Alan Lawman, TCS Financial Solutions

Basel II regulations define Operational Risk as “the risk of a change in value caused by the fact that actual losses, incurred for inadequate or failed internal processes, people and systems, or from external event, (differ from the expected losses)”.

However, Operational Risk is a broad discipline, and must be coupled with good management and quality management.
Basel II identifies seven event type categories:

  • Internal Fraud
  • External Fraud
  • Employment Practices & Workplace Safety
  • Client, Products & Business Practice
  • Damage to Physical Assets
  • Business Disruption & Systems Failures
  • Execution, Delivery & Process Management

Specifically for Asset Services, the focus  is within the seventh category. Further, let’s look at the definition of Operational Risk as seen within the Asset Servicing function – “the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events”.

What differentiates Operational Risk from other risk types is that they are not, usually, willingly incurred and neither are they revenue driven. Further, they are not able to be “laid off”, in that as long as people, systems and processes remain imperfect, the risk cannot be fully eliminated.

The target must be then to manage the Operational Risk, and ensure that any losses are within an agreed tolerance level, and so also the expected losses. This tolerance level is agreed on the principle of “how much risk are you prepared to accept in pursuit of the objectives”, and this is further driven, by the determination of balancing the costs of improvement against the expected benefits. Finally, Operational Risks affect client satisfaction and company reputation, whilst increasing business volatility.

So, Operational Risk has to be accepted as an unavoidable cost of “doing business”, and the focus must be on managing the risk and recording the instances of risk, be it actual loss or a ‘near miss’, and then using the data to model an Operational Risk approach and to calculate adequate capital reserves (and Risk Tolerances) going forward.

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