RISK MANAGEMENT &

FINANCIAL
INSTRUMENTS
Lecture 8 – Operational Risk: Fundamentals
and Framework
OPERATIONAL RISK: FUNDAMENTALS AND
FRAMEWORK
A. DEFINITION
B. EVENTS:
1. Fraud – internal, external
2. Workplace – practices, safety
3. Clients
4. Physical
5. Disruption
6. Execution
C. IMPACT
D. GOVERNANCE AND PROCESS
A. DEFINITION
1. Rough/residual definition:
• Before Basel II
• Risk of everything besides credit and market risks
• Limitations:
a) Doesn’t encourage banks to identify and assess operational risk as a standalone
risk
b) Inaccurate

2. Causal definition:
• Basel II
• Risk of loss resulting from inadequate or failed…
• Internal process, people and systems or external events
• See Fig 7.2 & Table 7.1 - Four sources, Definitions, Examples
B. EVENTS
Event types
1. Fraud:
• One internal party is involved
• Intend to commit fraud, misappropriate assets or circumvent
laws
2. Unauthorised activity:
• At least one internal party is involved
• Violate laws, regulations and company policies or to act
beyond what’s allowed
3. Theft/fraud:
• At least one internal party
• Misappropriate/defraud bank
B. EVENTS
4. External fraud:
• Involves a 3rd party
• Intend to defraud, misappropriate
5. Workplace – practices, safety:
• HR-related
• Acts inconsistent with employment , health, safety laws
6. Clients, products and business practices:
• Unintentional/negligent failure to meet professional
obligations to specific clients
• Defects in product nature/design
7. Damage to physical assets
B. EVENTS
8. Business disruption and system failures
9. Execution, delivery and process management
C. IMPACT
Probability/severity lo/hi matrix p224
• Probability – frequency of occurrence
• Severity – impact
• Action

One example of low probability/high impact is ‘rogue trading’:

• See in SPECTRUM, ‘additional resources’, “some articles on
rogue trading”
• For illustrations of high profile cases and nature of losses –
see “extracts from Jorion and Hull books”
D. GOVERNANCE & PROCESS
• Operational risk governance:
 Applies governance principles to identification, assessment, management and
communication
• Governance structure:
 Ops risk committee p227
 Three lines of defence model p227 – who, why
• Operational risk framework:
 Includes risk organisational and governance structure
 Policies, procedures, processes
 Systems used to identify, measure, monitor, control, mitigate
 Measurement system
• Operational risk strategy
 Reflect nature and source of ops risk
PROCESS
• Continuous cycle:
 Identify and assess
 Monitor and report
 Control and mitigate
RECAP - OPERATIONAL RISK:
FUNDAMENTALS AND FRAMEWORK
A. DEFINITION
B. EVENTS:
1. Fraud – internal, external
2. Workplace – practices, safety
3. Clients
4. Physical
5. Disruption
6. Execution
C. IMPACT
D. GOVERNANCE AND PROCESS