The researcher introduces the paper by echoing comments by the former Federal Reserve Board president Allan Greenspan’s who reiterated that risk taking is a primary economic function for regulated entities including banks and other financial institutions. The author argues that minimizing risk taking behavior totally, would eliminate the purpose for banking systems. It is therefore imperative that banking systems are designed to address risk challenges. In this regard, economic conditions have led to concerted efforts from different stakeholders.
The author explores how central bank governors from the G-10 countries embarked on proactive measures to safeguard banks from increased financial risk during the economic crisis of 1970/1980. For instance the author examines how the establishment of the Basel Committee helped to safeguard international financial institutions from the surging financial risks occasioned by the global economic depression. Similar strategies were employed in 1988 with the introduction of capital measurement system for regulation on requirements for exposure to market risks.
The Basel accord has undergone tremendous development since its inception. The author reveals that during the Asian economic crises of 1997 (BCBS 1999), economic integration and forces driven by globalization led to financial instabilities that necessitated refinement of the Basel accord. The author holds that this led to the proposal of introducing guidelines for new capital adequacy frameworks in 1999. This new framework also refers to as the Basel two accords are made up of three pillars. One of the pillars identified is the minimum capital requirements.
The second pillar identified under the Basel two accords is the supervisory review while the third pillar is the market discipline aspect of the guidelines. A critical analysis of the changes in the accord reveal that the main objective of revising the accord enacted in 1988 was to put in place a framework for stabilizing international banking systems. However, it is also notable that this review was also made to eliminate inconsistencies and competitive inequalities in players within the international banking sector.
Under this project, it is very clear that although operational risks have been ignored in the past, such risks have the potential of crumbling the global international financial systems. It is under this realization that the committee included operational risks in the Basel two frameworks in line with emerging trends where operational risks have been shown to have greater value in defining international financial stability and trends.
The increased attention on operational costs has also led the author to examine its definition, meaning the risk from internal and external factors. Jack (King 1998) has also stated that operational risks may emanate from not only operational failures and internal challenges but also from such external factors like terrorism attacks, failure in management or natural disasters. As such, it is imperative that financial institutions and banks must be cushioned against financial risks which are the fundamental reason for the inclusion of operational risk compensation (Walter 2003).
The author uses this purpose as the lynchpin to state his thesis which is to explore on various statistical methods to calculate capital charge for operational risk and their effectiveness. In chapter two, the researcher explores the ration for the research by underscoring how financial institutions are under pressure to manage operational risks. There is pressure for financial institutions to comply with regulatory requirements as well as for the institutions to adopt new technologies and sophisticated financial products and operational systems.