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Practice paper

Bank capital for operational risk: A tale of fragility and instability

Mark Ames, Til Schuermann and Hal S. Scott
Journal of Risk Management in Financial Institutions, 8 (3), 227-243 (2015)
https://doi.org/10.69554/UZLQ7770

Abstract

Operational risk is fundamentally different from all other risks taken on by a bank. It is embedded in every activity and product of an institution, and in contrast to the conventional financial risks (eg market, credit) is harder to measure and model, and not straightforwardly eliminated through simple adjustments like selling off a position. While it varies considerably, operational risk tends to represent about 10–30 per cent of the total risk pie, and has grown rapidly since the 2008–2009 crisis. It tends to be more fat-tailed than other risks, and the data are poorer. As a result, models are fragile — small changes in the data have dramatic impacts on modelled output — and thus required operational risk capital is unstable. Yet the US regulatory capital regime, the central focus of this paper, is surprisingly more rigidly model-focused for this risk than for any other. The authors are especially concerned with the absence of incentives to invest in and improve business control processes through the granting of regulatory capital relief, and make three, not mutually exclusive, policy suggestions. First, address model fragility directly through regulatory anchoring of key model parameters, yet allow each bank to scale capital to their data using robust methodologies. Secondly, relax the current tight linkage between statistical model output and required regulatory capital, incentivising prudent risk management through joint use of scenarios and control factors in addition to data-based statistical models in setting regulatory capital. Thirdly, provide allowance for real risk transfer through an insurance credit to capital, encouraging more effective risk sharing through future product innovation. Until the understanding of operational risks increases, required regulatory capital should be based on methodologies that are simpler, more standardised, more stable and more robust.

Keywords: model risk; bank capital; bank regulation

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Author's Biography

Mark Ames is a Partner at Oliver Wyman and has been involved in issues related to Operational Risk from the late 1990s at the time Basel II was being formulated and the specific provisions for regulatory capital for operational risk were becoming clear. Mark specializes in quantitative modelling, and has extensive background in risk measurement, capital attribution and allocation, and also in the challenges of using insurance to mitigate operational risk exposures.

Til Schuermann joined Oliver Wyman in August 2011 as a Partner in the Finance & Risk and Public Policy practices. His focus is on stress testing, capital planning, enterprise-wide risk management and corporate governance. Prior to Oliver Wyman, Til was a Senior Vice President at the Federal Reserve Bank of New York where he held numerous positions, including head of Financial Intermediation in Research and head of Credit Risk in Bank Supervision.

Hal S. Scott is the Nomura Professor and Director of the Program on International Financial Systems (PIFS) at Harvard Law School, where he has taught since 1975. He teaches courses on Capital Markets Regulation, International Finance, and Securities Regulation. Hal’s books include the law school textbook International Finance: Transactions, Policy and Regulation (20th ed. Foundation Press 2014). He is also the Director of the Committee on Capital Markets Regulation, a bi-partisan non-profit organisation dedicated to enhancing the competitiveness of US capital markets and ensuring the stability of the US financial system.

Citation

Ames, Mark, Schuermann, Til and Scott, Hal S. (2015, July 1). Bank capital for operational risk: A tale of fragility and instability. In the Journal of Risk Management in Financial Institutions, Volume 8, Issue 3. https://doi.org/10.69554/UZLQ7770.

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cover image, Journal of Risk Management in Financial Institutions
Journal of Risk Management in Financial Institutions
Volume 8 / Issue 3
© Henry Stewart
Publications LLP

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