FRBSF ECONOMIC LETTER

Number 2002-02, January 25, 2002

What Is Operational Risk?

Financial institutions are in the business of risk problems, such as employee fraud and product flaws.
management and reallocation, and they have devel- Because the risks from internal problems will be
oped sophisticated risk management systems to closely tied to a bank’s specific products and busi-
carry out these tasks.The basic components of a ness lines, they should be more firm-specific than
risk management system are identifying and defin- the risks due to external events.
ing the risks the firm is exposed to, assessing their
magnitude, mitigating them using a variety of pro- Measuring operational risk
cedures, and setting aside capital for potential losses. A key component of risk management is measuring
Over the past twenty years or so, financial institu- the size and scope of the firm’s risk exposures. As
tions have been using economic modeling in earnest yet, however, there is no clearly established, single
to assist them in these tasks. For example, the devel- way to measure operational risk on a firm-wide
opment of empirical models of financial volatility basis. Instead, several approaches have been devel-
led to increased modeling of market risk, which oped. An example is the “matrix” approach in
is the risk arising from the fluctuations of financial which losses are categorized according to the type
asset prices. In the area of credit risk, models have of event and the business line in which the event
recently been developed for large-scale credit risk occurred. In this way, a bank can hope to identify
management purposes. which events have the most impact across the entire
firm and which business practices are most sus-
Yet, not all of the risks faced by financial institutions ceptible to operational risk.
can be so easily categorized and modeled. For
example, the risks of electrical failures or employee Once potential loss events and actual losses are
fraud do not lend themselves as readily to mod- defined, a bank can hope to analyze and perhaps
eling. Such risks are typically categorized under even model their occurrence. Doing so requires
the rubric of “operational risk.” In this Economic constructing databases for monitoring such losses
Letter, we review the current status of operational and creating risk indicators that summarize these
risk management by financial institutions, particu- data. Examples of such indicators are the number
larly commercial banks, and the corresponding reg- of failed transactions over a period of time and
ulatory capital requirements proposed by the Basel the frequency of staff turnover within a division.
Committee on Banking Supervision (BCBS).
Potential losses can be categorized broadly as arising
Defining operational risk from “high frequency, low impact” (HFLI) events,
Although the definitions of market risk and credit such as minor accounting errors or bank teller
risk are relatively clear, the definition of operational mistakes, and “low frequency, high impact” (LFHI)
risk has evolved rapidly over the past few years. At events, such as terrorist attacks or major fraud. Data
first, it was commonly defined as every type of on losses arising from HFLI events are generally
unquantifiable risk faced by a bank. However, fur- available from a bank’s internal auditing systems.
ther analysis has refined the definition considerably. Hence, modeling and budgeting these expected
As reported by BCBS (September 2001), operational future losses due to operational risk potentially
risk can be defined as the risk of monetary losses could be done very accurately. However, LFHI
resulting from inadequate or failed internal processes, events are uncommon and thus limit a single bank
people, and systems or from external events. from having sufficient data for modeling purposes.
For such events, a bank may need to supplement
Losses from external events, such as a natural disaster its data with that from other firms. Several private-
that damages a firm’s physical assets or electrical or sector initiatives along these lines already have been
telecommunications failures that disrupt business, formed, such as the Global Operational Loss Data-
are relatively easier to define than losses from internal base managed by the British Bankers’ Association.

WESTERN BANKING Western Banking is a quarterly review of banking

developments in the Twelfth Federal Reserve District. It is published in the Economic Letter on the
fourth Friday of January, April, July, and October.
FBRSF Economic Letter 2 Number 2002-02, January 25, 2002

