TOO MUCH OPERATIONAL RISK might have been one of the major factors that led to the banking crisis of 2007–2009. That’s according to a new paper published by Brian Clark, assistant professor of banking and corporate finance at the Rensselaer Polytechnic Institute in Troy, New York, and Alireza Ebrahim of the Office of the Comptroller of the Currency in Washington, D.C. Using data collected by regulatory agencies, Clark and Ebrahim studied the activities of a sample of large U.S. banks. They concluded that a lack of prudent regulations in the years leading up to the crisis drastically exposed the banks to unnecessary operational risks.
Generally, they note, operational risk arises from the way a bank is managed or the way its systems and controls leave it vulnerable to fraud, legal claims, and external business disruptions. Operational risk does not include credit risk, which arises when a bank makes bad loans, or market risk, which occurs when a bank makes poor investment decisions. Authorities estimate that operational risk accounts for roughly 25 percent of the risk profile of large U.S. banks.
Why would banks leave themselves so vulnerable? Clark and Ebrahim argue that, in the years leading up to the financial crisis, banks assumed operational risks to get around regulations meant to limit total risk exposure—a practice known as regulatory arbitrage. The authors note that before the financial crisis, regulators considered operational risk benign, so they didn’t closely examine it in financial institutions. This opened the door for banks to increase their exposure over time without having to account for this risk on their books, ultimately allowing them to become riskier without regulators knowing it.
“Typically, there is a delay between the time of the risk and the financial loss,” explains Clark. “For example, banks can increase their exposure by not investing in or maintaining the latest information technology infrastructure or by cutting governance costs such as monitoring of employees. These actions can reduce costs or increase revenues in the short term, but in the long term they may lead to large losses from IT failures or misconduct by unmonitored employees.”
Ultimately, the banks’ risky operational decisions backfired, exacerbating the severity of the recession. Clark believes that banking controls such as the Dodd-Frank Act lead regulatory agencies to examine operational risk more closely today, making it less likely that it will contribute to another financial crisis in the future.
“Risk Shifting and Regulatory Arbitrage: Evidence from Operational Risk” was posted June 26, 2017, at papers.ssrn.com/sol3/papers.cfm?abstract_id=2991789.