Troy, N.Y. — How banks respond to regulations and manage risk isn’t always what it seems. Research at Rensselaer Polytechnic Institute (RPI) by Brian Clark, assistant professor of banking and corporate finance at the Lally School of Management—“Risk Shifting and Regulatory Arbitrage: Evidence from Operational Risk,” (2017) with Alireza Ebrahim of the Office of the Comptroller of the Currency—studied this concept closely. 

The researchers examined the state of the banking industry leading up to and including the financial crisis of 2007-2009, using data collected by regulatory agencies on operational losses incurred by a sample of large U.S. banks. They attribute the drastically increased exposure of banks to operational risk in the years leading up to the crisis to a lack of prudent regulations during this time. This increased exposure then contributed to the severity of the crisis. 

Generally, operational risk is seen as the risk of a loss resulting from the failure of a bank’s people or processes. It does not include credit or market risk. Credit risk arises when a bank makes bad loans and market risk arises when it makes poor investment decisions. Operational risk, however, refers to losses that may arise from the way a bank is managed, induced by poor systems and controls that leave it vulnerable to setbacks from activities such as fraud, legal exposure, and business disruptions caused by “acts of God.” 

The study references several prominent examples of operational losses:

• Insufficient controls that led rogue traders such as the “London Whale” at JP Morgan Chase to incur $6 billion in trading losses.

• The LIBOR interest rate rigging scandal where banks were accused of colluding to manipulate market prices and ultimately forced to pay large fines when they got caught.

• The mishandling of mortgage foreclosures and sale of mortgage-backed securities that forced banks to pay billions of dollars in penalties to government regulators.

• Improper sales practices such as the recent Wells Fargo cross-selling scandal where employees created fictitious accounts without customers’ knowledge and ultimately exposed the bank to millions of dollars in fines and penalties, public Senate hearings, and a top management shake-up.

So how important are these losses in the big picture? One public study by the Boston Consulting Group (2017) estimates that approximately $321 billion in fines were paid by North American and European banks in the aftermath of the recent financial crisis. Moreover, authorities estimate that operational risk composes roughly 25 percent of large U.S. banks’ risk profiles. So by either measure, operational failures are an important component of risk management in banking.

Turning to the question of why banks would take on such exposure, Clark and Ebrahim argue that banks amassed operational risk to get around regulations meant to limit total risk exposure, a process 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 banks to become riskier without regulators knowing it.

“Our research explains that operational risk offered a way for banks to leverage themselves in the moment but not have to pay for the consequences until later. Typically, there is a delay between the time of the risk and the financial loss,” said 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 study found that insufficient regulation prior to the financial crisis allowed banks to make risky operational decisions, which backfired on them during the crisis, thus exacerbating the severity of the crisis.

So what is the likelihood that operational risk will contribute to another financial crisis? According to Clark, regulatory agencies now examine it much more closely. It is a key component of the stress tests mandated by the Dodd-Frank Act and accounts for about 25 percent of the total risk assessed by regulators. With these controls, operational risk should play a smaller role than the last time in worsening any future financial crises.

The Rensselaer faculty research by Brian Clark exemplifies The New Polytechnic, an emerging paradigm for teaching, learning, and research at Rensselaer. The New Polytechnic emphasizes and supports collaboration across disciplines, sectors, and regions to address the great global challenges of our day, using the most advanced tools and technologies, many of which are developed at Rensselaer. Research at Rensselaer addresses some of the world’s most pressing technological challenges—from energy security and sustainable development to biotechnology and human health. The New Polytechnic is transformative in the global impact of research, in its innovative pedagogy, and in the lives of students at Rensselaer.

About Rensselaer Polytechnic Institute

Rensselaer Polytechnic Institute, founded in 1824, is America’s first technological research university. For nearly 200 years, Rensselaer has been defining the scientific and technological advances of our world. Rensselaer faculty and alumni represent 85 members of the National Academy of Engineering, 17 members of the National Academy of Sciences, 25 members of the American Academy of Arts and Sciences, 8 members of the National Academy of Medicine, 8 members of the National Academy of Inventors, and 5 members of the National Inventors Hall of Fame, as well as 6 National Medal of Technology winners, 5 National Medal of Science winners, and a Nobel Prize winner in Physics. With 7,000 students and nearly 100,000 living alumni, Rensselaer is addressing the global challenges facing the 21st century—to change lives, to advance society, and to change the world. To learn more, go to www.rpi.edu.

Disclaimer

The views in this article and the research study mentioned herein are those of the authors alone and do not necessarily reflect those of the Office of the Comptroller of the Currency.

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