Operational Risk
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Operational risk is a basic type of risk encompansses deficiencis in information, monitoring and controls leading to fraud, human error and system failure. In terms of priorty, operational risk ranks third:-
Credit risk, at the top centres on the failure of a single counterparty. Market risk, relates to the value of the contract based on its underlying transaction, as determined by the market. Operational risk, however focuses on the failure of mechanisms in handling transactions. Thus the price and all other conditions may remain equal, but the transaction may still fail in its execution. In the finance arena, operational risk, is covered by two main areas. Settlement Risk occurs with the possibility of timing differences between an institution either paying out funds or deliverable assets before receiving assets or payment. Another name for operational risk is Herstatt risk. In 1974 the German private bank Herstatt was closed in the afternoon, by German regulators. The bank had already received payments of deutsche marks, but had not made the corresponding U.S. dollar payments. It has to be noted that settlement risk is much more prevalent in the foreign exchange markets than in derivatives. Legal Risk ocurrs when a contract is not legally enforceable. A large range of reasons can lead to non-enforcement, including:- Inadequate documentation counterparty lacks authority to enter into transaction Underlying transaction is not permissible Bankruptcy or insolvency of the counterparty changes the contract conditions. Deficiencies in information or monitoring controls and systems. These can be manual or automated systems or controls. This encompasses a huge range from incorrectly worded contracts to failures of exchange software, causing records to be lost. The current regulatory compliance is placing an ever increasing pressure on financial institutions to measure and manage their risk. For financial institutions the upcoming Basel II accord means, capital adequacy requirements will be tied to the risk profile. The Sarbanes-Oxley Act of 2002, means that public companies have to confirm the effectiveness of internal control. One of the five elements of internal control is risk management.
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