Module: | MODULE B: RISK MANAGEMENT
Q300: Scenario: During an annual RBI inspection, the Chief Auditor discovers that the bank's treasury department suffered a massive loss due to a flawed algorithmic trading system executing erroneous trades. To hide the system failure, the management classified this loss entirely as a "general market risk" event in their financial reports. Based on Basel III guidelines, consider the following statements regarding the auditor's required regulatory actions:
1. The auditor must mandate the reclassification of this loss from market risk to operational risk, because the root cause was a failed internal IT system.
2. The erroneous trades executed by the algorithm, do not require any adjustments to the bank's operational risk loss database, since they occurred in the trading book.
3. Classifying a system-driven loss as a pure market movement, is a severe violation of the boundary rules between different risk capital frameworks.
Which of the statements given above is/are correct?
2. The erroneous trades executed by the algorithm, do not require any adjustments to the bank's operational risk loss database, since they occurred in the trading book.
3. Classifying a system-driven loss as a pure market movement, is a severe violation of the boundary rules between different risk capital frameworks.
Which of the statements given above is/are correct?
✅ Correct Answer: B
The correct answer is B. Statement 1 is correct: The root cause of the financial loss was not a natural movement in market prices, but rather a catastrophic failure of an internal IT system (the algorithmic code). Under Basel definitions, any loss arising from inadequate or failed internal systems is strictly classified as Operational Risk.
Statement 2 is incorrect: Regulators mandate that banks maintain a pristine Operational Risk Loss Database.
Even if a loss materializes in the trading book, if the root cause was an operational failure (system error, fat-finger trade), it MUST be recorded as an operational loss data point for future capital calculation.
Statement 3 is correct: Deliberately misclassifying a system failure as "general market risk" is a severe regulatory violation.
It distorts the bank's risk profile and subverts the strict boundary rules established between the market risk and operational risk capital frameworks.
Statement 2 is incorrect: Regulators mandate that banks maintain a pristine Operational Risk Loss Database.
Even if a loss materializes in the trading book, if the root cause was an operational failure (system error, fat-finger trade), it MUST be recorded as an operational loss data point for future capital calculation.
Statement 3 is correct: Deliberately misclassifying a system failure as "general market risk" is a severe regulatory violation.
It distorts the bank's risk profile and subverts the strict boundary rules established between the market risk and operational risk capital frameworks.