# Journal of Operational Risk

#### Editor's Letter

Welcome to the third issue of Volume 12 of The Journal of Operational Risk.

I have to say that I am truly encouraged by the number and quality of the papers we have been receiving here at The Journal of Operational Risk since Basel issued its consultative paper on the standardized measurement approach (SMA), which intends to eliminate the need for internal models to measure operational risk for banks. At first we feared that researchers would feel too discouraged to continue focusing on this area, and that quantitative practitioners would likewise move into new fields of study. But what has actually happened is that regulators have not yet published a final ruling on the issue, and have seemingly backtracked on their initial idea of killing internal models for operational risk capital. Meanwhile, the operational risk community has become stronger than ever, united against the SMA. If anything, the looming threat of the SMA has actually challenged the industry to improve its models and bring new ideas into this area. All of us here at The Journal of Operational Risk are honored to be the chosen vessel for these new ideas.

As the leading publication in this area, we aim to be at the forefront of these discussions, and welcome papers that shed light on the current state of affairs.

PAPERS

In this issue, we have one research paper, one forum paper and two papers for a special section on behavioral risk management. In the first research paper the author presents a very interesting take on assessing operational risk by using the impact of operational risk events on share prices. The author of the second paper answers our request for more discussion on the debate about the advanced measurement approach (AMA) versus SMA, and proposes an innovative midway approach to settle the score.

We also offer a special section on behavioral risk management in this issue of The Journal of Operational Risk. It features two of the best papers that were presented at the CFS Conference on Behavioral Risk Management, which took place at Bonn University in March 2017. This was organized by editorial board member Dr Thomas Kaiser along with Dr Mark Wahrenburg (Goethe University) and Dr Bernd Weber (Bonn University), whom we thank profusely for their collaboration.

RESEARCH PAPER

In the first paper, “An operational risk-based regime-switching model for stock prices”, Takashi Kanamura proposes a new risk-based regime-switching model for stock prices, using the price–volume relation to examine the effect of the operational risk events of industrial companies on stock prices. Kanamura’s model demonstrates that market risk, credit risk and operational risk should be represented by three different profiles. Empirical studies of operational risk are presented to estimate the parameters of mean-reverting regime-switching models using the stock prices of Volkswagen AG, Asahi Kasei Corporation and Toshiba Corporation. These companies have all experienced operational risk events: the violation of the Clean Air Act in the United States, and the data manipulation issue of construction piles and accounting fraud both in Japan. The results show that log prices in operational risk regimes have higher volatilities than log prices in market risk regimes for Volkswagen, Asahi Kasei and Toshiba. This may suggest that operational risk events trigger higher share price volatility than market and credit risks. The results for Volkswagen and Asahi Kasei show that the operational risk regime shows a mean reversion of log prices, while the market risk regime does not. This may suggest that the impact of operational risk does not persist for long, due to its mean-reversion properties. In addition, the model suggests that the mean reversion of log prices may come from the behavior of market participants as observed through the trading volume during operational risk periods.

FORUM SECTION

In this issue’s forum paper, “The issues with the standardized measurement approach and a potential future direction for operational risk capital modeling”, Ruben Cohen notes that although the validity of criticism of the SMA is demonstrated with analytical precision in several articles published in this journal, the praise for the AMA appears to lack similar reasoning. He feels the reason for this is that the simplicity and transparency of the SMA allows objective analysis whereas the complexity and opacity of the AMA does not. Moving on from this, it is proposed that a single, universal loss distribution approach-type (LDA-type) model may be the way forward for the next generation of operational risk capital models. In this way, simplicity and transparency can be retained as model qualities, while risk sensitivity, albeit at the entity level, can also be improved over that of the SMA due to the nature of the LDA.

SPECIAL SECTION: BEHAVIORAL RISK MANAGEMENT

In the first paper of our special section, “Behavioral risks at the systemic level”, Patrick McConnell claims that the possibility of Deutsche Bank being fined some US$14 billion by US regulators for grave misconduct before the global financial crisis (GFC) has recently raised the specter of a systemic banking crisis, as Deutsche Bank is considered to be a systemically important bank (SIB). Since the GFC, Deutsche Bank and several other SIBs have been made to pay over US$200 billion in fines and remediation costs for misconduct in a number of areas, beyond misselling of mortgages, such as manipulation of the London interbank offered rate (Libor) and foreign exchange (FX) benchmarks; misselling of insurance products (such as payment protection insurance); sanctions busting; money laundering; and other misconduct. The paper points out that these events are the results of a failure to manage operational risks, both at the level of the firm and across the banking system. Although research into individual and group behavioral biases has increased, less research has been conducted into misbehavior at the level of the banking system: that is, misconduct that occurs in multiple financial institutions, seemingly independently, at the same time. Comparing the Libor and FX benchmark manipulation scandals, the paper describes how misbehavior emerged independently in these two markets as well as the conditions that permitted the misconduct to survive and thrive. The paper also identifies areas for further research in this field.

In “Management of behavioral risk in the first line of defence”, our final paper, Jürgen Bott and Udo Milkau suggest that the major operational risk events of the last decade – the financial crisis, the settlement of legal claims against banks, criminal actions such as rogue trading, etc – have underlined the importance of operational risks for banks. Approaches for dealing with such operational risks cover everything from risk governance to the methodology of modeling risk. According to the authors, the behavior of decision makers in handling these events can itself be a new type of risk: behavioral risk. However, very little attention has been paid to behavioral risk management as the first line of defense. This paper discusses key features of managing behavioral risk in the business line of operations, which is the central hub for all transactions in a bank. Using examples such as best practice in aviation, different possible solutions – from training single subject-matter experts to better communication at the enterprise level – are discussed.

Marcelo Cruz

#### Papers in this issue

##### An operational risk-based regime-switching model for stock prices

This paper proposes a new risk-based regime-switching model for stock prices to examine the impact of operational risk events on stock prices.

##### The issues with the standardized measurement approach and a potential future direction for operational risk capital modeling

This paper discusses the criticism and praise the SMA and AMA have received, respectively, in many recent articles.

##### Behavioral risks at the systemic level

By comparing the Libor and FX benchmark manipulation scandals, this paper describes how misbehavior emerged independently in both of these markets and the conditions that permitted the misconduct to survive and thrive.

##### Management of behavioral risk in the first line of defence

This paper discusses key features of fighting behavioral risk in the business line of operations as the central hub for all transactions in a bank.

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