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Lacunae of Operational Risk

Author: Ms.Shivangi Raman - Software Engineer by profession, I gained interest in Law once I began studying law
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With the commencement of Basel I, the banks had got an idea as to how they are supposed to work in order to get optimum benefit and also invest in the market to rotate the capital that they have taken from the people. Operational risk was noticed when the employees who switched over their mode of operation from the manual mode to the computerized mode.

The operational risk was taken into account when the trivial errors made by the employees resulted in heavy losses by the banks. With the improvement in technology, the transactions began to get executed on computer rather than on paper and began to get executed in bulk. So the probability of experiencing errors and also making erroneous entries into the bank accounts became much more.

The banking organizations realized this major problem and made sure that there was a revision made in the Basel accord and such a risk that arose due to errors that were man made could be realized and their solutions sought for.

It was as a result of this that the Basel II Accord was created and operational risk was included in Pillar I of Basel Accord II. The operational risk has been defined as the risk that is caused by human intervention, system failures or errors due to external events. Basel II accord has many deficiencies some of them are those that we have identified. These lacunae are under the scope of this paper, and can be briefly expressed as under:
1. Double accounting of operational risk
2. Operational risk does not take into account, the lack of regular contingency planning.
3. Future risks and internal control environment are not taken into account while calculating operational risks.
The estimation of remedies for the lacunae of operational risk is out of the scope of this paper.

We would now discuss the problems in detail below:

Double accounting of operational risk

The calculation of operational risk is done by calculating the risk in the business line in which a bank operates. The business lines are defined in the Basel II Accord [1] [2] and have been discussed widely by different banks in their analysis and statements, that is worth commendation. But the serious mention should be done about certain realms that the banks have not touched so far, and that we need to ponder upon.
Discussing further upon this problem, we can state that the different business lines that a bank takes upon have different categorizations and different percentages of risk that have been defined as β (beta). β is stated as follows:
1. Corporate finance(β1) 18%
2. Trading and Sales(β2)18%
3. Retail Banking (β3) 12%
4. Commercial Banking(β4)15%
5. Payment and Settlement (β5)18%
6. Agency Services (β6) 15%
7. Asset management (β7) 12%
8. Retail brokerage (β8) 12%

Thus the different risks are calculated according to the business lines that are followed by different banks for their business and in the course of optimizing their benefits.
But the problem occurs when two business lines are calculated in one risk and are calculated twice. For instance, if the risk is calculated in such a way that the retail banking and commercial banking are getting calculated such that they fall under the same realm, then in that case, the gross income shall be calculated twice, i.e.,
Capital charge = Gross Annual Income X β(1-8) {which ever applicable),
Therefore, in this case the risk is calculated twice with the calculation of the annual income.
The calculation of risk twice shall lower the rate of lending of the bank and this shall become the risk for the bank as now lesser number of investors shall be attracted towards investing into the bank and the bank shall suffer a considerable loss from the bank.

Operational risk does not take into account, the lack of regular contingency planning.

The operational risk does not take into account any future planning as to the way a bank should try to combat operational risk. The effect of this is that the banks are not able to find out any countermeasure for fighting against monetary problems that occur due to manual errors or system failures that are caused by external or internal events that are unanticipated.

For example if the bank has invested in some dead shares then in such cases the bank shall be liable for its irresponsible actions but the other side of the coin is that despite the fact that the bankers would acknowledge their folly regarding their mistake of wrong investments they would not be having adequate money to return to their investors. This would depict the lack of proper contingency planning and reflect the inefficiency from the side of the bankers who are following the Basel II accord.

When the Basel II Accord will have the proper contingency planning for its banks then only the banks can apply these plans and would be able to operate upon the lines of thinking about proper contingency planning that they should be having so that despite problems they are able to run their business smoothly rather than ending up into a condition of bankruptcy.

Future risks and internal control environment are not taken into account while calculating operational risks.

The banks do not take into account the staff turnover and the risks that are caused by the manhandling of accounts by the staff and the managerial heads as well as the corruption prevailing in any bank for which the internal employees are responsible.

Also, it needs to be mentioned that the banks to the assessment of their output and efficiency in terms of the profit that they incur but they fail to assess their efficiency in terms of the quality of services that are provided by them or the accuracy by which the work is carried out in their various branches. Operational risk includes the fall in quality of the services of the banking sector, but this has not been included in the Basel II Accord and requires to be brought into consideration. It is not only the quantity of services (business lines upon which the banks operate) but also the quality of services that the banking sector provides that optimizes their profits and performance and also increases the customer satisfaction for their services. Further, quality of services attracts the customers to invest into the banks.

After discussing the various risks and reflecting upon the extensive study made by the Basel committee members about the different banks and their different ways of working, the lacunae were found out. There would be an extensive research that would tell us about further lacunae and would also tell us about the various steps that can be taken as a countermeasure to fix these lacunae so that the lacunae can be mitigated and with their mitigation, the operational risk could be subsidized as well, so as to further a step in the optimization of the functionalities of the banks working under the directives of the Basel II Accord.


[1]. Basel Committee on banking supervision- International convergence of Capital Measurements and Capital Standards - A revised framework (Comprehensive version) June 2006
[2]. Guidelines on operational risk management Control and provision for processes, individuals, systems and breakdowns Oesterreichische Bank- Vienna 2006

The author can be reached at: / Ph No: 09451217499
Added Date: 22 Nov 2009


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