Skip to main content

The Determinants of Operational Risk in U.S. Financial Institutions

  • Anna Chernobai (a1), Philippe Jorion (a2) and Fan Yu (a3)

We examine the incidence of operational losses among U.S. financial institutions using publicly reported loss data from 1980 to 2005. We show that most operational losses can be traced to a breakdown of internal control, and that firms suffering from these losses tend to be younger and more complex, and have higher credit risk, more antitakeover provisions, and chief executive officers (CEOs) with higher stock option holdings and bonuses relative to salary. These findings highlight the correlation between operational risk and credit risk, as well as the role of corporate governance and proper managerial incentives in mitigating operational risk.

Hide All
Acharya, V.; Davydenko, S.; and Strebulaev, I.. “Cash Holdings and Credit Risk.” Working Paper, University of Toronto (2007).
Allen, L., and Bali, T. G.. “Cyclicality in Catastrophic and Operational Risk Measurements.” Journal of Banking and Finance, 31 (2007), 11911235.
Arnold, M.; Larsen, P. T.; Hollinger, P.; O’Doherty, J.; and Milne, R.. “How Kerviel Exposed Lax Controls at Société Générale.” Financial Times (Feb. 7, 2008).
Ashbaugh-Skaife, H.; Collins, D. W.; and Kinney, W. R. Jr. “The Discovery and Reporting of Internal Control Deficiencies Prior to SOX-Mandated Audits.” Journal of Accounting and Economics, 44 (2007), 166192.
Ashbaugh-Skaife, H.; Collins, D. W.; Kinney, W. R. Jr.; and LaFond, R.. “The Effect of SOX Internal Control Deficiencies on Firm Risk and Cost of Equity.” Journal of Accounting Research, 47 (2009), 143.
Basel Committee on Banking Supervision. Operational Risk Management. Basel, Switzerland: Bank of International Settlements (1998).
Basel Committee on Banking Supervision. A New Capital Adequacy Framework. Basel, Switzerland: Bank of International Settlements (1999).
Basel Committee on Banking Supervision. Operational Risk. Basel, Switzerland: Bank of International Settlement (2001).
Basel Committee on Banking Supervision. International Convergence of Capital Measurement and Capital Standards. Basel, Switzerland: Bank of International Settlements (2006).
Basel Committee on Banking Supervision. Enhancements to the Basel II Framework. Basel, Switzerland: Bank of International Settlements (2009a).
Basel Committee on Banking Supervision. Observed Range of Practice in Key Elements of Advanced Measurement Approaches (AMA). Basel, Switzerland: Bank of International Settlements (2009b).
Basel Committee on Banking Supervision. Strengthening the Resilience of the Banking Sector. Basel, Switzerland: Bank of International Settlements (2009c).
Bertrand, M., and Mullainathan, S.. “Enjoying the Quiet Life? Corporate Governance and Managerial Preferences.” Journal of Political Economy, 111 (2003), 10431075.
Bharath, S. T., and Shumway, T.. “Forecasting Default with the Merton Distance to Default Model.” Review of Financial Studies, 21 (2008), 13391369.
Black, F., and Scholes, M.. “The Pricing of Options and Corporate Liabilities.” Journal of Political Economy, 81 (1973), 637654.
Brown, S.; Goetzmann, W.; Liang, B.; and Schwarz, C.. “Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund Registration.” Journal of Finance, 63 (2008), 27852815.
Burns, N., and Kedia, S.. “The Impact of Performance-Based Compensation on Misreporting.” Journal of Financial Economics, 79 (2006), 3567.
Callas, P. W.; Pastides, H.; and Hosmer, D. W.. “Empirical Comparisons of Proportional Hazards, Poisson, and Logistic Regression Modeling of Occupational Cohort Data.” American Journal of Industrial Medicine, 33 (1998), 3347.
