Op risk is much more than a capital allocation exercise, says Moody's

Moody's Investors Service said banks should treat operational risk management as much more than just another regulatory capital allocation exercise. In a special report, the international rating agency said capital is "an incomplete line of defence" against operational risks – especially the risk of fraud by rogue traders.

While banks are focusing on the capital allocation guidelines of Basel II – banking regulators' planned new guidelines for the allocation of bank capital against market, credit and operational risks, which is due in 2006 – Moody's said it is encouraged that some banks are nevertheless broadening their approach to address the true challenges of operational risk.

Sam Theodore, Moody's managing director for European bank ratings and author of the new report, said: "We also believe that the use of quantitative criteria for operational risk management - building a loss database for the bank, benchmarking it against external industry data or trying to predict expected operational losses through statistical models - certainly has its place, but only as first step."

What remains critically important is the implementation of an effective qualitative process of identifying, measuring, managing and controlling operational risk throughout the organisation, said Moody's in its report.