Operational risk: The direct measurement of exposure and risk in bank operations

Abstract

If risks and exposures are to be managed effectively, all affected parties must accept that the method of risk measurement produces a meaningful, relevant, consistent and comparable result. To date, banks have been unable to resolve this issue relative to operational risk, that is, the creation of a measurement tool or method that can be replicated across their businesses, and ultimately across the industry, to produce consistent and comparable measurements of operational risks and exposures. This paper discusses the implications of the current lack of a practical operational risk and exposure measurement framework and outlines one such framework. In the proposed framework, the notion of ‘risk units’ is presented, subjective judgments of risk are mapped to value-bearing and transaction-related ‘value bands’, operational processes are expanded to drill down to data and application-related risk exposures, and a methodology for calculating risk and exposure is put forth. Finally, the correlation of exposure to risk and actual operational losses are postulated with progressive and interactive modelling assumed over time to bring precision to the predictive capability of the method suggested in this paper.