In his book Systemic Operational Risk: Theory, Case Studies and Regulation, (McConnel, 2015) defines Systemic Operational Risk as operational risks that are not related to one firm only, but arise simultaneously across the financial system. Research reveals three frequently used concepts of what Systemic Operational Risk means. One of these concepts refers to a “big” shock or macro-shock that produces nearly simultaneous, large, adverse effects on most or all of the domestic economy or system. In this context, “systemic” refers to an event having effects on the entire banking, financial, or economic system, rather than just one or a few institutions.
There are various causes such as:
- Interbank Linkages – Chain reaction failures flowing through interconnected institutions.
- Dependence of international, national and economic systems on the financial sector.
- Common shock or reassessment failure – i.e. failure or near failure of one or several institutions from losses originating elsewhere and the reassessment by investors, creditors, and shareholders of other institutions.
- Scarcity of data to capture international dimensions of systematic operational risk.
- Different organizational structures
- Central banks and supervisory agencies differences.
Systematic operational risk can be minimized by doing the following:
1. Having back-up redundancies in systems. These may include existence of multiple exchange platforms – manual and electronic – if one fails others will be available.
2. Foster transparency which allows financial institutions to punish each other. Counterparty risks should be disclosed to ensure that other financial institutions know who they are going into business with and if it is viable to do so.
3. Special oversight over the larger financial institutions that are more interconnected.
4. Impose fines or other punitive measures to activities and behavior that poses risk to the system no matter how minor it is.
5. With respect to chain-reaction or direct-causation failures flowing through interconnected institutions, there are two lines of attack.
a. Supervisors can reduce the amount of loss in the initial failure by prompt closure rules.
b. Banks also have many ways, such as careful monitoring and exposure
ceilings, to protect themselves against defaults by their counterparties.
Why is it a high priority to review the regulation and requirements of systemic operational risks?
Regulation needs to view banks as part of a system. A lot of control is imposed on banks compared to other institutions. However, weaknesses in other institutions and industries have a direct impact on banks from a lender and financier perspective.
For chain reaction failures flowing through interconnected institutions it is important that regulation not undermine banks’ incentives to manage and monitor direct causation.