Prior to the onset of the Basel II Accord and its resulting loss event category structure, there was no existing or suggested standards for financial institutions in how to classify loss events and risks. The reality was that there was no need for a standard, as companies were not particularly focused on tracking loss events and identifying operational risks within a formal structure. As banks were nudged along the operational and enterprise risk management path by the regulators and Basel II, a need for guidance was evident and the Basel II loss event category structure emerged to meet the need. Of course, many financial institutions clung to the new standard and began to implement their programs. Although the Basel II category structure was largely designed for the classification of loss events, many institutions have been leveraging the taxonomy for a risk classification structure as well.
As financial Institutions gained experience in operational risk management and the implementation of such risk programs within their organizations, they began to question the business alignment and validity of the Basel II loss event category model. Various consortiums, industry associations, consultants, academic researchers, and analysts began to study the structure and started to poke holes in its loss type basis and alternate classification models began to emerge. The RMA joined with RiskBusiness to coordinate an effort with banks to establish standards for Key Risk Indicators, which resulted in a risk classification structure that is gaining popularity. The Operational Riskdata eXchange Association (ORX) formed as a consortium to provide a platform for the exchange of operational loss data, and in due course developed standards and a classification structure for its member financial institutions. We also see the BITS organization looking at loss and risk classification structures, as well as many articles that have been written on the topic.
One particular article of interest was written by Gene Alvarez, Ph.D., on Loss Event Classification. This article can be found on the GARP website at http://www.garp.com/resources/Articles/Operational%20RiskEventClassification.pdf
The article speaks of the importance of organizing data in a sound and clear-cut manner, and reaches a conclusion that the Basel II loss event category structure falls short with too much allowance for inconsistency. Dr. Alvarez proposes a classification schema that is based on causes, as opposed to types of loss events, which leads to a more structured and consistent classification of loss events. I encourage you to read t his article, as it article represents the current thinking in the industry, which is that the causes of an event are important to identify and understand, and when an organization captures its loss data and views risks form the causal point of view, it is better enabled to analyze the data and more effectively manage and mitigate risks, thereby being more successful in lowering operational losses and increasing operating efficiencies.
There will likely be more debate and thought put into loss event and risk taxonomies over the next few years, and the industry’s need for an effective and consistent standard that could enable benchmarking of operational risk will help drive convergence to a widely accepted loss event and risk data classification schema.