“The determinants of operational risk in U.S. financial institutions”

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Author Information : Anna Chernobai (Whitman School of Management, Syracuse University)
Philippe Jorion (Paul Merage School of Business, University of California at Irvine)
Fan yu (Claremont McKenna College)

Year of Publication : Journal of Financial and Quantitative Analysis (2011)

Summary of Findings : We show that most operational losses can be traced to a breakdown of internal control, and that firms suffering from these losses tend to be younger and more complex, and have higher credit risk, more antitakeover provisions, and chief executive officers (CEOs) with higher stock option holdings and bonuses relative to salary.

Research Questions : Is there a way for appropriately assess operational risk in the financial sector?

What we know : Many recent high-profile losses in the financial industry have been traced to operational risk. This research attempts to determine how to assess operational risk in financial institutions.

The Basel Capital Accord mandates banks worldwide to estimate their operational risk capital as a buffer against potential future operational losses.

Novel Findings : Most operational losses can be traced to a breakdown of internal control.

Firms suffering from these losses tend to be younger, more complex, have higher credit risk, more antitakeover provisions and CEOs with higher stock option holdings and salary bonuses.

Novel Methodology : This study used a new operational loss data source, Algo FIRST, that gathers information from public sources.

Unlike earlier academic studies on operational risk, this study uses an econometric methodology to assess the frequency of operational risk and evaluate the relevance of firm-specific and macroeconomic factors.

Implications for Practice : Businesses could mitigate operational losses by implementing stricter internal control and management oversight.

Businesses should not treat these operational loss events in a vacuum but rather should understand the internal measures of risk that led to the loss.

Operational risk is a channel through which financial distress and poor governance can lead to significant costs to firms.

Implications for Policy: This study is applicable to bank regulators and risk managers, who must develop quantitative measures of operational risk mitigation.

Implications for Society: This study seeks to determine how analyzing operational risk can mitigate financial losses at financial institutions, which often affect millions of investors. If businesses increase internal controls, there could be fewer instances of these significant high-profile losses.

Implications on Research: Academic research that sheds light on the determinants of operational risk in financial institutions is very limited and this paper fills that void.

Full Citations : Anna Chernobai, “The determinants of operational risk in U.S. financial institutions”
(with Jorion, P. & Yu, F.), Journal of Financial and Quantitative Analysis, 46 (6), pp. 1683-1725, 2011.

http://journals.cambridge.org/download.php?file=%2FJFQ%2FJFQ46_06%2FS0022109011000500a.pdf&code=aef03922b590f4568eb4aa14d4bda045

Abstract : We examine the incidence of operational losses among U.S. financial institutions using publicly reported loss data from 1980 to 2005. We show that most operational losses can be traced to a breakdown of internal control, and that firms suffering from these losses tend to be younger and more complex, and have higher credit risk, more antitakeover provisions, and chief executive officers (CEOs) with higher stock option holdings and bonuses relative to salary. These findings highlight the correlation between operational risk and credit risk, as well as the role of corporate governance and proper managerial incentives in mitigating operational risk.

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Anna Chernobai

Anna Chernobai

Professor Chernobai is an associate professor of finance. Her research interests lie in the area of financial mathematics and statistics applied to the management and modeling of financial risks in banking institutions.
Anna Chernobai
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