Insuring versus Self-Insuring Operational Risk

Abstract

Procedures for measuring exposure to market risk, and for allocating risk capital against it, have been put into place by banking authorities in Europe and the U.S. The next stage of the process, embodied in Basel II, brings operational risk into consideration as well. Although there is no reward in the form of higher returns from bearing operational risk, reducing it does entail increased costs, either in the form of more extensive and expensive internal controls, or as explicit protection purchased from outside insurers. This raises the familiar problem of conflict of interest between management, acting on behalf of a bank's shareholders, and the ‘debtholders,’ in this case the depositors, and/or the deposit insurance authority. This short article illustrates, in a simple example, the conflict of interest in mitigating operational risk within a bank.