Leading indicators for operational risk : case studies in financial services

It is somewhat ironic that while the major focus of regulators and institutions in the financial services sector over recent years has been on developing models for measuring and managing credit risk, most of the large losses in financial institutions over this time have been sourced to operational risk - and more specifically, the actions of single individuals, or small cohorts of individuals. A common thread has been excess risk taking by traders and credit managers - including unauthorised trading and misrepresentation of trades - leading to large, undercapitalised positions in the books of financial institutions. In the majority of cases individuals acted in response to incentives set before them, as encompassed in their remuneration schemes. Although these losses occurred in dealing operations, and thus appear more attuned to market risk than operational risk, the fact that these losses arose from inadequate and failed internal processes, systems and people classifies them as operational risk-related from the perspective of bank regulators. In this paper we compare and contrast the factors that led to large losses in three banking institutions over recent years: Barings, Allied-Irish and the National Australia Banks. We conclude it highly unlikely that these losses would have been recognised and consequently prevented under the revised capital standards for financial institutions currently promulgated by the Basel Committee on Banking Supervision of the Bank for International Settlements. With this in mind, we examine how various non-financial measures may have been robust leading indicators of operational risk losses in these institutions, and show how these indicators could be incorporated into a scorecard approach for risk-capital allocation and pricing decisions in financial institutions.