Bringing order to op risk and the duck-billed platypus

Industry co-operation on operational risk taxonomies might yield a valuable tool

Taxonomies are mostly found in biology, where they are used to classify and distinguish between different types of living organism. Using a taxonomy, species as diverse as the great-crested newt, lesser-spotted woodpecker and duck-billed platypus can be organised and arranged in a way that brings a sense of scientific order to our chaotic natural world.

In the field of operational risk management – which is often equally chaotic – taxonomies have come in very useful. The use of an op risk taxonomy, or risk register, forges a common language for the risks faced by a firm and assists with risk reporting. Perhaps more importantly, it can help firms to put in place an effective and comprehensive set of controls.

While a biological taxonomy might feature great pandas, muntjacs or spiny lumpsuckers, the entries in an op risk taxonomy are more likely to encompass internal fraud, terrorism, employee practices and workplace safety. Ideally, practitioners say that each of these risks or risk categories should be mirrored with a list of relevant controls. Against employee practices and workplace safety, for example, the controls listed might include recruitment, training or background checks.

As with many other aspects of risk management, there isn't necessarily a right or wrong way to do this. The correct taxonomy is likely to change depending on the exposure, activity and strategic objectives of your business.

The Basel Committee on Banking Supervision uses seven broad op risk loss event categories, but risk managers say these are far from definitive. Consequently, financial institutions have adopted different ways of tackling the issue; practitioners say banks' op risk taxonomies can include anything from 50 to 250 lower-level risks. "There's a marked variability between the different types of taxonomies used by financial services firms," remarks one London-based chief risk officer.

Still, there is much that financial firms can learn from each other. And major banks are increasingly looking to their peers for guidance on best practice. The need for co-operation in the area of op risk is perhaps all the more urgent, since banks face pressure to cut costs, boost shareholder returns and comply with onerous new regulations. If prowess in op risk management was ever viewed as a source of competitive advantage, well, things have changed.

In February, Risk.net reported that op risk practitioners from eight major banks, including Deutsche Bank, JP Morgan and HSBC, were attempting to draw up an industry standard taxonomy for use as a best-practice guide. When it comes to taxonomies, one size will never fit all, as Richard Cech, operational risk examiner at the Federal Reserve Bank of New York, has pointed out. But this is nonetheless a useful step towards creating a common frame of reference.

Armed with this valuable tool, firms might be able to make the world of op risk a little less chaotic, and perhaps more similar to that of the duck-billed platypus.