Cochran, W. G. “The χ 2 Test of Goodness of Fit.” Annals of Mathematical Statistics, 23 (1952), 315345.
Cochran, W. G. “Some Methods for Strengthening the Common χ 2 Tests.” Biometrics, 10 (1954), 417451.
Collier, C.; Forbush, S.; A Nuxoll, D.; and O’Keefe, J.. “The SCOR System of Off-Site Monitoring: Its Objectives, Functioning, and Performance.” FDIC Banking Review, 15 (2003), 1732.
Collin-Dufresne, P.; Goldstein, R. S.; and Helwege, J.. “Is Credit Event Risk Priced? Modeling Contagion via the Updating of Beliefs.” Working Paper, Carnegie-Mellon University (2003).
Core, J., and Guay, W.. “Estimating the Value of Employee Stock Option Portfolios and Their Sensitivities to Price and Volatility.” Journal of Accounting Research, 40 (2002), 613630.
Cummins, J. D.; Lewis, C. M.; and Wei, R.. “The Market Value Impact of Operational Loss Events for U.S. Banks and Insurers.” Journal of Banking and Finance, 30 (2006), 26052634.
Das, S. R.; Duffie, D.; Kapadia, N.; and Saita, L.. “Common Failings: How Corporate Defaults Are Correlated.” Journal of Finance, 62 (2007), 93117.
Dechow, P. M.; Sloan, R. G.; and Sweeney, A. P.. “Causes and Consequences of Earnings Manipulation: An Analysis of Firms Subject to Enforcement Actions by the SEC.” Contemporary Accounting Research, 13 (1996), 136.
DeFond, M. L., and Jiambalvo, J.. “Debt Covenant Violation and Manipulation of Accruals.” Journal of Accounting and Economics, 17 (1994), 145176.
de Fontnouvelle, P.; DeJesus-Rueff, V.; Jordan, J. S.; and Rosengren, E. S.. “Capital and Risk: New Evidence on Implications of Large Operational Losses.” Journal of Money, Credit, and Banking, 38 (2006), 18191846.
de Fontnouvelle, P.; Rosengren, E. S.; and Jordan, J. S.. “Implications of Alternative Operational Risk Modeling Techniques.” In The Risk of Financial Institutions, Carey, M. and Stulz, R. M., eds. Chicago, IL: University of Chicago Press (2006), 475512.
Dichev, I. D., and Skinner, D. J.. “Large-Sample Evidence on the Debt Covenant Hypothesis.” Journal of Accounting Research, 40 (2002), 10911123.
Doyle, J.; Ge, W.; and McVay, S.. “Determinants of Weaknesses in Internal Control over Financial Reporting.” Journal of Accounting and Economics, 44 (2007a), 193223.
Doyle, J. T.; Ge, W.; and McVay, S.. “Accruals Quality and Internal Control over Financial Reporting.” Accounting Review, 82 (2007b), 11411170.
Draper, N. R., and Smith, H.. Applied Regression Analysis. New York, NY: John Wiley & Sons (1981).
Duffie, D.; Eckner, A.; Horel, G.; and Saita, L.. “Frailty Correlated Default.” Journal of Finance, 64 (2009), 20892123.
Duffie, D.; Saita, L.; and Wang, K.. “Multi-Period Corporate Default Prediction with Stochastic Covariates.” Journal of Financial Economics, 83 (2007), 635665.
Duffie, D., and Singleton, K. J.. “Modeling Term Structures of Defaultable Bonds.” Review of Financial Studies, 12 (1999), 687720.
Efendi, J.; Srivastava, A.; and Swanson, E. P.. “Why Do Corporate Managers Misstate Financial Statements? The Role of Option Compensation and Other Factors.” Journal of Financial Economics, 85 (2007), 667708.
Elbannan, M. A. “Quality of Internal Control over Financial Reporting, Corporate Governance, and Credit Ratings.” International Journal of Disclosure and Governance, 6 (2009), 127149.
Estrella, A.; Park, S.; and Peristiani, S.. “Capital Ratios as Predictors of Bank Failure.” Federal Reserve Bank of New York Economic Policy Review, 6 (2000), 3352.
Fama, E. F., and French, K. R.. “The Cross-Section of Expected Stock Returns.” Journal of Finance, 47 (1992), 427465.
