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DOUGLAS G. HOFFMAN is an independent consultant specializing in operational risk management. His firm, Operational Risk Advisors, assists financial institutions and corporate clients worldwide in operational risk assessment, analysis, and response, as well as in the design, development, enhancement, and review of risk capital models and risk finance and insurance programs. During his career as a Managing Director at Bankers Trust, and then as CEO of a Web-based technology firm, teams under his lead were credited as pioneers in developing some of the first operational risk-based capital models, databases, operational risk finance and insurance programs, and technology in the industry.

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For today's financial institutions, Managing Operational Risk has the essential business tools to design optimal risk management programs and put your company well ahead of the curve in the face of anticipated new regulatory standards and capital requirements. This definitive book by an international expert covers every aspect of managing operational risk, including operational risk definitions, data collection, risk assessment, modeling, insurance, and risk finance, as well as a comprehensive introduction to information technology.
 
The complete evolution of operational risk management is covered here, including guidelines for setting objectives consistent with a corporate vision, educating management and staff on how to deal with operational risks, coordinating operational risk management functions, outlining various approaches to risk assessment and measurement, and examining techniques for responding to operational risk. This book supplements its descriptions by presenting varied approaches to each of the 20 featured strategies along with alternative tools and tactics for program development, so you can decide which management systems are best for your company. The author goes well beyond the usual downside-only perspective on operational risk management to explore the upside benefits of an effective enterprise-wide program. Each chapter is generously supplemented with cases that illustrate proven techniques, and cautions against techniques that have not been successful. In addition, financial considerations are addressed, including developing economic capital and regulatory models, insurance and risk finance, as well as risk-adjusted performance measures.
 
With a concluding synopsis of chapter highlights and lessons learned for easy skimming and quick reference, this is an essential resource for operational risk managers as well as CEOs and CFOs at investment and commercial banks, brokerages, insurance companies, mutual fund companies, and their e-business affiliates and subsidiaries.

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Details of the 20 best management strategies for operational risk
 
"Finally, we have a comprehensive, practical tool for operational risk. This book covers all critical aspects of operational risk, from simply how to get started to the complex modeling of the risk. The case studies are especially useful."
-Mark Balfan
Senior Vice President and Group Head, Corporate Risk Management
Bank of Tokyo Mitsubishi
 
"Doug Hoffman was in the business of managing operational risk before most and it shows. His book is both comprehensive and to the point-a tough combination to achieve."
-Simon Wills
Director, British Bankers' Association
 
"Operational risk has become a central issue in the management of enterprise risk and for capital adequacy standards for financial institutions. Doug Hoffman is among the very few pioneers in developing an understanding of operational risk, the discipline of operational risk management, and related capital attribution standards for economic and regulatory capital. This book will become a reference work for the financial services industry and financial regulators."
-George J. Vojta
Director, Financial Services Forum
 
"In a quickly evolving area, this book provides a balanced and thorough discussion of the variety of approaches a bank can use to establish a risk management and measurement system for operational risk. The book presents a solid conceptual analysis of the issues to consider, paired with practical guidance."
-Barbara Matthews
Banking Advisor and Regulatory Counsel, The Institute of International Finance, Inc.
 
Managing Operational Risk is the answer for executives and operational risk managers of financial firms who want to establish the best policies for bridling operational risk at a firmwide and enterprise-wide level. The techniques and practices presented here include:
* Dynamic risk monitoring and reporting-implement a continuum of data and risk tools for effective identification, assessment, mitigation, and finance
* Risk assessment, modeling, and risk-adjusted performance measures-calculate, monitor, and manage the effects of operational losses on firmwide and business unit levels
* Operational risk technology and systems-ensure program efficiency by leveraging technology in enterprise-wide data gathering
* Market perception-develop a plan and ongoing discipline for protecting corporate integrity and managing crises that may impact a firm's reputation, brand, or franchise
* Insurance and risk finance programs-design, evaluate, and fine-tune insurance and developing financial programs for operational risks

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Managing Operational Risk

John Wiley & Sons

Chapter One

An Executive Summary

THE ACCELERATED DEVELOPMENT OF OPERATIONAL RISK MANAGEMENT

Operational risk has been a challenge for financial service firms for years, but because of the infrequency of losses, it has not been recognized for its full potential until recently. Large loss events had occurred before. One-off events had caused both mass embarrassment and/or collapse, but they were widely considered to be extremely remote and perhaps even aberrations. Thus, operational risk didn't attract such significant attention until the 1990s, when a series of life threatening or fatal operational loss events at a number of different financial firms caused reorganization, management shakeup or a refocus on control environments, and a new focus on operational risk. Even more noteworthy was that operational losses were occurring at high profile and respected firms in the United States and Europe (i.e., Barings, Prudential, Kidder Peabody), thus further underscoring the danger of ignoring this area.