Although quantitative analysis of operational risk In parallel with industry developments, BCBS
is an important input to bank risk management proposed in 2001 that an explicit capital charge for
systems, these risks cannot be reduced to pure operational risk be incorporated into the new Basel
statistical analysis. Hence, qualitative assessments, Capital Accord. At first this capital charge would
such as scenario analysis, will be an integral part apply to internationally active banks.The Committee
of measuring a bank’s operational risks. initially proposed that the operational risk charge
capital requirement, but after a period of review,
Mitigating operational risk the Committee lowered the percentage to 12%.
In broad terms, risk management is the process of The final version of the Basel Accord is tentatively
mitigating the risks faced by a bank, either by hedg- scheduled for a year-end 2002 release.
ing financial transactions, purchasing insurance, or
even avoiding specific transactions.With respect to To encourage banks to improve their operational
operational risk, several steps can be taken to mit- risk management systems, the new Basel Accord
igate such losses. For example, damages due to also will set criteria for implementing more advanced
natural disaster can be insured against. Losses aris- approaches to operational risk. Such approaches are
ing from business disruptions due to electrical or based on banks’ internal calculations of the prob-
telecommunications failures can be mitigated by abilities of operational risk events occurring and the
establishing redundant backup facilities. Losses due average losses from those events.The use of these
to internal reasons, such as employee fraud or approaches will generally result in a reduction of
product flaws, are harder to identify and insure the operational risk capital requirement, as is cur-
against, but they can be mitigated with strong inter- rently done for market risk capital requirements
nal auditing procedures. and is proposed for credit risk capital requirements.
These criteria and the new capital regulations will
Since operational risk management will depend require bank supervisors to conduct evaluations of
on many firm-specific factors, many managerial operational risk management systems on a regular
methods also are possible and will probably be put basis. As noted by BCBS, these supervisory eval-
in place over time. However, some general princi- uations would be complemented greatly by public
ples, such as good management information systems disclosure sufficient to allow independent assess-
and contingency planning, are necessary for effective ments by market participants.
operational risk management. BCBS (December
2001) laid out a framework for managing operational Conclusion
risk at internationally active banks; this framework Operational risk is intrinsic to financial institutions
also could be more broadly applied to other types and thus should be an important component of
of financial institutions. their firm-wide risk management systems. However,
operational risk is harder to quantify and model
The framework consists of two general categories. than market and credit risks. Over the past few
The first includes general corporate principles for years, improvements in management information
developing and maintaining a bank’s operational systems and computing technology have opened
risk management environment. For example, a the way for improved operational risk measurement
bank’s governing board of directors should recog- and management. Over the coming few years,
nize operational risk as a distinct area of concern financial institutions and their regulators will con-
and establish internal processes for periodically tinue to develop their approaches for operational
reviewing operational risk strategy.To foster an effec- risk management and capital budgeting.
tive risk management environment, the strategy
should be integral to a bank’s regular activities and Jose A. Lopez
should involve all levels of bank personnel. Economist
The second category consists of general procedures
for actual operational risk management. For exam-
ple, banks should implement monitoring systems References
for operational risk exposures and losses for major
business lines. Policies and procedures for controlling Basel Committee on Banking Supervision. 2001.
or mitigating operational risk should be in place “Working Paper on the Regulatory Treatment of
and enforced through regular internal auditing. Operational Risk” (September). http://www.bis.org/
publ/bcbs_wp8.htm (accessed January 2002).
Capital budgeting for operational risk
Banks hold capital to absorb possible losses from Basel Committee on Banking Supervision. 2001.
their risk exposures, and the process of capital bud- “Sound Practices for the Management and Super-
geting for these exposures, including operational vision of Operational Risk” (December). http://
risk, is a key component of bank risk management. www.bis.org/publ/bcbs86.htm (accessed January 2002).
FBRSF Economic Letter 3 Number 2002-02, January 25, 2002

BANKS HEADQUARTERED BY REGION

SEPTEMBER 30, 2001
(NOT SEASONALLY ADJUSTED, PRELIMINARY DATA)
(BANKS WITH ASSETS LESS THAN OR EQUAL TO $1 BILLION ARE DEFINED AS SMALL)

UNITED STATES TWELFTH DISTRICT

 
ALL SMALL LARGE ALL SMALL LARGE
     
ASSETS AND LIABILITIES  $ MILLION
ASSETS TOTAL 6,499,722 1,027,140 5,472,582 637,305 93,619 543,686
FOREIGN 768,634 1,126 767,508 5,100 18 5,083
DOMESTIC 5,731,088 1,026,014 4,705,074 632,204 93,601 538,603

LOANS TOTAL 3,829,904 662,556 3,167,348 401,824 63,058 338,765

FOREIGN 286,471 1,021 285,449 3,665 46 3,619
DOMESTIC 3,543,433 661,534 2,881,899 398,159 63,012 335,147
REAL ESTATE 1,702,535 423,892 1,278,643 199,687 40,396 159,291
COMMERCIAL RE 490,307 153,567 336,740 73,844 21,225 52,619
SINGLE FAMILY RES 924,847 182,786 742,061 86,020 8,289 77,731
COMMERCIAL 846,929 116,656 730,273 93,253 13,509 79,744
CONSUMER 555,942 77,525 478,418 77,935 6,672 71,263
CREDIT CARDS 242,706 9,434 233,272 56,037 1,796 54,241
AGRICULTURAL 47,155 30,810 16,345 6,087 1,633 4,454
OTHER LOANS 390,871 12,652 378,220 21,198 803 20,396

