Pursuit of a wide range of activities, increased competition, blurring boundaries among financial services providers and the resulting falling spreads, management's commitment for enterprise-wide risk management, and banks' aggressive push into the technology mould have only increased banks' exposure to operational risk, calling for its focused management. The Basel II directives for allocating capital against operational risk have further heightened banks' interest in the operational risk.
The banking environment has dramatically changed in the recent past. At times the change was felt to be comforting; more so, when it threw open new opportunities. Nevertheless, more often than not its accompanying risks were quite threatening. One such all-pervasive risk that banks face is operational risk. It is one of the oldest risks that all along has been managed quite informally, but of late has suddenly caught everyone's attention for reasons galore. The Basel committee, having identified operational risk as an important risk faced by banks, proposed allocation of certain minimum capital by banks to protect themselves from such losses. In the light of these developments, this paper shall discuss what operational risk is all about; how Basel II expects banks to allocate capital against operational risk and the challenges posed by the suggested methodologies for measuring operational risk to banks.
Operational risk is as old as banking. It even precedes market and credit risks, and yet, there is no universally accepted definition of it. Operational risk is often defined by what it is not: any risk that is not related to credit market and liquidity risk is identified as operational risk.
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