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Basel II has become the de facto standard for operational risk classification. Although the accord does not enforce any particular classification, the fact that it provides a possible one (Annex 9 of the Revised Framework) means that a large number of banks have gone ahead using this classification or variations on it.
Operational risks of a behavioural nature such as management skills, management leadership, corporate direction and remuneration incentives are not referred to in the Basel classification at all. In fact, if we accept a view that these are strategic risks, then Basel II specifically excludes them (Clause 644).
A recent article by Wharton, the famous business school at the University of Pennsylvania, emphasises what it calls a “massive leadership failure across the financial services landscape”. It observes that executives at failed firms such as Lehman’s, AIG and Bear Stearns ignored or failed to see the risks their companies were taking on in their focus on enhanced results and their own compensation. Wharton Management Professor Peter Cappelli says this lapse in leadership dates back to the 1980s when companies started to focus on aligning executive incentives with shareholder interests. This has resulted in overemphasis on short-term financial targets and this is what is at the root of the crisis in the financial services sector. Cappelli also says that managers are abdicating their leadership responsibilities and simply providing huge financial incentives for individual results with the belief that this, when taken as a whole, will result in a successful company.
Some regulators have started to look at managerial culture. In 2006, the Office of Federal Housing Enterprise Oversight (OFHEO), which monitored Fannie Mae and Freddie Mac, identified “an unethical culture at Fannie Mae where employees manipulated earnings to generate higher bonuses for executives”. James Lockhart of the OFHEO said at the time "Our examination found an environment where the ends justified the means. Senior management manipulated accounting; reaped maximum, undeserved bonuses; and prevented the rest of the world from knowing. They co-opted their internal auditors. They stonewalled OFHEO.” And look what happened there!
Perhaps it is time that management and remuneration risk were emphasised in the operational risk assessments of financial firms? And the only way this will happen is if they are brought into Basel II and start to influence capital requirements.
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