Supervising Operational Risks: A New Index of Key Risk Indicators Approach

Abstract

This paper proposes a new index of Key Risk Indicators (KRI) as an effective framework for the measurement, management, and supervision of operational risks. In doing so, this paper collects thirty core KRI's with unified definitions for the January 2007-June 2010 period from six large Korean advanced measurement approach (AMA) banks. The core KRI's are selected in such a way to account for the operational risk types categorized by Basel II and the number of assigned core KRI's to each operational risk type is intended to mimic the observed pattern of the actual operational losses experienced by large banks during the 2004-2009 period. The historical banking industry operational risk index (ORI) suggests a downward trend since the Lehman Brothers bankruptcy, and particularly during the first half of 2009, reflecting in part, banks' tighter implementations of operational risk management to survive through a crisis, and thereof economic recession, and in part, tighter monitoring by the supervisors as part of micro-prudential surveillance during a crisis. The empirical results indicate that 35 percent of the variation of 6-month-ahead actual loss events is explained by the current banking industry ORI suggesting its potential usefulness as an early warning system for the state of operational risks. Further, the results suggest that the individual banks' operational risks are closely related to the characteristics of their portfolios.