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Capital Structure in Banks 197 credit and market risk 292 used so far and tries to measure the generally much larger impact of event (or discontinuous) risks on a bank’s cash flows and value. 293 However, it (mostly) does not include the (indirect) impact on the entire organization (and its employees) and the bank’s overall liquidity. 294 In order to clarify the broad definition given previously, we split operational risk into two subcategories of risk, which will be discussed in the light of its measurement and management in turn below: ■ ■ Event risk is the risk that losses to the bank are caused by rare events 295 such as a major systems failure, 296 process and control failures (e.g., errors and omissions), 297 fraud, 298 legal risk, 299 and external disruption (e.g., fire or other catastrophes). 300, 301 Business risk is the risk that the bank will experience losses through unexpected changes in either (future) revenues (affected by volume and price) or (fixed) costs that are not due to credit or market risk, 302 but rather driven by fundamental (and unexpected) changes in the bank’s competitive environment 303 (e.g., price wars, new competitors, 304 changes in regulation, etc.). 292 This book will not, however, cover the measurement and management of insurance risk. 293 See Damodaran (1997), p. 777. All recent big losses to banks basically stem from event risks and were already summarized in the Wheel of Misfortune (see Chapter 3). 294 Due to or leading to bank runs, see Cooper (1999), p. 7. 295 For a list of descriptions/definitions of such events see Lam and Cameron (1999), p. 85, Table 2. 296 Losses due to failed management information systems, communication, or computer systems. 297 Unintentional losses due to human error or noncompliance with established business guidelines. 298 Losses due to employee or third-party theft, mismanagement, or deceit. 299 Cost of legal fees, fines, and lost settlements resulting from legal actions and lawsuits or fines, and opportunity costs resulting from regulatory actions. 300 Losses due to, for example, natural disasters, failure of public infrastructure, labor disputes, terrorism, or kidnapping. 301 This includes the risks from back-office operations such as processing or settlement and their systems; see Lam and Cameron (1999), p. 82. 302 This is especially important since the fee-based income of banks increased proportionally. 303 This part of operational risk is not restricted to back-office operations. It, rather, addresses front-office applications such as strategy, client management, product development, pricing, and distribution. See Lam and Cameron (1999), p. 82. 304 Despite the high entry barriers in the banking market, those competitors from the new economy, in particular, challenge traditional, old-economy banks.
198 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS Steps to Derive Economic Capital for Operational Risk In this section, we discuss the effort to measure operational risk with the same analytical objectivity as market and credit risk (as described previously) using a similar, VaR-like approach. However, one should keep in mind that operational risk indicators, such as the number of failed deals or the number and loss rate of errors and omissions, 305 have no easily identifiable set of risk factors that drive unexpected losses as in market or credit risk. These factors are mostly only qualitative and, for example, used in the (internal) auditing assessments. 306 Given the broad definition for operational risk, it is not surprising that there is neither a singly accepted framework or methodology 307 nor that no single approach will be sufficient 308 to cover the diversity of operational risks. Operational risk is mostly managed by traditional approaches (e.g., internal auditing or guidelines) 309 and only leading banking organizations calculate and allocate economic capital for operational risks. 310 Between these two extremes, there are many other means to counter operational risk (e.g., buying insurance against losses from various sources). In fact, holding economic capital for all operational risks can be subopti-mal, and a bank should opt for the least expensive form to manage those risks. Of course, not every option is available for every event. Some events, such as natural disasters, cannot be controlled by tighter risk controls. Other events cannot be insured against. The key is to identify the sources of operational risk, estimate the exposure to each source of risk, and determine the most appropriate course of action, that is, the one that creates the most value. In practice, most institutions apply a combination of the available options to find an acceptable answer to managing operational risks and how much capital they need to hold against them. 311 305 See Wills et al. (1999), p. 61; for a more comprehensive list of such indicators, see ibid, p. 62. 306 See Basle Committee on Banking Supervision (1998), p. 4. 307 Since most banks are in the early stages of developing a framework, there are no binding regulatory guidelines to specify a consistent measurement methodology at the moment; see Basle Committee on Banking Supervision (1998), pp. 1, 2, and 7. 308 See Wills et al. (1999), p. 11. 309 These are, according to the Basle Committee on Banking Supervision (1998), p. 6, the major tools for managing operational risk. Note that this form of risk management is also costly to the bank. 310 See Buhr (2000), p. 202. 311 See Wills et al. (1999), p. 98.
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isk management and value creation i
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Copyright © 2002 by John Wiley & S
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preface From an empirical as well a
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acknowledgments No book is solely t
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x CONTENTS Goals of Risk Management
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xii CONTENTS Definition of RAROC 24
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xiv FIGURES Figure 5.5 Figure 5.6 F
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symbols ↑ ↓ α β i xvi Increas
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xviii SYMBOLS ln Natural logarithm
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abbreviations APT BIS bn bps CAPM C
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2 RISK MANAGEMENT AND VALUE CREATIO
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CHAPTER 2 Foundations for Determini
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Foundations for Determining the Lin
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eferences Aguais, Scott D., and Ant
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References 295 Blanden, Michael (19
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References 297 and Abuses,” Journ
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References 299 Froot, Kenneth A., a
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References 301 risiken aus Handelsg
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References 303 Investments in Stock
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References 305 Institute of Technol
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References 307 Sharpe, William F. (
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References 309 Wall, L.D., and John
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312 INDEX Approach (continued) top-
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314 INDEX Capital: Tier-1, 139, 146
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316 INDEX Credit: derivatives, 178,
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318 INDEX Expectations: homogeneous
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320 INDEX Incentive(s), 22, 33, 45,
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322 INDEX Managers, poorly diversif
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324 INDEX Overinvestment, 75, 79, 8
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326 INDEX Reserve(s) (continued) lo
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328 INDEX Risk, liquidity, 3, 165 R
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330 INDEX Sharpe ratio, 244, 252 Sh
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332 INDEX Value at risk (VaR) (cont
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