Operational Risk: After MF Global, Risk Management Again Takes Centre Stage
Wednesday, 25 January, 2012 1 Comment
I’m no banker (you must have misheard!) but the MF Global collapse only serves to illustrate how impotent Regulation and risk management for financial institutions really is!
The dramatic collapse of MF Global, the broker-dealer and clearing firm that was bankrupted by bad bets on European bonds, has sent financial services firms scurrying to make sure their risk management operations are up to the task, industry sources say. Even as much of Wall Street remains mired in a period of intense risk aversion in light of the European debt crisis and fragile U.S. economy, the demise of Jon Corzine’s company has most of the industry on red alert. Experts say the current risk management environment is a flashback to the period immediately following the collapse of Lehman Brothers in 2008, when the investment community realized how costly it can be to not fully understand counterparty risks.
The company may have been “…bankrupted by bad bets on European bonds” but how can that be when, quite apart from all the other rules and regulations, compliance with Basel requirements for OPERATIONAL RISK should provide a sound basis upon which to build…
The Basel Committee defines the operational risk as the “risk of loss resulting from inadequate or failed internal processes, people and systems or from external events”.
This definition includes human error, fraud and malice, failures of information systems, problems related to personnel management, commercial disputes, accidents, fires, floods… In other words, its scope seems so wide you do not immediately perceive the practical application.
Moreover, the concept of operational risk appears at first glance not very innovative, since the banks did not wait for the Basel Committee to organise their activities in the form of procedures, and to develop internal audit departments to verify the correct application of these procedures. However, spectacular failures, like Baring’s, have attracted the attention of regulators on the need to provide banks with prevention and coverage mechanisms against operational risks (through the allocation of dedicated capital).
The implementation advocated by an increasing number of studies on this subject is to consider as an actual operational risk:
- any event that disrupts the normal flow of business processes
- and which generates financial loss or damage to the image of the bank (although the latter outcome has been explicitly excluded from the definition of the Basel Committee, it still remains a major concern).
Operations for multi-functional organisations [systems] are, by definition, highly complex: complexity is the “problem-solving” capability without which, the functions, tasks and processes that generate revenue CANNOT be undertaken.
Complex systems are dynamic [no single equilibrium], non-linear and entropic [subject to 2nd Law of Thermodynamics – tends toward disorder (chaos)]
A system that is poorly structured for information-flow across the “operational framework” is a source of complexity: a risk that cannot be identified by conventional RM tools
A risk that cannot be identified, quantified or “managed” does not dissipate but is amplified and communicated, both up and downstream into connected stakeholder operations, “the market” and economy [ecosystem] as increased uncertainty and volatility, etc.
You will be familiar with the expression “what goes around comes around”! It isn’t just a glib saying. It has a scientific basis, a “feedback loop”.
So, the next time you hear someone blaming “market” uncertainty/volatility, “the economy” or some other man-made external force, for their performance/failure, think about organisations that, by their own failure to manage the risks, created as a bi-product of their operations, they become casualties – they are NOT victims we are!!!