Chapter 5 - Operational Risk and Business Risk

Abstract

Operational and business risks represent important components of the overall risks of a bank. Operational risk has gained increasing attention since the mid-1990s not only because of banking crises such as Barings), which were driven mostly by fraud, human error, and missing controls, but also because the Basel Committee made clear since 1999 the intention to introduce a new regulatory capital requirement for operational risk in addition to market and credit risk. The Basel Committee also proposed a regulatory definition of operational risk, whose boundaries often used to vary significantly from bank to bank. Operational risk is defined as “the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk.” The Basel II Accord has introduced a capital requirement for operational risks defining three alternative approaches of increasing complexity: the Basic Indicator Approach, the Standardized Approach, and the Advanced Measurement Approach. Business risk, in contrast, is not associated with any regulatory capital requirement, nor has it received an agreed-upon definition. Yet, with some differences, it is considered a relevant component by many large international banks. Its impact can be measured first through earnings volatility and its corresponding capital at risk may be substantially different, depending on whether one wants to consider business risk's usually limited impact on book capital or the typically much larger impact on market capitalization.