WASHINGTON - Federal regulators weighing whether to require large banks to hold more capital to cover operational risks will likely be emboldened by a study showing investors react swiftly when a bank suffers losses from problems such as weak internal controls.
The study, conducted through the University of Pennsylvania's Wharton School, found that when such factors as the line of business in which a loss occurred and the type of event causing the loss are controlled for, a publicly traded bank or insurance company can expect its market value to drop an average of 5.3 times the amount of any loss caused by operational risk.
That means a bank that announces a system failure resulting in a $100 million loss can expect its market value to drop by $530 million.
The authors of the study, to be published in the Journal of Banking and Finance, found that the drop in market value occurs within a 10-day period beginning five days before the announcement. That finding suggests that information about operational losses begins to leak to investors in the days before it is officially acknowledged.
The results have significant implications for managers intent on preserving shareholder value. But they are also important for regulators, who have been pushing banks to get serious about managing the risk of "direct or indirect loss resulting from inadequate or failed internal processes, people, and systems, or from external events," as the Basel Committee on Banking Supervision defines operational risk.
"What this is highlighting is that operational risk and operational loss events do have a real impact on shareholder value," said Christopher M. Lewis, a vice president with Hartford Insurance Group and one of the study's authors. "People have called operational risk a non-balance-sheet risk. But if this were not a material risk to investors, they would shrug off operational loss events. What this study shows is that investors recognize the loss and incorporate it into their view of the company. This makes it clear that it is a real economic risk."
The predicted losses were even larger for banks with high levels of expected growth - those whose market value significantly exceeds the estimated replacement cost of their assets.
"Clearly, this is even more important for CEOs who have a strategy for growth that has been built into their stock price," said Ashish Dev, an executive vice president with KeyCorp in Cleveland. "These kinds of large numbers have got to attract the attention of people in the highest levels of the bank."
Eric S. Rosengren, the senior vice president for supervision, regulation, and credit at the Federal Reserve Bank of Boston, said operational losses have "a reputational effect," so the dramatic impact on stock prices is not surprising. "When something goes wrong, it tells the market about what other things might happen.
"If you had an instance of a serious fraud problem, and investors thought it was indicative of broader control problems across the organization, it wouldn't be surprising to find that the market loss is more than one to one," Mr. Rosengren said.
The study was based on 403 observations of operational losses of $10 million or more that go back nearly 30 years for banks and insurance companies. The data was collected by OpVantage, a subsidiary of Fitch Inc.
"Overall, the results strongly support the regulatory view that operational risk poses a significant threat to the market value of both banks and insurers, providing a rationale for firms to manage operational risks," the study's authors wrote.
"The stock market reaction to operational loss announcements also supports the view that market discipline can serve as a powerful tool for regulators in policing the management of operational risk," they wrote. "Finally, this analysis demonstrates that investors 'price' operational risk into their views on the future profitability of a firm, supporting the contention that the management of operational risk is a core competency for financial institutions."
(The study was written by J. David Cummins and Ran Wei, who teach at Wharton, as well as Mr. Lewis.)
Mr. Dev argued that the study's conclusion is a strong incentive for banks to adopt the most sophisticated risk management tools available under the proposed capital regime known as Basel II.
Investors and analysts have little basis for judging the relative operational risk management systems of different banks, so they treat any institution that suffers such losses as one likely to experience similar events again, regardless of the actual likelihood, he said.
"My hypothesis is that the market will generally punish you less if you are able to signal to the market that you have good operational risk management procedures in place," Mr. Dev said. Qualifying for Basel's Advanced Measurement Approach is one of the only ways for a bank to demonstrate to observers not steeped in the technology of operational risk management that it has a good system in place.
