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The Onus of Operational Risk

With the final version of Basel II coming down the pipeline, are financial institutions ready?

Financial institutions are beginning to take on the burden of preparing for the impending New Basel Capital Accord, according to a roundtable held by Massachusetts-based Celent Communications earlier this week.

The first Basel Accord was created in 1988 to ensure capital allocation by examining market and credit risk within banking institutions. The new version, Basel II, will make modifications to its evaluation of credit risk, as well as assess operational risk, an area previously undefined by the financial services marketplace.

Although firms have been looking at forms of operational risk for some time, including disaster recovery and business-continuity planning, it has only been recently that firms have been expected to quantify these risks by assigning a dollar amount to them, says Michael Haney, a senior analyst with Celent Communications.

"Operational risk is hard to define or quantify. It is so encompassing that many banks feel that there is no way to get their arms around it," Haney says.

Most large institutions realize that Basel II is a reality and have already begun to prepare by implementing strategies and technologies to measure operational risk.

Many banks are using scorecards for an immediate valuation, where heads of business lines can identify potential risks and valuations using questionnaires and spreadsheets, Haney explains. As operational incidents occur, he adds, banks can log the information, with the long-term goal of using that information to create databases from which to derive quantitative information.

Barry Macklin, Senior Vice President at JPMorgan Chase, notes that Basel II compliance is not just about technological solutions, but about a corporate philosophy. "You must have a commitment in your firm, a corporate culture to adopt operational risk clean-up, and senior management must agree," he says.

Haney says that while Basel II will probably only be applied to the ten largest banks in the United States, it will also provide a best-practices example for second and third-tier banks, who might eventually adopt operational risk mitigation to stay competitive. Smaller banks, Haney says, are hoping to escape immediate inclusion in Basel II since their cost of measuring operational risk would not be justified with adequate return.

While the final version is in progress, Haney says that Basel II is expected to be published by the end of the year, followed by review by banks and regulators, and finally implementation by 2007.

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