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Reflections on Risk

Leading banks are pursuing new ways to achieve competitive advantage through superior risk management.

Pinning Down Operational Risk

Compared to market risk and credit risk, operational risk has been harder to pin down. "Operational risk is still a fairly nascent science, perhaps more a bit of an art at this stage," Wilson says. "Even just coming up with a definition of operational risk is taking time."

By contrast, the constant activity of buyers and sellers in the equity, fixed income, derivatives and credit markets generates useful data for risk management. Currently, there's no liquid market for trading financial instruments tied to operational risk. Instead, banks rely on data about operational risk failures in their own businesses or those available in the public domain. "In many cases, there's not enough data to make a model," BoNY's Gibbons explains.

Nevertheless, there are ways to assemble data. "We put together years of our own historical losses," Gibbons adds. "There are some vendors that scour all publicly available information to make a pretty significant database with loss histories on operational risk-related losses in financial institutions. We subscribe to that data, and we use it to make people aware of potential outcomes and potential problems," he says.

"It's really no different than the framework from credit and market risk," Gibbons continues. "The difference is that market and credit risk are easier to measure."

Nobody said that banking would be easy. "The quality of the information feeding the analytics is still not nearly what it needs to be in order to have that accurate, complete and timely view of [operational] risk across the enterprise," TowerGroup's Garcia says.

The solution may come from upgrading core systems. "Yes, we have a lot of innovation in analytics, and in data management and enterprisewide data models," Garcia suggests. "But what about the core systems? What about those loan and deposit systems, the claims processing systems, the underwriting systems - these ancient systems designed with accounting in mind?" she asks.

"The information that these core systems should be retaining and feeding into more innovative tools for operational risk management isn't being kept," Garcia continues. "That information is not being extracted."

Once risks can be measured, the next step is to find a way to hedge them. "Insurance companies are starting to think about this as a way in which they can actually provide risk mitigation techniques for credit derivatives and operational risk," Accenture's Wilson says. "It's a fairly natural extension of how they might think about their business."

Indeed, the potential for a market to hedge operational risk may attract a high level of interest. "The potential evolution of the market [may involve] laying off those operational risks through insurance and reinsurance," Wilson suggests.

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