Fundamentals of Risk Management

Risk governance
362
internal and external. External risks also include legal action by customers of finan-
cial institutions in relation to negligence or fraud committed by staff.
The definitions of market risk and credit risk are also worth considering in rela-
tion to financial institutions. Market risk is the risk that the value of investments 
may decline over a period, simply because of economic changes or other events that 
impact large portions of the market. Credit risk is the risk that there will be a failure 
by a customer/client to repay the principal and/or interest on a loan or other out-
standing debt in a timely manner, or at all. Underwriting risk is also important for 
insurance companies; it is the exposure to the risks of the client through insurance 
policies.
Operational risk management is at a crucial point in its development. Numerous approaches 
have been developed across different industries, but many institutions are struggling to make 
these fully effective by really embedding them into the day-to-day management of their 
business. In order to overcome this challenge, it is essential to define clearly the relationship 
between operational risk processes and the overall control environment.
Indeed, the effectiveness of operational risk management has been impeded by a 
common failure to truly embed operational risk into the overall management of risk and 
control. Group risk functions must demonstrate to business-unit staff the full potential of 
using operational risk processes, developed under the group framework to manage the 
actual risks in the business.
As a consequence, the governance of operational risks involves more than just 
calculating the yearly operational risk capital. As economies and financial conditions change 
over time, so does the operational risk exposure. This implies that a number of specific 
operational risk events may become even more likely, which in times of crises require the 
attention of top management.
Failure of operational risk management
The losses associated with the failure to manage operational risk can be very
substantial. Losses suffered by so-called rogue traders are sometimes attributed to 
market risk. The argument is that the losses occurred because market conditions 
changed in an unexpected way and significant losses materialized. From an opera-
tional risk perspective, this analysis is incorrect.
It is more correct to say that the losses occurred because of a failure to control
the activities of traders. If the operations had been controlled by adequate 
operational risk controls, the traders would not have been in a position to have
put substantial assets of the bank at risk. Blaming the losses on the market risk
when such substantial assets of the bank should not have been in the market at all is 
incorrect.

---