INV. SECURITIES TOTAL 1,087,441 229,847 857,594 119,392 15,664 103,728

U.S. TREASURIES 46,787 12,158 34,629 3,476 824 2,652
U.S. AGENCIES, TOTAL 663,040 153,216 509,824 48,592 10,019 38,573
U.S. AGENCIES, MBS 486,051 69,611 416,440 36,219 5,212 31,007
OTHER MBS 64,714 3,725 60,988 9,960 466 9,494
OTHER SECURITIES 312,900 60,746 252,153 57,365 4,355 53,010

LIABILITIES TOTAL 5,909,901 922,665 4,987,236 570,264 83,514 486,750

DOMESTIC 5,141,266 921,539 4,219,728 565,164 83,496 481,667

DEPOSITS TOTAL 4,261,885 844,065 3,417,820 432,116 75,704 356,413

FOREIGN 680,653 1,716 678,937 14,420 45 14,374
DOMESTIC 3,581,232 842,349 2,738,883 417,697 75,658 342,038
DEMAND 494,377 114,818 379,559 54,533 11,868 42,665
MMDA & SAVINGS 1,611,048 233,074 1,377,974 235,903 26,788 209,115
SMALL TIME 761,583 269,589 491,994 56,540 16,293 40,247
LARGE TIME 564,208 138,578 425,631 62,026 15,877 46,149
OTHER DEPOSITS 150,016 86,290 63,726 8,694 4,831 3,862

OTHER BORROWINGS 482,849 22,635 460,214 38,108 1,452 36,656

EQUITY CAPITAL 581,684 104,445 477,239 66,891 10,102 56,789
LOAN LOSS RESERVE 67,763 9,376 58,387 9,156 1,218 7,938
LOAN COMMITMENTS 4,758,520 603,856 4,154,664 757,803 294,468 463,334

TIER1 CAPITAL RATIO 0.097 0.136 0.090 0.108 0.128 0.105

TOTAL CAPITAL RATIO 0.125 0.147 0.121 0.137 0.141 0.136
LEVERAGE RATIO 0.078 0.096 0.075 0.089 0.101 0.087
LOAN LOSS RESERVE RATIO 1.769 1.415 1.843 2.279 1.931 2.343

QUARTERLY EARNINGS AND RETURNS  $ MILLION

INCOME TOTAL 140,398 21,921 118,478 16,569 2,446 14,123
INTEREST 100,327 18,232 82,095 11,586 1,850 9,736
FEES & CHARGES 6,752 1,079 5,673 647 78 569

EXPENSES TOTAL 112,283 17,640 94,642 12,163 1,902 10,262

INTEREST 45,680 8,093 37,586 4,277 662 3,615
SALARIES 23,290 4,285 19,006 2,332 482 1,851
LOAN LOSS PROVISION 11,848 929 10,919 1,555 172 1,383
OTHER 31,464 4,334 27,131 3,999 585 3,413

TAXES 8,985 1,210 7,774 1,595 222 1,373

NET INCOME 17,290 2,959 14,330 2,581 311 2,271

ROA (% ANNUALIZED) 1.099 1.172 1.085 1.645 1.350 1.695

ROE (% ANNUALIZED) 11.890 11.334 12.011 15.436 12.305 15.993
NET INTEREST MARGIN (% ANNUALIZED) 3.472 4.014 3.369 4.656 5.157 4.570

ASSET QUALITY PERCENT OF LOANS

NET CHARGEOFFS (% ANNUALIZED)
TOTAL 0.999 0.382 1.128 1.283 0.649 1.401
REAL ESTATE 0.305 0.065 0.383 0.091 0.053 0.101
COMMERCIAL 1.433 0.766 1.521 1.595 0.882 1.713
CONSUMER 2.697 1.418 2.887 4.267 3.865 4.304
CREDIT CARDS 4.632 5.048 4.615 5.229 8.889 5.108
AGRICULTURAL 1.139 0.611 2.089 0.167 0.378 0.089