Federal Deposit Insurance Corporation. “The Banking Crises of the 1980s and Early 1990s: Summary and Implications.” FDIC Banking Review, 11 (1998), 155.
Gompers, P.; Ishii, J. Y.; and Metrick, A.. “Corporate Governance and Equity Prices.” Quarterly Journal of Economics, 118 (2003), 107155.
Hammersley, J.; Myers, L.; and Zhou, J.. “The Failure to Remediate Previously-Disclosed Material Weaknesses in Internal Controls.” Working Paper, University of Georgia (2009).
Hocking, R. R. “The Analysis and Selection of Variables in Linear Regression.” Biometrics, 32 (1976), 149.
Jarrow, R. A.; Bennett, R. L.; Fu, M. C.; Nuxoll, D. A.; and Zhang, H.. “A General Martingale Approach to Measuring and Valuing the Risk to the FDIC Deposit Insurance Funds.” Working Paper, FDIC (2003).
Jarrow, R. A., and Turnbull, S. M.. “Pricing Derivatives on Financial Securities Subject to Credit Risk.” Journal of Finance, 50 (1995), 5385.
Jarrow, R. A., and Yu, F.. “Counterparty and the Pricing of Defaultable Securities.” Journal of Finance, 56 (2001), 17651799.
Jin, L., and Myers, S. C.. “ R 2 Around the World: New Theory and New Tests.” Journal of Financial Economics, 79 (2006), 257292.
Lando, D.On Cox Processes and Credit Risky Securities.” Review of Derivatives Research, 2 (1998), 99120.
Lando, D., and Nielsen, M. S.. “Correlation in Corporate Defaults: Contagion or Conditional Independence?Journal of Financial Intermediation, 19 (2010), 355372.
Merton, R. C. “On the Pricing of Corporate Debt: The Risk Structure of Interest Rates.” Journal of Finance, 29 (1974), 449470.
Moody’s Investors Service. Moody’s RiskCalc™ Model for Privately-Held U.S. Banks. (2002).
Moody’s Investors Service. Section 404 Reports on Internal Control. (2004).
Office of the Comptroller of the Currency. An Examiner’s Guide to Problem Bank Identification, Rehabilitation, and Resolution. (2001).
Perry, J., and de Fontnouvelle, P.. “Measuring Reputational Risk: The Market Reaction to Operational Loss Announcements.” Working Paper, Federal Reserve Bank of Boston (2005).
Petersen, M. A. “Estimating Standard Errors in Finance Panel Data Sets: Comparing Approaches.” Review of Financial Studies, 22 (2009), 435480.
Povel, P.; Singh, R.; and Winton, A.. “Booms, Busts, and Fraud.” Review of Financial Studies, 20 (2007), 12191254.
Public Company Accounting Oversight Board. An Audit of Internal Control over Financial Reporting Performed in Conjunction with an Audit of Financial Statements. (2004).
Richardson, S.; Tuna, I.; and Wu, M.. “Predicting Earnings Management: The Case of Earnings Restatements.” Working Paper, University of Pennsylvania (2002).
Rosenberg, J. V., and Schuermann, T.. “A General Approach to Integrated Risk Management with Skewed, Fat-Tailed Risks.” Journal of Financial Economics, 79 (2006), 569614.
Sweeney, A. P. “Debt-Covenant Violations and Managers’ Accounting Responses.” Journal of Accounting and Economics, 17 (1994), 281308.
Vassalou, M., and Xing, Y.. “Default Risk in Equity Returns.” Journal of Finance, 59 (2004), 831868.
Recommend this journal

Email your librarian or administrator to recommend adding this journal to your organisation's collection.

Journal of Financial and Quantitative Analysis
  • ISSN: 0022-1090
  • EISSN: 1756-6916
  • URL: /core/journals/journal-of-financial-and-quantitative-analysis
Please enter your name
Please enter a valid email address
Who would you like to send this to? *


Full text views

Total number of HTML views: 0
Total number of PDF views: 228 *
Loading metrics...

Abstract views

Total abstract views: 1042 *
Loading metrics...

* Views captured on Cambridge Core between September 2016 - 22nd May 2018. This data will be updated every 24 hours.