Most international banks are increasing their operational-risk cover to comply with the new capital requirements in Basel II.1 Operational risk is a financial institution's exposure to losses arising from mistakes (such as computer failure and breach of regulations) and conspiracies (including loan fraud and embezzlement) that affect its day-to-day business.
Banks generally calculate their operational-risk cover by estimating the probability that a particular event might occur and the resulting financial loss—such as the fine for breaking a rule or the sum pocketed by an embezzler. But operational crises also upset shareholders and can lead to a decline in market value.
Few institutions, however, factor such potential market losses into their risk-cover calculations or operational-risk-management plans. New research suggests that they should. The decline in market value following an operational crisis can be far greater than the financial loss. The first step for banks will be to measure and understand the full extent of their operational risk.
We analyzed operational crises at European and North American institutions for which the actual financial loss was more than $1 million.2 The average actual loss for the sample was $65 million. In the short term, the decline in shareholder value was, on...