This chapter addresses the issue of whether and to what extent banks should be required by regulation to hold capital against operational risks. It argues that the types of operational risk for which Basel II requires capital, internal or external event risks, are and should be dealt with
by other means–better controls, loss provisions or insurance. Basel’s definition of “operational risk” excludes the major category of nonfinancial risk for which banks do hold capital–namely, business risk. According to the chapter’s estimates, business risk accounts for slightly more than half of a bank’s total nonfinancial risk, which, in turn, averages about 25-30% of economic capital. Analyzing legal risk, as a type of operational risk, the chapter shows the difficulties in defining or predicting such risk, and that the amount of such risk will vary depending on the
legal jurisdictions to which a bank is subject. It also argues that the Basel II limit of 20% on capital mitigation achievable through insurance is arbitrary and creates a perverse incentive for banks to be underinsured. It generally concludes that banks should not be required by regulation
to hold capital for operational risks; the issue would be better dealt with through supervision and market discipline.