Systemic operational risk: does it exist and, if so, how do we regulate it?

Patrick McConnell and Keith Blacker

Abstract

ABSTRACT

Since the global financial crisis, banking regulators and academics have extended the traditional, narrow definition of "systemic risk" to encompass concepts such as "interconnectedness" and "shadow banking". But, at the time of writing, a definition of systemic risk that covers all of the factors that precipitated the global financial crisis is still emerging. This paper first describes the debate around the emerging definition(s) of systemic risk and discusses some of the initiatives to address systemic risk by international regulators. These initiatives include microprudential regulations, such as increasing capital for systemically important banks, and macroprudential initiatives, such as the creation of the European Systemic Risk Board. Recognizing that systemic risks arise not only from credit and market risk factors, this paper views systemic risk through the lens of operational risk, arguing that key risk factors, especially people and process risks, were pervasive across the global financial industry prior to the global financial crisis and, consequently, operational risk must be considered as a contributor to, and in some instances a trigger for, systemic risk. The paper goes on to describe the microprudential approach to operational risk within the Basel II regulations and identifies and describes operational risks that were present prior to the global financial crisis. The paper concludes that there is indeed a systemic dimension to operational risk that should be recognized and addressed by banking regulators. Finally, the paper makes some suggestions as to how the management of systemic operational risks may be addressed by banks and regulators.