Operational Risk Supervision Quiz

Questions and Answers

What is the main purpose of thematic on-site visits conducted by supervisors?

To dictate firm-specific actions without broader trends

To assess operational risks across the industry (correct)

To increase supervisory staff numbers

To evaluate a specific firm's financial condition

Which operational risk is likely addressed by thematic visits after major events like 9/11 or the 2007-9 crisis?

Documentation risk (correct)

Confidentiality risk

Interest rate risk

Market risk

Supervisory bodies rely on which of the following to manage their resources effectively?

Generalized knowledge from all staff

Adherence to outdated operational risk models

Available knowledge and skills of their staff (correct)

Insufficient resources for detailed coverage

What is a common approach by supervisors in issuing guidance on operational risk?

Principles-based approach linked to standard-setters Signup and view all the answers

Which of these is NOT a focus for supervisors during thematic visits?

Market fluctuation risk Signup and view all the answers

What type of events influence the resource allocation of supervisory bodies?

Current events and crises Signup and view all the answers

When conducting thematic visits, which type of expert might a supervisory body hire?

Cyber-crime experts Signup and view all the answers

Which statement accurately reflects the supervisory approach towards operational risk?

Guidance may range from detailed instructions to high-level principles. Signup and view all the answers

What act was implemented in response to corporate failures around the year 2000?

Sarbanes-Oxley Act Signup and view all the answers

What was a key aim of the Sarbanes-Oxley Act regarding financial accounts?

To enhance disclosure of financial information Signup and view all the answers

Which financial scandals prompted the implementation of the Sarbanes-Oxley Act?

Enron and Worldcom Signup and view all the answers

What significant requirement does the Sarbanes-Oxley Act impose on large firms?

To identify and document key controls in financial reporting Signup and view all the answers

What consequence does a failure to comply with the Sarbanes-Oxley Act have?

Potential criminal action against individuals Signup and view all the answers

How did critics view the implications of implementing the Sarbanes-Oxley Act?

It required extensive documentation and was expensive Signup and view all the answers

What aspect of financial reporting did SOX particularly emphasize?

Controls around both on-balance sheet and off-balance sheet items Signup and view all the answers

What has been a routine practice in US corporations since the inception of the Sarbanes-Oxley Act?

Integration of SOX compliance into risk and control frameworks Signup and view all the answers

What is a commonly held view regarding setting capital for operational risk in banks?

It serves no purpose as losses are absorbed in annual profit. Signup and view all the answers

What problem arises from the Basel Committee's capital levels in relation to operational risk?

They may be inadequate in case of a catastrophic operational risk event. Signup and view all the answers

What do critics argue about the calibration of capital standards for operational risk?

They are often arbitrarily set and may not reflect actual operational risks. Signup and view all the answers

How might the correlation (or lack thereof) between operational, credit, and market risk affect bank capital management?

It could mean that capital allocated for other risks may cover operational losses. Signup and view all the answers

What criticism is levied against banks concerning the management of operational risk?

They focus excessively on capital instead of risk management. Signup and view all the answers

What is the primary issue identified in the operational risk capital approaches discussed?

They are overly simplified and do not capture the risks banks face. Signup and view all the answers

Which of the following describes the relationship between operational losses and annual profit in banks?

Annual profit is typically enough to cover operational losses. Signup and view all the answers

What might the setting of capital for operational risk potentially distract banks from?

Implementing robust risk management systems. Signup and view all the answers

What does the Internal Loss Multiplier (ILM) relate to in calculating capital requirements?

Historical operational risk losses Signup and view all the answers

How does the ILM change with respect to the ratio of Loss Component (LC) to Bank Internal Capital (BIC)?

It increases at a decreasing rate Signup and view all the answers

What discretion do national supervisors have regarding the ILM?

They can set the ILM to one for all banks Signup and view all the answers

What significant change occurred in operational risk regulation for insurance firms with the introduction of Solvency II?

It greatly expanded the regulations concerning operational risk Signup and view all the answers

What is the Loss Component (LC) based on for calculating the ILM?

