Operational Loss Recoveries and the Macroeconomic Environment: Evidence from the U.S. Banking Sector — Journal of Money, Credit and Banking

How do economic conditions affect the ability of banks to recover losses due to operational risk? Operational losses arise from unforeseen circumstances, human or system error, inadequate or failed internal processes, as well as legal proceedings. The risk of such losses in the financial sector has emerged as a key focus for financial regulators, and research has shown that operational losses increase during economic downturns. Once an operational loss has occurred, banks may pursue various internal and external channels to recover, at least partially, some of the funds that have been lost. Frame et al. provide new evidence that the ability of bank holding companies to recover operational losses declines in downturns as well.

Bank holding companies recover about 7.6 percent of operational losses on average, and recovery rates are positively correlated with the strength of the economy. One plausible explanation for this relationship is that the risk management functions of bank holding companies face resource constraints during downturns. Bank holding companies with better risk governance have higher operational loss recovery rates during economic downturns, suggesting that they are less vulnerable to these resource constraints. These findings provide new evidence on how economic shocks transmit to banking industry losses, with implications for risk management and supervision. Losses during a downturn may ultimately depend not only on a bank holding company’s risk exposures before the downturn, but also on its ability to recoup losses after the fact. As a result, recovery plans and frameworks may need to be taken into consideration by banking supervisors when estimating losses in stress testing exercises.