The growing impact of operational risks and its application to banks

Abstract

Since their implementation in the banks in January 2007, operational risks are considered a main point of the strategy of banks. Operational risks are defined as "the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events1." The Basel II Accords, signed in June 2004 and officially implemented in banks in
January 2007, give the banks the guidelines to follow when dealing with their operational risks. By following those guidelines, the banks will improve the management of their operational risks and decrease their exposition to those risks. The aim of this report is to point out how important the management of the operational risks for the banks is.

It was necessary for the financial institutions to take into account the evolution of the operational risks at the end of the last century. Several events such as the Barings' bankruptcy or the terrorist attacks on New York City in 2001 sounded the alarm bell. That is why the Basel Committee wanted to improve the management of the operational risks through the new regulations included in the Basel II Accords. By improving the management of the operational risks, the banks would reduce their exposure to those risks and decrease their operational losses. Though these changes represent a big effort and huge investments for
banks, their repercussions are very beneficial. The reduction of the banks' exposition to the operational risks will permit them to avoid traumatisms such as the Barings experienced ten years ago. The application of the Basel II Accords has a positive effect on the banks' costs as well as on the banks' revenue. In fact, by imposing new regulations on the banks, those accords also proved to be profitable for the banks' client. The new banking rules have the advantage of improving the quality of the banks' services.

Since the implementation of the Basel II Accords in January 2007, analysts thought that the banks were totally protected from the operational risks by them. However, the several internal frauds that touched the banks since the sub primes crisis in summer 2007 questioned the banks' management of the operational risks and pointed out that the banks still need to improve the management of those risks.

The Basel II Accords were written by the Basel Committee on Banking Supervision in June 2004. Since this date, every bank had to prepare itself in order to be ready on January 2007 to implement the new Basel II regulations. These new regulations had a deep impact on the organization of the banks. All banks need to rethink the way they have been organized in the past in order to integrate the management of the operational risks. Indeed, the Basel II Accords impose new criterion to respect in order to protect the financial institution from operational risks. Now that the operational risks are considered a risk category (such as the market and the credit risks), they have a deep impact on the business of the banks. That is why it is important for banks to take those risks into account.