I am becoming more and more convinced that operational risk is just as procyclical as credit risk under Basel II.
This idea of the procyclicality in operational risk is a fairly new one - I heard rumblings about it at our OpRisk USA and OpRisk Europe conferences earlier this year. Just what do I mean? This is an issue beyond mere economic or regulatory capital levels. Operational risk, at its core, is about the management and mitigation of losses due to people, processes, systems and external events. Yet, if you look at patterns of investment - think of it as 'capital investment' - made by financial services firms in new technology, new systems, new controls, training, and staff in their compliance and op risk departments, one thing is abundantly clear - when times are good, investment remains pathetically low. Just when firms should be reinvesting healthy profits in their infrastructure, they aren't. They wait until a large event that provokes headlines, to invest.
For example, look at the report published by PricewaterhouseCoopers into the Societe Generale rogue trader incident at the end of May. The report points out that "against a backdrop of strong growth in trading volumes in the equities division, there was a mismatch between the resources allocated to support and control functions and the level of front office activities. A lack of seniority also diminished the effectiveness of the back and middle office teams". The report goes on to point out that the IT couldn't handle the volume and complexity of the transactions taking place, and that there was a "heavy reliance" on manual processing.
If you haven't read the report, I highly recommend it - it is fascinating reading. But getting back to my point - if business was booming, why not reinvest some of the profits in improving systems and controls, as well as staff? Clearly, whatever investment SocGen had made, it wasn't enough. But they are not alone in this. Look, for example, at the serious amount of regulatory pressure that has been brought to bear on the credit and equity derivatives back-office processing issue overall. Once again, a booming business that lacked systems and people power.
Regulators - and firms - need to restructure their incentives and strategic priorities so that it becomes both acceptable and desirable to invest when times are good - and so that operational risk is no longer procyclical.
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