Beyond traditional performance metrics: Incorporating operational risk into measuring banks’ financial performance

Abstract

This paper aims to open the discussion on the implementation of performance metrics that are adjusted to operational risk in the context of banks. It introduces the subject of new and improved versions of RAROC and EVA, the two main risk-adjusted performance metrics, but this time, taking into account the probable loss caused by operational risk within banks or banks business units. It is based on a narrative literature review, using a flexible approach to engage in a critical and conceptual discussion on incorporating operational risk into bank performance indicators. This work followed a logical order of analysis, discussing financial performance as well as operational performance before diving into operational risk and glossing over some of the difficulties associated with measuring and managing it, all while discussing the Basel II requirements associated with it. Towards the end, it establishes the relationship between financial performance and operational risk and proceeds to dismantle the traditional performance metrics such as ROA for their lack of consideration of operational risk or any risk for that matter and reaffirms the need of performance risk-adjusted metrics especially ones attuned to operational risk due to both its variety and complexity.

Classification JEL: G20

Paper Type: Theoretical Research.