FEAS Yearbook FEAS Yearbook 2003 | Page 12

HEWLETT-PACKARD OPERATIONAL RISK MITIGATION - BEYOND COMPLIANCE TO BASEL 2 Stuart Hotchkiss Lead Security Consultant FSI, HPS Consulting & Integration SUMMARY Operational risk can represent a higher residual risk than any other type of risk and the potential impact is sufficient to drive a company out of business. Although the Basel 2 accords are an excellent way forward in the management of operational risk and the reduction of operational losses to acceptable levels, there is a danger that mere compliance to the accords will persuade banks that their operational risk is under control. A potential consequence is that the opportunity afforded by the Basel 2 accords is lost! Alexander de Lange HP Director International Sales-Capital Markets-CEEMEA The Basel accords related to operational risk are a combination of the objective and the subjective – the objective being the loss database and the subjective being the regulators judgement of the degree of control. The Basel accords related to operational risk are a combination of the objective and the subjective – the objective being the loss database and the subjective being the regulators judgement of the degree of control. Both are equally important but the impact of each is not equal – being out of control can be devastating for clients, shareholders and directors alike. Most institutions are aiming for an Advanced Measurement Approach where the capital charge is based on historical losses, however, looking at historical losses as a basis for future losses is similar to treating a patients symptoms and hoping the disease will go away. The frameworks proposed for operational risk control are complete but subjective and the focus is likely to be on the data gathering side rather than the fundamentals. This trend in the financial services industry needs to be corrected if regulators and business partners are to believe that operational risk is under control. The disease of operational risk needs to be treated bottom up rather than top down. Some observations are that: • Auditing and management controls will not stop operational risk • Operational risk is hard to predict and modelling is of little use • There needs to be a change in the accounting culture related to OR • Operational loss history tells a lot about the past and little about the future • Most risks come from the IT infrastructure and its processes INTRODUCTION Operational risks are defined by the Basel committee as those losses caused by people, processes and technology. Specifically, directors should: • Provide specific accountability, policy and control • Review and approve security control processes • Take measures to authenticate and authorise clients • Ensure non-repudiation of transactions • Ensure segregation of duties • Ensure access control to assets • Ensure audit trails exist • Ensure data privacy • Have adequate continuity and disaster plans in place Any one of these areas is a source of multiple, and particularly operational, risks. Of the three risk categories cited by the Basel Committee, credit risk probably has the largest numbers and for this reason, there is an assumption that this represents the largest risk. This is not true because credit risks are largely deflected, avoided or mitigated in some way. The residual risks are actually very low. A risk manager can avoid credit risks by not extending credit to existing clients. He can mitigate the risk by insisting on insurance being paid by the client to guard against his own insolvency and can insist on payment conditions such that only very healthy businesses of low risk can meet them. Credit risk can also be modelled to avoid risks or models used to provide very early warnings of default. Even in a well-managed company, market risk can represent a major problem if there is collusion that avoids management controls on investments. In general, market risk, like credit risk is characterized by choice. A risk manager can decide into which markets he will go as he can decide which credits he takes and in both cases, can set a limit on exposure according to his appetite for risk. Market risk can be modelled with some success and correlation between markets events can form some basis for prediction and hence risk reduction or avoidance. The other characteristic of market and credit risk is that the loss is almost always limited to the asset value or the amount at stake. Operational risk is different. Operational risk can do the most damage in the best-managed company. The reasons? The impact of an operational risk event bears no relation to the asset value at risk and the choice of risks to accept or not does not exist in practice. Modelling is of limited or no value. FEDERATION OF EURO-ASIAN STOCK EXCHANGES YEARBOOK 2003/2004 PAGE 10