Operational Risk – government ownership brings new considerations

It could be argued that everything in market risk has been written, all that is missing is the will to implement its findings. Credit risk with few variables is equally mature, providing we get the valuation of probability, currently with the rating agencies, right, and we implement basic credit allocation practices. But operational risk is not so well defined.

Operational risk has struggled with inadequate definitions – “anything that is not market or credit risk, including the effective implementation of these” is probably the best current definition. Basel II attempted to narrow it down to what could be, in some way, measured. This was understandable given the overall objective of Basel II was to calculate operational risk-based capital; but it did not prevent excluded risks such as strategic, remuneration and reputational risks contributing to the downfall of so many.

Operational risk managers are now battling with the challenges of bringing in the previously excluded risk into their sphere of management, into their risk categories, if not yet into their quantitative models. Now a further risk category, cultural risk, has been added.

Cultural risk, or my definition of it, is the risk of an adverse situation brought about by infringing the rules, customs or dogma of the political, religious or social environments in which an institution operates – and it may operate in many different or overlapping such environments.

Government intervention, government ownership will, for the first time, create such an environment in Western banks. These banks were able to ignore cultural implications as long as they stayed within legal and financial regulatory boundaries – many of the failed and failing European and American banks were not noted for their cultural sympathies. Now to whom they lend will be constrained – small business and mortgage applicants, i.e. voters, preferred. How much they pay themselves will be watched closely – costs such as bonuses, private jets and office decorations will be subject to intense scrutiny. Companies and countries in whom they invest will have to satisfy political considerations. All of these will be further compliance conditions, infringement of which will be operational risks and will have to be categorised by the operational risk manager.

There are precedents for this. For a long time banks in heavily socialist countries have had resident party secretaries working closely with their boards and senior management. Effectively these are operational risk managers who ensure that political risk is not incurred. In Islamic banks, infringement of Shariah Law and failure to provide adequate Shariah governance are high on the risks that their operational risk manager must watch. Significant or repeated risk incidents here can close a bank down as effectively as a portfolio of toxic securitised sub-prime mortgages.

Operational risk is fast moving and the definition grows every day. Business practices – management, remuneration, strategies, reputation – are being brought into the definition - and their impact on value at risk will have to be estimated if capital requirements are to continue as an effective method of avoiding failure. Now cultural risk must be brought into the equation and its impact allowed for in capital levels.