Essay On Operational Risk Management

INTRODUCTION

In this dynamic environment, regulators struggle to stay ahead of time. Banks and financial institutions are an asset these regulators bank upon. In course of their operations, they invariably face different types of risks. These cause negative effect on the business activities and ultimately have a cascading effect on the growth of the economy. Risk management involves risk identification, measurement and assessment. It aims at minimising the negative effect that risks can have on the financial results and capital of a bank. This entails banks to create separate risk management department and issue specific procedures to minimalise the same. The various risks include liquidity, credit, interest rate, exchange rate, exposure,

Operational Risk leads to downfall of the Banking and Financial Institutions. Banking and financial institutions markets are transforming over growing consolidation, rising customer expectations, proliferating financial engineering, increasing regulatory requirements, uprising technological innovation and mounting competition. This increases the probability of operational failures, thereby increasing focus on risk management.

It is quantified under Basel-II and occurs throughout a bank’s business model. It refers to the challenges faced by a bank in quantifying, controlling and allocating regulatory capital to different Tasks that banks are required to do. It is pervasive in nature. It is embedded and inherent in internal processes.

BANK CAPITAL

Bank Capital is defined as the amount of capital the bank requires to hold as required by financial regulators. It is referred to as the difference between a bank’s assets and liabilities. It represents the bank’s value to its investors and consequently the net worth of the bank. The aggregate money or resources that a bank operates on is referred to as the bank capital. Bank capital is a cushion that helps prevent bank failure.

Bank Capital is classified into two tiers:

Tier I: Book value of stock and retained

All three of them entail calculation of operational risk capital charges in continuum of increased sophistication and sensitivity of risk. BASIC INDICATOR:

A minimum capital requirement of 15% is required under this approach. This 15% is calculated on the basis of a relevant indicator which is defined as the average of three years of the summation of net interest income and net non interest income. These are monthly observations at the end of the financial year. When audited reports are not available business estimates are used.

This indicator is calculated before any deductions are made in respect of provisions and operating expenses. Some elements are not considered while taking the average of the relevant indicator. These include realised profit/ losses from the sale of non trading book items; income from extraordinary or routine items; and income derived from insurance.

A provisional multiplication factor called alpha is used for calculation of average risk for more accurate calibration. Here gross income is the basic indicator which is multiplied by the factor alpha to arrive at the capital the bank holds to meet operational risk. It is desirable to set alpha at a higher level to hedge operational