The financial crisis in an operational risk management context - A review of causes and influencing factors

Global macroeconomic imbalance combined with deregulation of US banks and increasing US real estate prices formed the basis for aggressive growth in worldwide trading of so called Collateralized Debt Obligations (CDO), i.e. similar loans pooled to create a financial derivative that can be bought or sold. The CDOs consisted mainly of prime and subprime housing loans, where the latter type is characterized by a high probability for default. Due to the growing market demand for this derivative and the subsequent shortage of prime loans, the subprime share in the CDOs increased from 43% to 71% from 2003 to 2007. Surprisingly the credit rating agencies did not change the top level (AAA) credit rating of the CDOs in the same period of time. How was this possible? And how could the tremendously resourceful firms that insured the derivatives by selling so called Credit Default Swaps to CDO owners avoid understanding the enormous risk they took on? What later was to be called the financial crisis emerges in the spring of 2008 in line with the fall in US real estate prices and subsequent evaporation of the CDO market. The chain of events that led to numerous bankruptcies and threw the world into a recession not seen since the early 1930s has been labeled a system crisis, liquidity crisis, and a crisis of confidence (in the financial markets) among others. In this paper we survey how, and to what extent, operational risk exposure in the organizations of mortgage brokers and banks, insurance companies, credit rating agencies, and investment banks contributed to the financial crisis. Bayesian Network analysis of causes and influencing factors in these four types of organizations indicates that operational risk exposure played a crucial role in triggering the financial crisis. Our findings suggest that the financial crisis for a large part was the result of an industry wide failure to manage risk in general, and operational risk in particular. & 2011 Elsevier Ltd. All rights reserved.