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Principles for the sound management of operational risk in banking

The Operational Risk & Stress Testing in Banking Conference will be hosted from 15-17 August 2017 at the Indaba Hotel-Fourways, Johannesburg and will include a third-day interactive workshop.

Speakers addressing the event will update participants on the latest strategies for establishing strong foundational risk and business practices, the dynamic understanding of the true risk profile, including sensitivities of losses and capital to key events and drivers.

There has been no better time to attend a gathering of thought leaders from within South Africa’s banking sector whom will be discussing and sharing the latest challenges and developments for developing a future-proof operational risk management framework in SA’s volatile yet resilient banking environment.

Financial institutions are facing heightened supervisory scrutiny, but those that establish a structured and calibrated approach to operational risk stress testing will thrive.

The past few years have seen the emergence of a new normal in the discipline of operational risk, especially in the financial-services sector. Financial institutions have experienced an increased number of significant incidents with major financial implications. These have ranged from cybersecurity breaches to rogue-trading events to problems in sales to large supervisory penalties and class-action lawsuits.

These events have led to heightened supervisory scrutiny of both measurement and management practices in operational risk. In the United States, supervisors have raised the bar for strong operational-risk-management practices and have mandated bank holding companies (BHCs) to perform comprehensive operational risk stress testing as part of the overall comprehensive capital analysis and review (CCAR) process. Projections of losses arising from inadequate or failed internal processes, people, and systems or from external events must be reported by the BHC as operational-risk losses, a component of pre-provision net revenues.

This paper focuses on the measurement of operational risk, specifically for stress-testing purposes. With practices in operational risk stress testing still evolving, banks are faced with a range of questions on methodological choices and the corresponding trade-offs. These questions primarily are centered on the challenge in correlating operational-risk losses with macroeconomic factors and business environment and external control factors; the handling of large historical losses in internal loss data sets; stressing historical, current, and future legal losses; and incorporating large plausible events that might occur during the nine-quarter forecast period for stress-testing purposes.

Hence, it is important for BHCs to establish a structured and calibrated approach to operational risk stress testing. Establishing such an approach will help them avoid supervisory objections (matters requiring immediate attention and matters requiring attention) by suitably addressing rising regulatory expectations. It will also benefit the institution through the establishment of strong foundational risk and business practices, for example, loss-data capture and loss-reduction actions, scenario analysis and risks/controls assessments and corresponding risk-mitigation actions, and getting a dynamic understanding of the true risk profile, including sensitivities of losses and capital to key events and drivers.

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