Operational disruptions and business cycles

Abstract

In the aftermath of the financial crisis, companies have advanced models for measuring and managing operational disruptions. However, the measurement and management approaches neglect the existence of business cycles. In this exploratory research, we investigate the relationship between business cycles and operational risk in two distinct U.S. industry sectors, namely financial services and manufacturing. We find that a positive lagged relationship between business cycles and the severity of operational disruptions exists. Moreover, we identify and model the dynamics of that relationship when operational risk is categorized according to the industry sector. Our findings also suggest that there is a degree of dependency between operational risk losses in the two sectors. Finally, we provide implications for improved forecasting of operational risk and the development of an effective policy design. The effects of business cycles should be taken into account to more accurately calibrate operational risk models used not only by banks but also by manufacturing firms.