How Regulations Have Affected Operational Risk?

Companies all over the world today acknowledge operational risk as a serious threat to the survival of their organizations. This is the reason that they explicitly mention operational risks in their risk policies and make efforts to reduce or eliminate these risks.

It is important to note that this was not always the case. Just a couple of decades ago, companies would pay a lot of attention to market and credit risks. However, operational risks were largely ignored. However, this has changed over the past few years.

A part of the change has happened voluntarily whereas another part of the change has been imposed by regulatory bodies all over the world. In this article, we will have a closer look to try and understand how increasing regulations have led to an increase in the recognition and mitigation of operational risks.

Let’s understand the history of these regulations and how they affect the organization.

The Basel Accord

The Basel Accord is an agreement that has been reached amongst the various financial institutions and central banks of the world. The agreement contains rules about how banks are supposed to function. These rules are issued by the Bank of International Settlements (BIS). Since this bank is located in Basel, these rules are referred to as the Basel Accord.

The Basel Accord also includes some rules about how operational risks need to be managed at banks. These steps were not included in Basel I rules. However, when Basel II was created, it was realized that managing operational risk is also extremely important while managing overall risk in any organization. This is the reason why Basel II provides extensive specifications about the best practices which need to be followed in this regard.

In 2007, the European Parliament made it mandatory for all financial organizations to adopt the Basel II standards in managing their operational risk. This is the reason why there was a sudden increase in the efforts being undertaken by the organization in order to manage their operational risk.

The United States government took some time to get adapted to the Basel II norms regarding operational risk. This is because even though they thought that the Basel II norms were effective in managing operational risks, they wanted the Securities and Exchange Commission (SEC) to be the ultimate governing body.

This is the reason why they adopted the Basel Framework to change the rules regarding the regulatory bodies before they made it mandatory for American financial institutions to adopt them. This is the reason that the norms were adopted one year late in the year 2008.

The string of regulations continued unabated for the next couple of years also. In 2009, the Central European Banking Supervisors (CEBS) organization formulated and released its own guidelines regarding how operational risk needs to be managed in financial institutions. Most banks and financial institutions were forced to adhere to these guidelines as well.

In the year 2011, the Federal Reserve issued some interagency guidelines about how operational risk needs to be managed by the members of the American Banking Institution. The purpose of the interagency guidance was to standardize the risk management process across all American banks.

Procedures were created which allowed the financial organizations to increase effective governance, develop methods to identify and quantify operational risks across the entire banking system. Data related to the operational risk was also required to be shared with the regulatory agencies from time to time to allow them to monitor the situation.

Since Europe and America are the financial centers of the world and the governments in these two places decided to aggressively pursue the implementation of operational risk measurement and management norms, these norms have now become mainstream. In most parts of the world, these norms are being followed even though they may not be legally mandatory.

Why is there Need for Extensive Regulation?

There is a need for extensive regulation in this area because of two reasons:

1. Firstly, financial institutions work in a systemic way. This means that all the banks in the financial world tend to form a closed loop. They all owe money to each other. Hence, if anyone bank also goes bankrupt, there is a huge risk of a contagion effect. This is because the bankrupt bank will no longer be able to honor its dues.

   As a result, it will the balance sheets of its partner banks will get affected who may then not be able to pay up their own dues. Hence, the operational risk of a bank isn’t really its internal matter. It endangers the entire banking system. Hence, it is necessary to monitor it at a systemic level.

2. Secondly, financial institutions all over the world take deposits from the general public. Hence, if they default on their obligations, they are not the only ones that lose money. The general public loses money and hence there is a risk of an economywide recession because of the misdeeds of a few banks.

   In most cases, the government guarantees these deposits to a large extent. This is the reason that the government has enough skin in the game that it needs to take the initiative to prevent any organization from undertaking unnecessary risks.

The bottom line is that governments and international regulatory bodies have played a huge role in the implementation of measures to manage operational risks.