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MANAGING OPERATIONAL RISK : IMPLICATIONS FROM THE ANALYSIS OF SECURITIES FRAUD

This paper is concerned with the design of an appropriate managerial framework to control operational risk. Our particular emphasis is fraudulent activity in the financial services industry, but the results have more general applicability. Loss mitigating constraints on operational control procedures in financial services can be divided into two categories. First, internal operational risk control systems within financial institutions, both those designed by the institution itself, and those mandated by third parties. Second, the disincentive effects attributed to the threat of legal sanctions initiated by injured parties once the fraudulent activity has been identified. The paper begins by critically evaluating the effectiveness of both classes of constraints. Its central contribution follows, which is an attempt to identify empirically the degree to which losses from fraudulent activity can be identified with the breakdown of individual constraints. To ensure comparability, our focus is exclusively upon one type of fraud, unauthorised trading. Our sample consists of 37 such cases drawn from financial institutions in eight countries. The results suggest that internal controls present the primary defence against severe fraud losses. They also indicate that regulatory penalties imposed on senior supervisory management, in addition to the fraudster, are crucial in ensuring efficient fraud loss mitigation. We conclude by reviewing the regulatory policy implications of our results.