PAST DUE & NON-ACCRUAL

TOTAL 2.687 2.349 2.757 2.630 2.426 2.668
REAL ESTATE 2.042 2.008 2.053 1.820 1.714 1.846
CONSTRUCTION 2.334 2.291 2.349 2.773 2.547 2.857
COMMERCIAL 1.842 1.843 1.842 1.427 1.376 1.448
FARM 2.528 2.112 3.471 4.715 4.377 4.920
HOME EQUITY LINES 1.293 1.152 1.312 1.198 0.777 1.265
MORTGAGES 2.371 2.224 2.411 1.962 2.121 1.946
MULTI-FAMILY 1.129 1.065 1.146 1.093 0.585 1.268
COMMERCIAL 3.269 3.081 3.294 3.467 3.041 3.538
CONSUMER 3.769 3.424 3.820 3.650 5.627 3.466
CREDIT CARDS 4.422 7.089 4.314 4.116 11.617 3.868
AGRICULTURAL 2.464 1.437 4.306 4.517 1.943 5.460

NUMBER OF BANKS 8,129 7,737 392 582 507 75

NUMBER OF EMPLOYEES 1,656,021 386,055 1,269,966 156,974 36,526 120,448

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INTEREST RATES ON LOANS

AUG NOV FEB MAY AUG NOV FEB MAY AUG NOV
TYPE OF LOAN 1999 1999 2000 2000 2000 2000 2001 2001 2001 2001
COMMERCIAL and INDUSTRIAL LOANS
TOTAL U.S. 6.78 7.03 7.44 7.78 8.28 8.15 7.19 6.22 5.61 3.89
DISTRICT 6.69 6.98 7.04 7.42 7.90 7.85 7.04 5.94 5.22 3.58
BY RISK RATING:
MINIMAL RISK U.S. 6.05 6.01 6.47 6.82 7.42 7.54 6.23 6.01 4.50 2.97
DISTRICT 7.19 6.36 6.49 6.19 7.25 6.66 6.54 4.98 4.46 2.88
LOW RISK U.S. 5.90 6.52 6.87 7.15 7.55 7.57 6.54 5.44 4.81 3.08
DISTRICT 6.20 6.74 6.79 6.99 7.65 7.68 6.53 5.42 4.66 3.14

MODERATE RISK U.S. 6.93 7.22 7.54 7.97 8.41 8.33 7.28 6.38 5.57 4.25
DISTRICT 7.15 7.15 7.15 7.57 8.06 8.04 7.51 6.35 5.54 3.84

OTHER U.S. 7.55 7.71 8.24 8.63 8.95 8.85 7.97 6.82 6.16 4.31
DISTRICT 6.66 6.93 7.23 7.57 8.00 7.79 7.70 6.64 6.35 4.39
BY MATURITY/REPRICING INTERVAL:
DAILY U.S. 6.15 6.43 6.84 7.21 7.74 7.84 6.88 5.94 5.15 3.67
DISTRICT 6.65 7.08 6.87 7.59 7.94 7.85 7.22 6.03 5.33 3.91
2 TO 30 DAYS U.S. 6.62 6.80 7.42 7.60 8.18 7.60 6.94 5.80 5.84 3.66
DISTRICT 6.56 6.86 7.00 7.37 7.83 7.78 6.96 5.87 5.16 3.47
31 TO 365 DAYS U.S. 6.88 7.58 7.67 8.04 8.13 8.04 7.22 5.90 5.42 3.94
DISTRICT 6.97 6.85 6.96 7.05 7.70 7.68 6.39 5.47 4.72 3.23
OVER 365 DAYS U.S. 7.73 8.02 8.81 8.37 8.84 8.37 8.48 7.61 7.02 6.09
DISTRICT 8.43 8.28 7.90 4.64 8.72 9.03 7.36 7.70 7.30 5.08

CONSUMER, AUTOMOBILE U.S. 8.44 8.66 8.88 9.21 9.62 9.63 9.17 8.67 8.31 7.86
DISTRICT 8.98 9.07 9.28 9.23 9.87 9.87 9.94 9.34 8.34 8.54
CONSUMER, PERSONAL U.S. 13.38 13.52 13.76 13.88 13.85 14.12 13.71 13.28 13.25 12.62
DISTRICT 13.62 14.45 14.41 14.89 13.25 13.25 13.67 12.48 13.22 12.45
CONSUMER, CREDIT CARD U.S. 15.08 15.13 15.47 15.39 15.98 15.99 15.66 15.07 14.60 14.22
DISTRICT 15.73 15.63 15.60 15.76 16.16 16.25 16.94 15.54 15.28 15.01

SOURCES: SURVEY OF TERMS OF BUSINESS LENDING AND TERMS OF CONSUMER CREDIT