Journal of Operational Risk

Marcelo Cruz

Welcome to the second issue of Volume 17 of The Journal of Operational Risk.

We promise you another very interesting issue, offering several valuable and novel discussions. For the first time we have a paper on climate risk (one of the top risks that needs to be tackled by the financial industry) and its impacts on operational risk. Regulators worldwide are considering implementing regulations to curb global warming. While it is still unclear how the financial industry can help on this issue, we are happy to see the discussion reaching this journal.

Operational risk resilience is another key interest in the industry right now and we would welcome more submissions on this subject. In addition to resilience, we also welcome more papers on cyber and IT risks – not just on their quantification, but also on better ways to manage them. We would also like to publish more papers on important subjects such as enterprise risk management and everything this broad subject encompasses, eg, establishing risk policies and procedures, implementing firm-wide controls, risk aggregation and revamping risk organization. As I alluded to in previous issues, analytical papers on operational risk measurement could focus on stress testing and actually managing these risks.

These are certainly exciting times! The Journal of Operational Risk, as the leading publication in the area, aims to be at the forefront of these discussions, and we would welcome papers that shed some light on these areas.

RESEARCH PAPERS

In the issue’s first paper, “Correlations in operational risk stress testing: use and abuse”, Peter Mitic notes that correlations between operational risk loss severity, loss frequency and economic factors have been a de facto tool for assessing economic and regulatory capital since 1990. He demonstrates, using data from a single retail bank, that the use of these correlations does not apply universally, and projections of capital requirements are subject to wide error margins, some of which can be explained in terms of data trends. Given worldwide regulatory requirements to assess the resilience of financial institutions to economic shock, Mitic proposes an alternative to using correlations that makes use of economic data. His proposal is consistent with a much broader interpretation of capital allocation than has applied to date. He also claims that the Covid-19 pandemic has had a minimal impact on operational risk losses, showing that the existence (or otherwise) of significant correlations depends on the regression model used (whether or not data series show trends),the time window concerned and the geographical location and type of financial institution. This is a very thought-provoking discussion.

In our second paper, “How climate change may impact operational risk”, Michael Grimwade rightly claims that there has been “very limited focus” on the impacts of climate change on operational risk. This paper provides an overview of the possible consequences of climate change and concludes that climate change may drive operational risk losses through complex interactions between three factors: changes in human and institutional behaviors; significant and rapid changes in economic metrics; and direct physical impacts. Grimwade claims that the influence of these three factors will vary depending upon the course of action pursued by humanity. Early action, ie, changes in human and institutional behaviors now, would be the most influential and would limit the economic consequences to specific vulnerable sectors. Late action, ie, action taken between 2030 and 2035, would mean a demand-side economic shock that would drive operational risk losses. Finally, no additional action would see extreme events from 2045 onward, causing economic shocks through supply-side disruption, and behavioral changes would combine to drive operational risk losses. Grimwade draws parallels with past crises to make systematic predictions. Tailored approaches are required for assessing the different consequences. The most significant operational risk losses may arise from litigation from the transference to customers and investors of market and credit risks without adequately disclosing their sensitivities to climate change, in particular those associated with economic shocks. Control enhancements now, however, may mitigate future losses.

In the third paper in this issue, “The status of people risk management in UK banks”, Kumbirai Mabwe, Patrick Ring and RobertWebb examine the place of “people risk” in the context of operational risk management against a background of a succession of financial mishaps in the UK banking industry, all of which were deeply rooted in the behavior of individual employees. Informed by a literature review alongside empirical evidence from 25 semi-structured interviews with operational risk practitioners in UK banks, Mabwe et al find varying levels of awareness and understanding of people risk. As a result of a regulatory focus on quantitative capital requirements, management of people risk is generally subsumed by this regulatory approach, and Mabwe et al show that the “embedded” nature of people risk has hindered the development of a more comprehensive industry-wide approach to people risk management. Nevertheless, some operational risk managers are working more closely with their human resources partners to develop a more cohesive approach to people risk management. In the context of current reforms to the capital requirements for operational risk, now may be an opportune time to examine the regulatory approach to people risk in banks.

Finally, in our fourth paper, “Technology risk management in fintech: underlying mechanisms and challenges”, Xiaohui Chen, Hongwei Zhang and Lei Teng focus on the underlying technology of fintech to address technology risk, discussing how fintech risk may be treated as a specific technology risk, given how these new fintech ventures work. The authors’ results show that there are three major factors in technology risk in fintech: algorithms, the cloud and data. These three factors may have adverse effects on financial consumers, fintech innovators and the financial system. Fintech technology risk may make it difficult for financial consumers to effectively manage risk, leading to forced default and even directly causing property losses. Further, it may cause fintech innovators’ traditional core competitiveness to disappear and could affect the quality of their credit assets, possibly jeopardizing their sustainable operation. Finally, it may induce systemic financial risk, either directly or indirectly, through the financial system. Therefore, Chen et al recommend that innovators review and reconstruct their comprehensive risk management systems and other mechanisms, while regulators should reconstruct their systematic financial risk prevention and control mechanisms. Chen et al also recommend developing regulatory sandboxes to test regulations before they are implemented.