Time for a paradigm change: Problems with the financial industry's approach to operational risk

Abstract

AbstractOrganizational and risk cultures in the financial industry are argued to be the root cause of banking problems. It is concerning that financial regulators and practitioners still consider the industry to be seriously fragile in several respects, particularly to operational risks and risks associated with digital transformation and innovation—not that the risks of organizational misconduct have disappeared. The rescue of Credit Suisse in 2023 confirms this. This paper employs extant theories of organizational culture, learning, and action to critically evaluate the existing risk paradigm in banking and to highlight its deficiencies, which practitioners can only address by questioning the flawed assumptions and dysfunctional values and behaviors found to be endemic in banks. However, business and risk practitioners are also married to institutional approaches that focus on assessing risk and measuring historical losses to allocate regulatory capital, rather than forward‐looking approaches to measure and manage risk. This requires a paradigm change. This paper presents a novel risk measurement and accounting methodology, Risk Accounting, to help underpin such change. Risk accounting measures risk exposure in quantitative and qualitative terms and can be implemented using an AI‐enabled digital architecture that could solve endemic problems with risk data aggregation and analysis. Significantly, risk accounting enables a financial value to be placed on risk exposures at a granular level. This level of transparency provides an incentive to change behaviors in banks and support cultural change while providing a basis for a paradigm change in the way operational risk is managed.