Finance, FRM

What is Operational Risk?

Definition:

  •  Operational Risk – The risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.
  •  The operational risk definition explicitly includes legal risk, but does not address reputation risk or strategic risk

Categories Definition
People Includes: fraud; breaches of employment law; unauthorized activity; loss or lack of key personnel; inadequate training; inadequate supervision
Process Includes: payment or settlement failures; documentation which is not fit for purpose; errors in valuation/pricing models and processes; project management failures; internal/external reporting; (mis)selling.
System Includes: failures during the development and systems implementation process, as well as failures of the system itself; inadequate resources.
External Event Includes: external crime; outsourcing (and insourcing) risk; natural and other disasters; regulatory risk; political risk; utilities failures; competition

 

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Examples of Operational Risk:

People: Trader Pleaded Guilty to Fraud

Nick Leeson was a former derivatives trader whose unauthorized and unsupervised trading on the Singapore International Money Exchange caused the collapse of what was at the time the United Kingdom’s oldest investment bank, Baring’s Bank.

An audit in February 1995 uncovered losses that amounted to more than GBP 800 million, almost the entire assets of the bank. Dozens of executives who were implicated in the failure to control Leeson resigned or were sacked.

Leeson pleaded guilty to fraud and was sentenced to six and a half years in Leeson pleaded guilty to fraud and was sentenced to six and a half years in prison.

A similar incident happened at Société Générale where an unsupervised trading loss incident in January 2008 caused the bank to lose approximately EUR 4.9 billion.

 

Process – Westpac’s Costly Mistake

Example According to the Herald Sun, in June 2009, Westpac had mistakenly sent a fax authorizing a transfer of NZD 3.47 million into a computer firm’s account, even though the actual amount owed was only NZD 34,680.

A Westpac spokesperson put the mistake down to a “simple typing error typing error” when sending the fax Westpac made a very similar when sending the fax. Westpac made a very similar but costlier data processing error only one month earlier when an NZD 8 million transfer was made instead of NZD 80,645.

In that case, the account holders fled with the money and Westpac wasn’t able to recover all of its losses

 

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System  -Barclays Technology Crash

In June 2009, UK-based Barclays PLC experienced a technology breakdown that left millions of customers, primarily in the South of England, unable to withdraw money from ATMs for most of the afternoon.

Barclay’s internet and telephone banking services were also impacted and a small number of customers experienced difficulty using their cards to make payments at retailers payments at retailers.

 

External Events – Squirrel Brings Down the NASDAQ

In August of 1994, the NASDAQ market had to close for more than half an hour, losing valuable trading time, as an energetic squirrel had gnawed through the power lines supplying the stock market’s computer centre in Trumbull, Connecticut.

The system failed to perform the automatic switchover to the temporary backup power supply and consequently the market was down for 34 minutes.

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What is Liquidity Risk

 

 

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