Operational Risk

A Brief Overview on Operational Risk at Banks and Basel II Framework

-Prakash Bhandari

Operational Risk in banking sector is something new phenomenon compared to other types of risks i.e. credit risk, marketing risk, liquidity risk etc. But operational risk stands for the most important risk and needs to be handled with utmost care.

Before going on the nature of operational risks in detail, we briefly try to understand what the operational risks are for the banks.

Basel Committee has defined Operational Risk as “Operational risk is the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events. It includes legal risk but excludes strategic and reputational risk.”

How to Identify the Operational Risks?

From the definition as stated above, it is clear that the operational risks are not consciously taken. But they invariably arise in the course of conducting business activities. The key challenge is to identify and anticipate the various kinds of operational risk that may arise. The Basle committee has categorically defined framework to identify the Operational Risks as follows:

1. Internal fraud: (Intentional misreporting of trading positions, employee theft, and insider trading on an employee’s own account ect.) This risk is considered low frequency, high severity.

2. External fraud: (computer hacking, robbery and forgery etc.) This risk is considered high/medium frequency, low/medium severity.

3. Employment practices and workplace safety: (worker compensation claims and sexual discrimination claims etc.) This risk is considered low frequency, low severity.

4. Clients, products, and business practices: (misuse of confidential customer information, improper trading activities on the Bank’s account and money laundering etc.) This risk is considered low/medium frequency and high/medium severity.

5. Damage to physical assets: (earthquakes, fires and floods etc.) This risk is...