and policy, the increasing general regulatory and compliance environment has made banks a lot more aware of operational risk.

Yet he also emphasises the inherent risks of human failure have also been key drivers. "No matter what actually occurs, any bank's biggest vulnerabilities and contingency plans depend on the quality of the people it has," he says.

The importance of people has not eluded other banks such as the National Australia Bank. The bank uses an operating risk field force to constantly discuss new and emerging risks (and prevention measures) with the business units. The bank started this at the time of Y2K "millennium bug" preparations (remember those?) and has continued with it as a major focus.

What Basel means

The Basel committee's rules have been the global benchmark for banks' capital adequacy for more than a decade. The committee consists of central banks and bank supervisory agencies from the G10 countries, operating under the auspices of the Bank for International Settlements (BIS).

The Australian Prudential Regulation Authority believes the objective of the reforms is to develop more risk sensitive and internationally accepted capital adequacy guidelines, aligned more accurately with individual risk profiles of particular institutions.

The proposed new rules will also lessen regulatory arbitrage opportunities and offer greater regulatory flexibility to recognise and encourage the use of more sophisticated risk management techniques, APRA says. …

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