Academic journal article ABA Banking Journal

Basel II: A Guide to Operational Risk Implications

Academic journal article ABA Banking Journal

Basel II: A Guide to Operational Risk Implications

Article excerpt

One school of thought about the new Basel Capital Accord says it has almost nothing to do with operational risk.

It's main concern, instead, is recalibrating credit risk to accommodate ever more complex instruments and keep banks from the taint of moral hazard. In this line of reasoning, Basel II merely touches on new reserve requirements for operational risk as an afterthought.

In some sense, the market of ideas supports this notion. Outside of a few exceptions, the presence of the evolving accord hasn't provoked much discussion about process transformation within individual banks. Neither have many bankers presented views on how Basel itself might play a positive role by "normalizing" risk, that is, getting everyone, more openly sharing information to reframe it from random inevitability to something that can be evaluated and tamed. Nor has there been much publicly said about what will need to go on differently inside a given financial services firm so it might enhance itself sufficiently to determine: 1. its own explicit capital reserve charge as a "set aside" for potential loss related to automation, process, workflow, and people; and 2. how it needs to be managed differently to become, in fact, more resilient.

Even if the regulators intended otherwise, this thinking goes, most of the large, internationally-active banks will add reserves for operational risk quite routinely without much difference in day-to-day functioning.

This is because operational risk is too new a discipline and the data the industry has on what contributes to loss is still too sketchy to give bankers much in the way of meaningful, predictive information that they can really act on.

If the true agenda of the Basel Committee, a Banking Supervision, is to give firms more control, say critics, the money would be better spent on a case-by-case basis. Six Sigma or other business process improvement projects might work wonders in the absence of generally mandated preparations for enterprise risk measurement and mitigation procedures.

Transformation--or more of the same?

Yet not everyone sees Basel as either a nuisance or non-issue for operational risk. In fact, forerunners in the field mostly side with the Basel Committee.

"We support Basel II," says Joe Sabatini, managing director, head of corporate operational risk at JP Morgan Chase.

"The committee was surprisingly flexible in the development of operational risk practice guidelines. They offered options for measurement. They worked collaboratively with us and were open to suggestion," Sabatini explains. "The basic direction and approach of the accord is on target."

JP Morgan Chase uses a mix of centralized and line-of-business controls but is gradually heading toward an enterprise method, which is a prerequisite to meeting the new accord's expectations. (For more see, p. 55)

Wachovia also stands behind Basel II. More importantly, it approves of engaging in a thorough risk management approach that yields true protection. Wachovia sees this as a responsibility to customers and other stakeholders and a source of competitive advantage, "whether the Basel Committee requires it or not," says Yousef Valine, senior vice-president and group executive, head of operational risk management. "We believe that firms who make this a priority of corporate governance--evaluating risk and setting up controls effectively--have fewer losses, less earnings volatility, and happier customers," says Valine.

Having a strict focus on credit risk without really assessing and possibly rethinking operations would be missing the point entirely, adds Keith Stock, global director of financial services, Cap Gemini Ernst & Young, based in New York City. There aren't neat demarcations between credit, market, and operational risk. They intermingle.

"The Basel Committee intended for risk to be thought of holistically," Stock continues. …

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