Now it's op risk's turn to take centre stage

It's official. Operational risk has just as much potential to be systemic as credit and market risk. Here's hoping this will generate a bit more R-E-S-P-E-C-T among the general risk community for a discipline that aficionados of this magazine already know is a deadly serious one for the global financial system.

When the Société Générale rogue trader scandal broke in late January, firms were still licking their wounds from one of the worst stock market weeks in years. Around the world, markets had plummeted, and the situation was only halted by the US Federal Reserve's 75 basis point interest rate cut. Now, even SG executives concede that the off-loading of €50 million in equity derivatives positions on Monday, January 21 probably added momentum to the negative conditions on European bourses and set the stage for the Federal Reserve's interest rate move.

Wow...this is big stuff. Op risk has suffered from a mistaken identity for years - the collapse of Barings was down to a rogue trader but little was made of the systemic implications of this after the dust had settled, and many in the industry saw it as a once-in-a-lifetime event. Long Term Capital Management's problems were down to model risk and, although LTCM had systemic implications, few people viewed model risk as an op risk at the time.

And even when speaking about the subprime crisis - which operational risk executives could clearly see was a systemic event that had its roots in their discipline - most of the general focus has been on the resulting credit crunch.

But with the SG event, there is no denying it. This was an operational risk rogue trader event - and it caused such systemic shocks that it helped the Federal Reserve decide to lower interest rates 75 basis points.

So now it is up to the industry, and regulators, to decide what action to take. Sources say SG might have had approval from the French regulator for its advanced measurement approach. If so, what does this say for Basel II's op risk framework? Has it failed because it didn't predict this loss, prevent the loss, or presumably cover the loss in terms of regulatory capital?

Perhaps it is time for the industry to look more closely at the management aspects of operational risk: fraud prevention, rogue trading, market abuse, and Treating Customers Fairly violations are all low-hanging fruit for banks. And regulators must turn their attention away from models and curve-fitting, and towards initiatives that will actually make a difference to the world economy.

Ellen Davis, Editor