THE FINANCIAL CRISIS AN OPERATIONAL RISK VIEW

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1 THE FINANCIAL CRISIS AN OPERATIONAL RISK VIEW Roxana HERGHILIGIU Alexandru Ioan Cuza University of Iasi Iasi, Romania Abstract The 2008 financial crisis is branded as Made in USA and it is largely believed to be a subprime credit crisis. Lately, the role of operational risk in the financial crisis is analyzed. The aim of this paper is to study the influence of operational risk in the causes of the 2008 financial crisis and how it influenced it. Our results show that operational risk was present in the lack of the documentation, background check, in the behavior of the mortgage lenders, unauthorized trades and in the worth of securitized loans when they were sold in volatile markets. Moreover, the operational risk had a great influence in the duration of the crisis. It is considered that the 2008 financial crisis can be described as the worst crisis ever from operational risk point of view. Lastly, we suggest how operational risk management can be improved so we did not face major losses due to operational risk. Keywords: operational risk, financial crisis, banks JEL Classification: G21, G32 1. INTRODUCTION The 2007/2008 Financial Crises is considered to be one of the most severe financial catastrophe in the all times and proliferate the susceptibility of the operational risk management. Likewise it triggered the attention on the scheme compensation of the employees of the banks, the innovation of the financial instruments, on the volatility of the market and on the regulation of prudential requirements. The aim of this paper is to study the role of operational risk in the 2007/2008 financial crises and to identify the proposals to develop the procedures of operational risk for a better understanding, measuring, monitoring and a better protection against big losses due to operational risk events. 2. OVERVIEW OF OPERATIONAL RISK Basel II defines operational risk as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events (BCBS, 2006). This definition includes legal risk, but excludes strategic risk and reputational risk.

2 The most important types of operational risk are: internal fraud, external fraud, losses due to inadequate management processes, employee errors, natural disasters, equipment failures and IT system disruptions. Some of the most high impact/low probability operational risk events that were as a black swan due to their unpredictability are the terrorist attacks from September 2001 in The United States of America and the hurricane from 2012 in Japan. Internal fraud Internal frauds are losses caused by acts of a type intended to defraud, misappropriate property, or circumvent regulations, the law or company policy, which involves at least one internal employee. An example of internal fraud is in the case of Daiwa Bank from 1995: the head of government bond trading in New York, Iguchi Toshihide, stole money from the clients of the bank to cover US $1.1 bn. unreported losses. External fraud External frauds are losses caused by acts aiming to dupe, embezzle property or bypass the law, by a third party. Examples of external frauds are credit card theft or their misusage. Rough trading and self-dealing Rogue traders are employees who have a major appetite for high risks. One example of an event with a major operational loss is the, well known, case of Barings Bank. Nick Leeson is a rogue trader who lost an amount of US$ 1 billion. IT disruptions An example of an IT disruption is the case of The Sweed Bank. In November 2010, it has cropped up a system disruption that affected the ATMs the internet banking system, the cards system and branch system. External extreme events or black swan events The black swan events, which had a great impact on financial results of the banks and on the entire economy were the terrorist crash into the World Trade Center in New York and the Pentagon in Washington in September OVERVIEW OF FINANCIAL CRISIS A financial crisis is the situation in which quantity of money is narrower than the demand of money. This means that there are massive withdrawn of liquidity from banks and that force banks either to sell another investments or to be in a bankruptcy. The financial crisis had it s debut in 2007 when Lehman Brothers, one of the most important banks from The United States of America, collapsed. This bankruptcy engendered huge losses in other big companies which were the bank s clients. Some of the causes of the 2007/2008 financial crisis were: The loose of the monetary policy and the system leverage had created huge assets bubbles and provided the increasing or different types of risk (Hess, C., 2011).

