However, we are at least talking about a reasonably well-defined type of risk and one which is quantifiable in statistical terms. We are in much more difficult territory when it comes to operational risk. The term operational risk covers a wide range of types and sources of risk, and banks’ data bases of loss are generally patchy. There are numerous questions not only about the appropriate design of the charge, but also about the appropriate level. It is clear that some types of operational risk, such as fraud, can result in huge spikes of loss, as we saw in the case of Barings and Morgan Grenfell. Even though we are concerned with protecting the system, I feel it would be inappropriate to expect most banks to hold an additional cushion of capital to cover these sorts of very rare events: it would either be grossly excessive for most of the time, or alternatively seriously inadequate if a major problem arose. So the focus here must be on systems and controls, and on using variable target capital ratios under Pillar 2 to encourage improvements in these. Moreover, the appropriate level of capital will depend in part on how far we think operational losses are correlated with other types of loss which are already covered by capital. Probably there are some types of operational loss - processing errors, settlement delays - which do not exhibit a high correlation with either credit or market risk.
But in practice, there is clear evidence that credit or market losses put pressure on the firm, which can push managers into fraud or result in operationally-risky cost cutting. There have certainly been occasions when operational losses have only been revealed because of a market downturn or similar event. As I heard it graphically expressed the other day: “It is only when the tide goes out that you discover who is not wearing a bathing costume”! I am optimistic that, over time, operational risk will become more measurable and that, as was the case for market risk models, a consensus on methods of quantifying it will emerge. The Basel Committee’s framework will certainly have to be flexible in the face of this evolution. However, we should also not lose sight of the fact that the Committee’s announced aim is not just coverage of operational risks, but “other” risks more generally. Episodes of market turmoil over the past couple of years have BIS Review 132/1999  4  demonstrated just how wide is the range of risks that are not currently explicitly covered by regulatory capital; I would include under this heading market liquidity risk, individual bank liquidity risk, correlation risk between credit and market risks, and legal and reputational risk. These types of risk can certainly produce systemic disruptions. My expectation would be that, even with further advances on measuring operational and credit risk, most banks will want to carry a chunk of fairly undefined capital to cover rainy day events.