Risk management's final frontier
Banks measure credit and market risk because they can, not because these are the biggest risks they face. Operational risk is larger, more dangerous and no-one knows exactly what to do about it. Mark Parsley looks at banks' first faltering steps in this area
What is the use of having state-of-the-art market-risk measurement tools if one rogue trader can bankrupt your institution in a matter of weeks? Why bother with the complexities of modelling credit and counterparty risk if a fund manager at one of your foreign subsidiaries can cost you £200 million in cash, and untold millions in tarnished reputation and credit standing?
While the leading financial institutions can claim to have half-way scientific ways of measuring, monitoring and providing for credit and market risks, most would agree that they struggle even to define potentially the largest and most pernicious class of risks they face operational risks. At the cutting edge, however, banks are now developing methodologies to complete the risk-management triangle. Their ultimate aim is a capital allocation system that takes all risks into account.
The pat definition of operational risk is simply any risk of earnings volatility that is not market or credit related. In this sense it is the set of risks banks share with most other publicly-owned commercial organizations: product liability risk, the risk of fire and explosion, business interruption risk of any kind, image impairment risk, directors' liability, technology risk and so on.