A Theory of Operational Risk

We study the dynamic decision making of a financial institution in the presence of a novel implementation friction that gives rise to operational risk. We distinguish between internal and external operational risks depending on whether the institution has control over them. Internal operational risk naturally arises in the context of model risk, as the institution exposes itself to operational errors whenever it updates and improves its investment model. In this case, it is no longer optimal to implement the best model available, thus leaving scope for endogenous deviation from it, and hence model sophistication. We show that the optimal exposure to operational risk may well become decreasing in the level of internal operational risk, which in turn makes the exposure to market risk less volatile. We uncover that financial constraints interact with operational risk, whether internal or external, and prompt the institution to always adopt a more sophisticated model. While such constraints are always detrimental when operational risk is internal, they may be beneficial, despite inducing an excessive level of sophistication, when it is external.