3 The poor understanding of the risks by the banks and that lead to the underestimation of the effect of illiquidity, contagion and default correlation. An amiss risk management that failed in providing an appropriate protection to the stakeholders. The immense number of people who borrowed money from banks to buy houses and they failed in paying their interest. This happened because the banks took a colossal operational risk by deciding to lend an amount of money bigger than the debtor could afford it (Cagan, P., 2008). Many banks believed in the expressions no money down, no income verification because the bank never loses. But, when the bubble smashed some banks loosed an enormous amount of money. And some banks collapsed even if they were the too big to fail ( e.g. Lehman Brothers). The compensation scheme had a major influence in the subprime credit crisis, because people who worked in the front-office gained huge incomes if they had many clients and sole a substantial credit product. So the majority of bankers were motivated to sell improper products to clients with small incomes because they were not interested if the client manage to pay his interest or debt, they were more interested in having higher and higher compensations (Williams, M.,. 2010). The level of perceived risk was very law because they rated risks with lower scores because they wanted to have low costs. So the banks did not have enough capital to cover the losses if the risks had happened. Many Banks should have been scored BBB but they scored AAA. 4. THE IMPLICATIONS OF OPERATIONAL RISK IN THE FINANCIAL CRISIS The commercial banks granted loans to people who could not pay their loans because they transferred the risk to the investment banks: the commercial banks sole the mortgage backed securities to the investments banks. The investment banks bought that mortgage backed securities without requesting any additional information about them. They believed that they bought bonds with a low risk. This was due to a poor management who focused on massive profits on short term. They did not care what could happen on long term. The constructed securities received good investment grade because the departments did not have o proper documented procedure describing how to accomplish CDO s ratings. Likewise, there was no documented procedure in how to inspect CDO ratings.

4 It should be pointed out that there were no historical data that resemble with the situation from the period Accordingly, no econometric model could predict the evolution of the subprime loans and haw would they act in the future. 5. IMPROVING OPERATIONAL RISK MANAGEMENT It is important to manage operational risk because if it is overlooked it may generate major losses that could cost the collapse of the banks. Besides, it may engender a financial crisis through the supply chain. Managers are one of the most important agent risk because they have to create an appropriate compensation scheme that could lead the employees to work in the best interest of the bank. Moreover, the best interest of the bank should be the best interest of the every employee. Also an employee who makes a huge mistake and cause big losses to the bank should experience negative consequences. The measuring and managing of operational risk is an important issue, too. It should be developed a new model which should have a prediction of the losses closer to the real potential loss. The models that are used right now can not predict a loss bigger than the highest loss that occurred in the past (Grinvsen, J., 2009). Operational risk events are a consequence of market volatility. Jongh, E., Jongh, D., (2013) consider warns when volatility rises, there should be no tolerance for traders who breach their limits. When there is a big volatility on the market, the the attention to control the traders and the market risk should increase. The capital level of operational risk should be big enough to minimize the potential losses due to an operational risk event. 6. CONCLUSION After the 2007/2008 financial crisis the banks are more aware of the factors that could generate enormous losses. An important focus should be on the risks that are important and that could change the course of history in a negative way. It is important to understand and to manage adequately the operational risk, especially in this period when we have complex IT systems, innovative financial instrument that few people know what impact may have when they are used in an improper manner. The guidelines proposed to improve operational risk management are: - Banks should pay attention to the procedures of managing operational risk - Managers should make a compensation scheme that would motivate the employee to not to be influenced in selling the wrong products to the clients.

5 - The personnel should be trained in the managing and measuring operational risk - It should invest in finding the best econometric model in predicting the real potential loss due to the events of operational risks - The financial supervisors should have a better control on the traders. - The rogue traders should be aware that if they not comply with the procedures they would suffer negative severe consequences. - The management should create better procedures in evaluating, managing, controlling and preventing operational risk References [1] BCBS,(2006). International Convergence of Capital Measurement and Capital Standards. Bank of International Settlements. Retrieved from [2] Cagan, P., (2008). What Lies Beneath Operational Risk Issues Underlying the Subprime Crises. The RMA Journal, [3] Grinvsen, J., (2009). Improving Operational Risk Management. Amsterdam: IOS Press BV. [4] Hess, C., (2011). The Impact on the Financial Crisis on Operational Risk in the Financial Services Industry: Empirical Evidence. The Journal of Operational Risk [5] Jongh, E., Jongh, D., Jongh, R., Vuuren, G.,. (2013). A Review of Operational Risk in Banks And it s Role in the Financial Crisis. Sajems [6] Williams, M.,. (2010) Uncontrolled Risk the Lessons of Lehman Brothers and How Systemic Risk Can Still Bring Down The World Financial System. New York: The McGraw-Hill Companies, Inc.