This series of loss events, coupled with a changing risk landscape, has perhaps forever changed management's perceptions and priorities. At one time, operational risk could be defined as an area characterized by frequent small and predictable events such as processing errors, reconciliation breaks, or system glitches, accompanied by the one-in-five-or-ten-year large system failure and loss, defalcation, or customer dispute. More recently, however, these larger loss events have become far too commonplace and visible in the industry news for management's comfort. Couple this with the advent of increased management and directorship accountability forced by legal actions against officers and directors and a chain reaction has been set in motion.

Recent trends in business complexity, highly visible operational losses, and the need to manage risks associated with them have given rise to a new field called operational risk management (ORM). Many of its underlying component parts, like the existence of various control functions, have been in place for years. There is a new recognition, however, of the importance of identifying, understanding, and measuring operational risks more intelligently, as well as weaving an effective web of approaches to managing them given their complexity and potentially devastating impact on firms today.

Management, bank boards, and regulators have been forced to ask questions like, "What else besides credit and market losses can put our firm at substantial risk? What is operational risk? How do we define, measure, and best manage it? Can we hedge it? Perhaps we should be thinking more holistically about risk on a truly enterprise-wide basis so we are not blindsided in the future."

This chapter is an overview-an executive summary, focused on key trends in operational risk management, as well as on the changes in the underlying risk factors that could well serve to increase the focus even further. It covers executive management needs and perspectives, ORM trends to date, the ORM upside opportunity, risk assessment, performance measures and risk finance. Last, it includes a brief overview of Bankers Trust's early work on operational risk measurement, including our advancements on operational risk-based capital, and in the general implementation of operational risk management. As a credited pioneer in operational risk management, the work of Bankers Trust (BT) on risk measurement and risk financing still remains a beacon of insight and innovation even today.

EXECUTIVE MANAGEMENT NEEDS AND PERSPECTIVES

In the wake of headline losses and business and technology changes, chief executives and senior managers at the best firms have concluded that they must:

* Understand more fully the extent of the impact of operational risk (i.e., risk identification and risk capital measurement).

* Obtain management information about operational risk: its sources and causative factors.

* Determine capital adequacy for operational risk just as they have done for market, credit, and liquidity risks.

* Effect risk response through clearly assigned ownership and responsibility for risk management.

* Provide incentives for risk management through performance measures such as risk capital attribution and links to incentive compensation.

* Make better-informed decisions about hedging or risk financing (e.g., risk reserves, insurance, and other financing techniques).

* Combine the net impact of operational risk with credit and market risk potential for a firmwide view of risk and aggregated risk capital adequacy.

* Balance risk management investment against upside from operational risk management efforts.

Before we begin to discuss the practical details of operational risk management, it is important that we dispel a common myth. (ORM Myth: "Risk Measurement = Risk Management."). No one actually makes this statement, of course, but it is often implied. Many risk practitioners and consultants say risk management, when they are actually practicing risk measurement. Risk measurement is a subset, of course, of risk management (i.e., once you identify risk, you should evaluate, analyze, and measure it, before mitigating it through risk controls, and financing or hedging it). Although measuring risk adds much value in drawing attention for mitigation and management purposes, in isolation the measurement process does not have much value until the numbers are integrated back into management, for instance, and used in a performance management or behavior modification sense. Without a doubt, the most effective methods are those that have a direct impact on incentive compensation. For instance, quantifying the possible loss costs of weak controls in sales or trading systems is all well and good, but you haven't achieved much unless you reduce or withhold a manager's bonus until such time as the controls are strengthened.

What are we actually going to do about the risk once we have identified it, understand it, and have dimensioned it? Here we want to look into the various types of control measures, behavioral modifications, and other means of mitigating risks that we are looking to minimize-or shed altogether -from the organization. The primary objective of risk mitigation is simple enough: to reduce the risk of operational losses. It's the strategies, methods, tools, and style of implementation that make up the complex part.

It is also important to clarify a few key points about operational risk mitigation. Few, if any, have suggested that operational risk management subsume existing control infrastructures. So, a key part of the risk mitigation challenge will be to provide support and enhance the existing risk-control environment. To do this we need to do two things: First, create incentives for the business manager to improve upon control and behavioral risk-indicator results, thus improving the overall state of operational risk management in the firm; second, provide incentives to support existing functions, such as policy and procedures and internal audit, and link those to the numbers in operational risk management.

However, we want to go even one better than that. The logical objective...