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London, United Kingdom, 2006/01/26 - In order to comply with Basel II, banks have to measure all legal risks. This is really difficult, as there is no official definition in the new Basel Accord - Legal-Risk.com.
In order to meet the Basel ii requirements, banks have to measure operational risk.
According to Basel ii Accord Section 644 to 651, Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk.
Legal risk, according to the Basel committee, includes, but is not limited to, exposure to fines, penalties, or punitive damages resulting from supervisory actions, as well as private settlements.
George Lekatis, a senior risk and compliance consultant, certified trainer, and general manager of a firm that bears his name, leads several Basel ii compliance classes every year in London, Europe and Asia. In all the classes, professionals from international banks ask the same questions:
First Question: "What is legal risk? Is there an official definition?"
The answer: There is no official definition of legal risk. To make things worse, there is confusion between legal risk and operational risk in the official document.
According to the Basel committee, these are some of the legal and/or operational risks:
• Internal fraud
• External fraud
• Employment practices leading to workers' compensation claims or other forms of liability
• Client, product and business practice issues
• Fiduciary breaches
• Improper trading
• Money laundering
• Sales of unauthorized products
• Collateral management failures
• Incomplete legal documentation
• Unapproved access to client accounts.
Second Question: "How can we manage legal risk, and allocate capital for this risk using an advanced measurement approach?"
There are three approaches to the measurement of operational risk in Basel.
1. The basic approach: We apply a standard percentage to "the income" of the firm as a whole. It is difficult to call it "risk measurement"
2. The standardized approach: We do the same, but not for all the organization, but for each business line separately.
3. The advanced measurement approach: We need to know the "expected loss" and the "unexpected loss" amounts (it is unexpected loss... but it is expected that we can measure it using models).
It is obvious that even when banks use the "advanced" measurement approach, they do not really measure the legal risk. George Lekatis, in his web site presents several issues regarding the disclosure, management and measurement of the legal risk, according to the Basel ii and Sarbanes Oxley requirements.