Defining Operational (& Business) Risk

The Basel committee has chosen a definition of operational risk that excludes business and strategic risks. It defines operational risk as "the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events".

Austega promoted a holistic definition of operational risk being considered to encompass all risks other than those captured by credit and market risks, but accepts that the Basel definition is likely to become the dominant industry definition. It is a question of establishing common use of jargon - Basel certainly notes the existence of significant "other risks" that an entity needs to manage.

While the debate may appear to be only an issue of semantics, the issue of clarifying the goals of the organisation in undertaking risk measurement and management is critically important.

Measuring operational risk as defined by the Basel proposals will do just that. It will allow regulatory operational risk capital to be measured. It will allow the regulatory capital impact of some operational risks to be compared. It may allow the costs of controls on certain operational risks to be compared with the savings in regulatory capital achieved. All of these are important.

But significantly more has been foregone. It will not allow the overall risk of an business or part of a business to be measured. It will not allow risk vs return profiles to be established or compared between different businesses or products. It will not support shareholder wealth analysis under different business plans.

It is possible to achieve the best of both worlds. This requires a measurement of operational risk as per the Basel proposals, but does not stop there. Rather it adds in assessment of the business and strategic risks associated with the entity's business. It not only collects loss data as defined by Basel, but also looks at other deviations from plan as evidence of the existence of one or more business or strategic risks. This can be done at the detail level that suits the entity.

The remainder of this discussion assumes that the institution is interested in gaining this full measure of the risks that it faces and manages. These other risks, not captured in Basel's proposed definition of operational risk, or in credit and market risk, will be conveniently captured in the term "business risk".

To Drivers behind measurement

Last updated:16/5/07

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