Average historical losses over the last 10 years Signup and view all the answers

Why must banks disclose their historical operational risk losses, even if the ILM is set to one?

To facilitate comparability among banks Signup and view all the answers

When was the Solvency II directive implemented for insurance regulation?

January 1, 2016 Signup and view all the answers

Which of the following best describes the purpose of the Internal Loss Multiplier (ILM)?

To assess the operational risks for capital requirements Signup and view all the answers

What is a primary concern regulators address through inspection teams sent to outsourced bodies?

Chain outsourcing activities Signup and view all the answers

What event significantly increased the emphasis on business continuity management by regulators?

The terrorist attacks on September 11, 2001 Signup and view all the answers

What is a key requirement for financial firms regarding their business continuity management plans?

They must be tested in live conditions periodically Signup and view all the answers

What document introduced regulatory guidelines on business continuity management in 2006?

High-Level Principles for Business Continuity Signup and view all the answers

Why have regulators intensified their focus on legal and documentation risk?

Following issues in the securitization market post-2007 Signup and view all the answers

What aspect of legal risks are firms advised to consider in their first line of defense?

The necessity of general counsel support Signup and view all the answers

What are regulators particularly concerned about in relation to third-party legal opinions?

Ensuring firms keep them current and relevant Signup and view all the answers

What can be a consequence of faulty backup arrangements in firms, as highlighted by historical events?

Potential systemic risk to the financial system Signup and view all the answers

Study Notes

Sarbanes-Oxley Act (SOX) of 2002

Implemented in response to corporate scandals like Enron and WorldCom, aimed at restoring investor confidence.
Requires large firms to clearly define and document key controls and processes for financial accounting.
Mandates sign-off by firm executives and external auditors for the accuracy of financial reports.
Non-compliance can result in criminal charges, emphasizing accountability.
Focuses on both on-balance sheet and off-balance sheet items, addressing vulnerabilities that led to scandals.
Criticized for high implementation costs and extensive documentation, raising concerns about readability and understanding.
Since its inception, compliance has become a normalized part of risk management frameworks in U.S. corporations.

Evolving Approaches to Regulation and Supervision

Supervision of Operational Risk

Supervisors conduct thematic on-site visits to examine specific operational risks, such as cybercrime or financial crime.
Thematic visits result in guidance papers indicating necessary industry improvements.
Supervisors utilize specialized staff or external consultants to address particular risks due to limited resources.

Business Continuity Management

Became a priority for regulators after 9/11, prompted by inadequate backup systems found in key financial firms.
Regulations now mandate effective business continuity plans that must be periodically tested under real conditions.
Scenarios and peer comparisons assist in evaluating firms' preparedness for systemic risks.

Documentation and Legal Risk

Increasing litigation has heightened regulatory focus on the adequacy of firms' legal procedures and documentation.
Regulators expect compliance with current legal practices and often require third-party legal opinions.
Firms should involve general counsel in assessing legal risks, considering this need in their risk management strategy.

Operational Risk Capital for Banks

Operational risk models assess the probability (frequency) of risk events against their severity (losses).
Criticism exists regarding the effectiveness of setting capital for operational risks, with debates on its necessity given actual loss experiences.
Concerns about correlation between operational, credit, and market risks; a catastrophic event might expose capital inadequacies.
Discussion on whether capital allocation distracts from effective operational risk management through systems and controls.
Internal Loss Multiplier (ILM) and Business Indicator Component (BIC) calculations play roles in determining capital requirements based on historical losses.

Operational Risk Capital for Insurance Firms

Insurance companies in the European Economic Area adhere to the Solvency I directive, which has limited directives on operational risk.
Introduction of Solvency II directive in January 2016 marked a significant shift in regulation, enhancing governance frameworks for insurance operations.

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Description

This quiz explores the role of thematic on-site visits in overseeing operational risks like cyber-crime and financial crime. It focuses on how supervisors assess the industry’s practices and suggest improvements. Test your understanding of supervisory frameworks and risk management techniques.