Operational risk emerging as linchpin of Basel capital debate

By Kyle Campbell

What had for months been a broad debate around the wisdom and process of the Basel III capital proposal has narrowed in recent weeks to center on a particular aspect of that proposal: capital retention for banks’ operational risks…Karen Petrou, managing partner at Federal Financial Analytics, said capital is a “poor palliative” for operational risks, because it is different from other types of risks…. “Operational risk is very different from credit and market risk. It’s equivalent to what you do when the lights go out, and the approach that somehow, if you have a pot of money, you will see better is nonsensical,” Petrou said. “What you actually need is a generator, and that costs money.” … But Petrou notes that the rule retains the seven categories of operational risk — internal fraud, external fraud, employee practices and workplace safety, products and business practices, damage to physical assets, systems failures and process management — remain unchanged by the proposal. She also noted that the best way to address future risks is not to look at past outcomes, but for bank supervisors to diligently manage existing risks. “These rules reflect the fact that regulators don’t trust themselves,” Petrou said. “They’re using capital as a stand-in for effective supervision, which would be far more effective when it comes to operational risk.” … Petrou said the issues presented by the proposed treatment of operational risks could not be addressed by small tweaks. Instead, she said, it requires “redesigning” to a degree that the agency would have to put forth a new rule to satisfy the Administrative Procedure Act … “A final rule that only modestly changes the proposal is possible, but only modest changes to the proposal will have a lot of perverse consequences,” Petrou said.