Definition: the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems

or from external events. This definition include legal risk but excludes strategic and reputational risk The Committee estimates operational risk at 20% of min regulatory capital as measured under the 1988, and proposes 3 increasingly sophisticated approaches to capital requirements for operational risk: The basic indicator approach, which links the capital charge for operational risk to a single indicator that serves as a proxy for the banks overall risk exposure, eg if gross income is the indicator, each bank should hold capital for operational risk equal to a fixed % (alpha factor) of its gross income

 The standardized approach, which builds on the basic indicator approach by dividing a banks activities into a number of standardized business lines, eg corporate finance and retail banking. Within each business line, the capital charge is a selected indicator of operational risk times a fixed % (beta factor); both the indicator and the beta factors may differ across business lines

 The internal measurement approach, allowing banks to rely on internal data for regulatory capital purposes. This technique necessitates 3 inputs for a specified set of business lines and risk types:
An operational risk exposure indicator The probability that a loss event occurs The losses given such events

These components together make up a loss distribution for operational risks; nevertheless, the loss distribution might differ from the industry-wide loss distribution, thereby necessitating an adjustment, which is the gamma factor

Categories Process risk

Pretransaction: marketing risks, selling risks, new connection, model risk Transaction: error, fraud, contract risk, product complexity, capacity risk Management information Erroneous disclosure risk

People risk
Integrity: fraud, collusion, malice, unauthorized use of information, rogue trading Competency Management Key personnel Health and safety

 Systems risk
Data corruption Programming errors / fraud Security breach Capacity risks System suitability Compatibility risks System failure Strategic risks (platform / supplier) Change management Project management Strategy Political

Business strategy risk

 External environment risk

Outsourcing / external supplier risk External fraud Physical security Money laundering Compliance Financial reporting Tax Legal (litigation) Natural disaster Terrorist threat War Collapse of markets Strike risk Reputation risk Relationship risk

Technology risk
Programming error Model risk Mark-to-market error Management information IT systems failure Telecommunications failure Technology provider failure Contingency planning

The problem in assessing operational risk is that it can be separated into high-frequency low-severity (HFLS) events, which occur regularly and for which data can be found, and low-frequency high-severity (LFHS) events, which are rare. Measuring operational risk will need to account for both types
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Cost of event ()

 This figure illustrates the case where high-risk events are quite rare and individual banks use case experiences from other banks, whereas low-risk events are quite frequent and each bank will have experienced some such events. To calculate the expected operational loss E(L), the bank needs to have a probability (), which is often subjective, of the operational loss event and the cost of the operational loss event (), thus E(L) = Unexpected losses can then be modeled using the VAR methodology; however banks are reluctant in providing information about HFLS events that may be useful to a competitor. HFLS events are made public when a bank can not keep such an event hidden from the market and the media. Both types of events are the gossip of the banking fraternity long before official information seeps out into the media and the attention of regulators

Technological innovation and profitability An efficient technological base for a bank can result in:
Lower costs, by combining labour and capital in a more efficient mix Increased revenues, by allowing a wider array of financial services to be produced or innovated and sold to customers

The importance of a banks operating costs and the efficient use of technology impacting these costs is clearly demonstrated by the following simplified profit function:
Earnings or PBT = (Interest income Interest expense) + (Other income Noninterest expense) Provision for loan losses

Technology is important because well-chosen technological investments have the potential to increase both the banks net interest margin, or the difference between interest income and interest expense, and other net income