Occasionally, you will hear a news report about an operational breakdown that exposed a bank to fraud or other misdeeds. In some instances, the losses incurred from the breakdown caused the bank to fail. One well-publicized incident is the 1995 failure of Barings PLC. This bank failed after losing $1.4 billion on trades made by a rogue futures trader at its Hong Kong office.

Sometimes, the losses—although large—don’t bring down the institution completely, but instead might cause it significant financial harm and damage its reputation. For example in 2008, Societe Generale reported $7.6 billion in trading losses, also at the hands of a rogue futures trader.

Although the previously stated examples pertained to large financial organizations, operational breakdowns affect banks of all sizes. As then-Governor Susan Schmidt Bies said in an August 10, 2003, speech before the American Bar Association, "If you look at small banks that have failed, they’re not failing anymore…because of credit risk like they traditionally have. Most failures now…are due to breaks in operating risk…" That observation still holds true. In fact, many of the bank failures that have occurred in the United States have involved fraud at smaller banks.

Fraud, embezzlement, unintentional human error, natural disasters and other events that can harm a bank are commonly grouped together in a category known as operational risk. In this lesson, you will learn how a bank identifies and controls operational risk to limit its financial harm.

Lesson Objectives

After you complete this lesson, you should be able to:

• define operational risk,
• identify sources of operational risk,
• describe methods used to control or mitigate operational risk, and
• list ways that banks monitor the adequacy of their operational risk management.