Abstract: This chapter addresses the issue of whether and to what extent banks should be required by regulation to hold capital against operational risks. It argues that the types of operational risk for which Basel II requires capital, internal or external event risks, are and should be dealt with by other means — better controls, loss provisions, or insurance. Basel's definition of “operational risk” excludes the major category of non-financial risk for which banks do hold capital — namely, business risk. It is estimated that business risk accounts for slightly more than half of a bank's total non-financial risk, which, in turn, averages about 25 to 30% of economic capital. Analysing legal risk, as a type of operational risk, the chapter shows the difficulties in defining or predicting such risk, and that the amount of such risk will vary depending on the legal jurisdictions to which a bank is subject. It also argues that the Basel II limit of 20% on capital mitigation achievable through insurance is arbitrary and creates a perverse incentive for banks to be underinsured. It generally concludes that banks should not be required by regulation to hold capital for operational risks; the issue would be better dealt with through supervision and market discipline.

Keywords: capital regulation, banks, legal risk, business risk, risk management,