Is Operational Risk being measured properly?

19-02-2016 | POINT OF VIEWCurrent debates about Capital Standards ignore important questions about risk

Shares in European and US banks have fallen sharply since the New Year, amid concerns about their resilience and wider fears over the global economy. It is perhaps no surprise, therefore, that the issues around banking stability and capital standards have been raised in recent weeks by market commentators and policy makers.
Sir John Vickers, Chairman of the Independent Commission on Banking (ICB) and architect of the ‘ring-fencing’ structural reform of banks, recently argued that the Bank of England should impose higher equity capital to ensure resilience of the banking system. This, in turn, prompted responses from others to defend the current Bank of England proposals and highlight the additional measures put in place to ensure stability and protect the taxpayer (eg, the capacity to convert debt into equity (contingent capital) in the event of a bank failure).
The debate about the right levels of capital is likely to continue, with differing opinions about whether regulators have struck the right balance between ensuring resilience and managing increased borrowing costs for banks. Within this debate, however, relatively little attention has been paid to the measurement and management of risk within a bank and how this works within a capital framework.
As capital requirements are based on a bank’s risk-weighted assets (RWAs), there are legitimate questions to be asked as to whether advanced modelling of RWAs is fully fit for purpose. Among market supervisors and regulators, policies have drifted towards a standardised approach, at least for some portfolios (such as commercial real estate), or setting the standardised measure or leverage ratio act as a floor. In the USA, the Federal Reserve’s entire focus has been on the Comprehensive Capital Analysis and Review (CCAR) or stress testing with less emphasis on the RWAs. CCAR recognises that the best measures for capital are stress testing frameworks based on scenarios which measure capital in a world of uncertainty.
While there is reliance on risk-weighted equity being the regulatory measure on which to base prudential capital, there are ongoing changes and complications – including countercyclical buffers, TBTF surcharges and Pillar 2 incremental supervisory charges. It is, therefore, questionable as to whether RWAs capture the objective reality of risk – and particularly the growing levels of operational or ‘supply chain risk’ – within a bank.
While credit and market risk have long been regarded as fundamental to a balance sheet, operational risk is becoming an increasingly important and dominant factor in risk management as the governance of banks’ processes, people, organisations and systems grows ever more complex. Yet Parker Fitzgerald research suggests that the measure of RWAs allocated to operational risk is a fraction of credit risk at around 11% of RWAs.
Numerous challenges to operations are arising from technological innovation and the additional complexity brought about by new regulations from multiple jurisdictions, resolution planning and imposed structural change on banks. Indeed, the new ring-fencing rules to separate retail and investment banking operations, as prescribed by Sir John Vickers, will add a significant layer of complication to the management of risk functions, which will not only impact on the profitability of investment banks, but also increase operational risk by making it more difficult to assess exposures across two separate entities. Further innovation in the digital space will require a brand new way of thinking about supply chain risk.
Banks must now manage this increased complexity and focus significant resources on the management of the supply chain of risk. This is needed to minimise threats such as poor lending decisions, misconduct and system failure, including threats relating to fraud and cybersecurity. The Financial Stability Board has already defined new core operational risks in its directive of BCBS 239 which focuses on 14 principles including risk aggregation and reporting.
These principles broadly categorised into an ecosystem of adaptability, completeness and timeliness do not explicitly define the supply chain. Furthermore, there is no overarching mechanism to translate these core elements into RWAs – or indeed capital standards. It could therefore be argued that for as long as the RWA share of operational risk capital stays at 11 percent of total capital, the way that capital is derived lacks credibility.
Ultimately, regardless of the metric used for capital measurement, the resilience of the banking system relies on sound governance and risk management. This includes the appropriate measurement and management of operational and supply chain risks. Yet, the process of managing these risks is becoming ever more difficult as the industry faces greater complexity associated with market and technological changes. Furthermore, it is clear that some of the new regulations designed to safeguard financial stability have had the unintended consequence of making banking systems even more complex. It is questionable as to whether this additional complexity is making our banks safer.

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