Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Ignoring operational risk

Operational risk has always been less glamorous compared to market risk, interest rate risk and credit risk which are all now dominated by sophisticated mathematical models and apparent analytical rigour. Regulators too are uncomfortable dealing with operational risk because of its judgemental nature. Yesterday, for example, the US Federal Reserve Board announced that the largest US banks would no longer be subject to the “qualitative objection” which was the rubric under which it dealt with operational risk (see pages 13-14 of the summary instructions).

The reality however is that in big financial institutions with large well diversified portfolios, most risk management failures involve operational risk. This was true for example of JP Morgan’s London Whale, of the Nirav Modi scam at Punjab National Bank, of Nick Leeson, and many other cases. Even in the Global Financial Crisis, many of the largest losses were due as much to operational risk as to systemic events (which is why some banks had much larger losses than others).

Chernobai, Ozdagli and Wang have a paper showing that operational risk is aggravated for large and complex institutions (Business Complexity and Risk Management: Evidence from Operational Risk Events in U.S. Bank Holding Companies (December 18, 2018). Available at SSRN). They show that operational risk increased significantly when the business complexity of banks increased and provide evidence that this results from managerial failure rather than strategic risk taking. A year ago, I wrote on this blog that

banks are so opaque that even insiders cannot see through the opacity when bad things happen … Even a very competent chief executive can be clueless about some activities in a corner of the bank that have the potential to bring down the bank or at least cause severe losses.

Ignoring operational risks for the largest and most complex banks because it is too qualitative and judgemental does not appear to me to be a very good idea.

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