Operational Risk Definition, Content And Models (Research Paper Sample)

Introduction
Over the past decade consolidation, the growth of e-commerce, outsourcing, globalization, breakin geographical boundaries through effective use of complicated technology, and deregulation have significantly resulted in evolution both business and economic climate of the banking sector in the globe. The above issue has played a crucial role in introducing complexities into bank risk profiles such as in Societe Generale (Schürmann et al., 2016).
Due to the developments, Societe Generale has viewed operational risk management as an integral part of various risk management activities. The activities include as credit and market risk management. Today being a dynamic world, measurement and identification of operation risk are seen as a key consideration in the modern day banking systems. The Basel Committee on Banking Supervision (BCBS) made a decision of introducing as a capital charge for risk management as an integral part of the capital adequacy existing framework (Basel II).
Basel Committee on Banking Supervision referees operation risk management as loss generated by failed or inadequate internal processes initiated by people or external events operation risk tends to materialize directly or indirectly to the banking system. According to Bluhm et al.,(2014), direct operation risk in Societe Generale is demonstrated through electronic fund transfer or indirectly through market or credit loss. Operation risk has also been an associated with other types of risk in the banking industry (Bluhm et al., 2014).
The main aim of this paper reports is to review operation risk in the banking systems its roles and how it operates work. The paper also profoundly explains the concept of operation risk by evaluating the risk management system.
OPERATIONAL RISK DEFINITION AND CONTENT
The Basel Committee suggested that banks operation risk tend to be a unique profile which requires expertly tailored risk management option according to the size of the financial organization. Trkman et al., (2009), argued that In a banking industry operation risks can be adequately be determined by a various multitude of factors such as the geographical dispersion, business units, complexity of bank industry structure and the full range of product and services it offers. According to The Basel Committee, operational risk is referred to as "the risk of indirect or direct loss which resulting from failed or inadequate external events, people, and systems or internal process" [Basel, 2001, 2]
Operational risks can efficiently be generated through various causes such as for systems failures and business disruption, compliance gaps, workplace safety, processes failure, people behavior, failing controls, employment practices and damage to physical assets. These operation risks can be increased by inadequate controls, poor training, and poor staffing resources. Wilden et al., (2010) argued that there is great value for a satisfactory employee experience for the staff and a professional profile and irrespective of their job position in a banking industry to minimize risks.
OPERATIONAL RISK MODELS
Operational risk models are associated with a variety of econometric and statistical models, and it is designed to measure the economic and regulatory capital efficiently. Operation risk models are also supposed to be held against operational risk. The models are intended to identify the primary consequences and causes of the operation risk. Peccia (2003) suggested that operational risk modeling has played a vital role in the immediate environment within which banks conduct their financial duties by effectively changing it dramatically. Rao et al., (2006), also suggested that AMA is concerned with calculating regulatory capital and operational risk management and. Chernobai et al.,( 2007) argued that There are two primary ways of effectively modeling operational risks, the bottom-up approach, and the top-down approach. While the bottom-up model seeks to quantify these operational risks at a micro level by understanding the internal operational risk event and how and why they are caused.
The Models for effectively quantifying operational risk are seen to be at a relatively early stage of maturity. Basel II provided a decisive impetus to allow the development of appropriate operation risk models effectively. “High-frequency representing a low-severity” while on the other hand “low-frequency representing high-severity” losses which involve various modeling essentials (Chernobai et al., 2007).
Top–down methods model
Operations risk are measured and covered at a central level, so local business units (e.g. bank branches) are not involved in the measurement and allocation process. The calculation of capital requirement is effectively performed using various variables which are correlated with ultimate risk exposure. According to the Basel Committee Basic Indicator Approach (BIA) is an example of top- down methods model.
According to Desmettre et al., (2015), losses in any given market are seen as the crucial realization of any continuous process. While on the other hand losses in a credit risk situation is referred to as the recognition between the continuous and a binary process (Desmettre et al., 2015). Consequently, losses in operation risk are suitable realizations associated with convolution which exist between a counting process and continuous ones (severities), Two approaches can be fundamentally integrated into a business structure to adequately model operational risk (Fischer et al., 2015). The top-down approach effectively seeks to fully quantify all the losses at a macro level without identifying the causes or event which give rise to these losses (Chernobai et al., 2007).
Bottom–up methods model
The bottom-up approach quantifies operational risk on a micro-level. Bolton and Berkey(2005) argued that “Sound Practices Paper” offers an excellent basis for creating an effective operational risk management platform which can provide tangible advantages which cannot be distracted by any challenges in the operational risk model. The primary objectives of Basel’s committee main are to efficiently estimate loss distribution in a financial organization it also plays a vital role in the I deriving various functions such as Value at Risk from the estimated loss. The bottom-up model approach effectively seeks to fully quantify all the losses at a micro level with carefully identifying the causes or events which give rise to these losses (Chernobai et al., 2007)
Basak et al., (2015), argued that the simplest economic setting in which operational risk notion can be incorporated into leads to the formulation of an optimal decision.Where by the financial institution which is our commercial agent accounts for the presence of operational risk. The financial institutions have to rely on an efficient model to allow it to make successful investment decisions. Operational risk is generated from insufficient implementation models most financial institutions quickly adopt in performing their financial operations. Therefore financial institutions need to keep updating their operation management models often to safeguard their success from operational risks (Chernobai et al., 2007).
OPERATIONAL RISK REGULATORY FRAMEWORK
Various fundamental changes in the financial industries are related to the tremendous impact on the nature and magnitude of the operation risks, which are confronting the banking sector. Due to the severe service failures present in the financial markets operation risk emphasis have gradually increased. The gradual increase has actively motivated either, leading regulators, rating agencies, and auditors to effectively expand their focus on the banking industry so as to establish operation risk as an independent entity by itself besides other risks such as credit and market.According to the New Basel Capital Accord framework, operational risk was actively incorporated into the Basel Pillars. The Basel Committee argued that integration the operation risk into the banking industry have substantially played a vital role in promoting both market discipline and transparency(Schürmann et al., 2016).
Due to operation risk being treated as a separate risk category in the banking industry, it has led to the development of a continuum concept. The idea was proposed to allow banks to choose for the most practical approach to the minimum calculation of administrative operation risk capital charges. The continuum concept represents three ideas whereby the decrease in the capital charge as a degree of sophistication is directly associated with an increase in the qualification criteria (Jebrin 2012).
Carey et al., (2001), argued that operation risk management plays a vital role in the financial industry. Carey suggested that financial institution should struggle to should mainly focus on risk management rather than risk elimination. The eradication of risk in a financial system is relatively impossible. According to Carey, banks which are seen as financial institutions should have a well-controlled and established internal risk management system so as to effectively reduce risk exposures (Carey et al., 2001).
Apart from the capital requirement, Basel Committee has also adequately addressed other corresponding disclosure issues which are related to the market discipline (Basel Pillar 3).Apart of this pillar the New Basel Capital Accord also has actively integrated effective sound practices for both supervision and management of operation risks. Jebrin et al., (2012), argued that process risk in a business can be seen as rigid structure element which effectively represents evaluation, control or even a specific plan. A quantifying operation risk management option should effectively play a vital role assisting either internal or ...