![Operational Risks in Financial Organizations 9
“Operational Risk is the risk that deficiencies in information systems
or internal controls will result in unexpected loss. The risk is
associated with human error, systems failure and inadequate pro-
cedures or controls” (Bank for International Settlements [BIS]).7
“Operational Risk is the risk of losses resulting from inadequate
or failed processes, people, and system or from external events.”8
A survey conducted in June 2000 by the Risk Management Group
(RMG) of the Basel Committee, through its Other Risks Technical Working
Group (ORTWG),9 indicated that although a range of definitions is pres-
ently used, there has been a high degree of convergence during the past
one to two years. The following definition of operational risk, or close
variants of it, is used by a large number of banks: “the risk of direct or
indirect loss resulting from inadequate or failed internal processes, people,
and systems or from external events.” Although some banks included legal
risk in their definitions, almost all organizations reject the idea of including
strategic and business risk in a regulatory capital charge (although many
allocate economic capital for this).
Operational risks are only eliminated if a bank ceases to exist; and
although market and credit risks are revenue driven, operational risks are
not. Credit and market risks originate from outside the bank. In contrast,
operational risks originate primarily from within the specific bank, except
risks in the category “external” as discussed in the subsequent section.
Losses from external events, such as a natural disaster that damages an
organization’s physical assets or electrical or telecommunications failures
that disrupt the business, are somewhat easier to define than losses from
internal problems, such as employees’ fraud and product flaws. Because
the risks from internal problems will be closely tied to a bank’s specific
products and business lines, they should be more organization specific than
the risks due to external events.
Because operational risks exist in the natural course of corporate
activity, there is a great emphasis on process orientation in the operational
risk concept, which positions the definition of operational risk manage-
ment closer to “total quality management.” In the banking sector, opera-
tional risk resembles similar risks in industry more closely than it resembles
market or credit risks in a bank. Operational risk should be managed
whenever the way something is usually done is modified, to make the
chances of success as great as possible, while making the chances of
failure, injury, or loss as small as possible. It is a common-sense approach
to balancing the risks against the benefits to be gained in a situation and
then choosing the most effective course of action.
To further understand operational risks, it is important to view this
type of risk in the context of the other risks that affect financial organi-
zations. These risks are generally defined as follows:](https://image.slidesharecdn.com/932351-250620022025-f65c3431/85/Guide-To-Optimal-Operational-Risk-And-Basel-Ii-1st-Edition-Ioannis-S-Akkizidis-42-320.jpg)
![Jackeymo turned to Leonard with the look of an enraged tiger. How
you dare, scum of de earth that you are, cried he,[13] how you
dare make cry the signorina? And his English not supplying familiar
vituperatives sufficiently, he poured out upon Lenny such a profusion
of Italian abuse, that the boy turned red and white in a breath with
rage and perplexity.
Violante took instant compassion upon the victim she had made,
and, with true feminine caprice, now began to scold Jackeymo for
his anger, and, finally approaching Leonard, laid her hand on his
arm, and said with a kindness at once childlike and queenly, and in
the prettiest imaginable mixture of imperfect English and soft Italian,
to which I can not pretend to do justice, and shall therefore
translate: Don't mind him. I dare say it was all my fault, only I did
not understand you: are not these things weeds?
No, my darling signorina, said Jackeymo, in Italian, looking ruefully
at the celery-bed, they are not weeds, and they sell very well at this
time of the year. But still, if it amuses you to pluck them up, I should
like to see who's to prevent it.
Lenny walked away. He had been called the scum of the earth, by
a foreigner, too! He had again been ill-treated for doing what he
conceived his duty. He was again feeling the distinction between rich
and poor, and he now fancied that that distinction involved deadly
warfare, for he had read from beginning to end those two damnable
tracts which the Tinker had presented to him. But in the midst of all
the angry disturbance of his mind, he felt the soft touch of the
infant's hand, the soothing influence of her conciliating words, and
he was half ashamed that he had spoken so roughly to a child.
Still, not trusting himself to speak, he walked away, and sat down at
a distance. I don't see, thought he, why there should be rich and
poor, master and servant. Lenny, be it remembered, had not heard
the Parson's Political Sermon.](https://image.slidesharecdn.com/932351-250620022025-f65c3431/85/Guide-To-Optimal-Operational-Risk-And-Basel-Ii-1st-Edition-Ioannis-S-Akkizidis-68-320.jpg)
Guide To Optimal Operational Risk And Basel Ii 1st Edition Ioannis S Akkizidis
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- 6. AU3813_half title page 9/23/05 3:27 PM Page 1 GUIDE TO OPTIMAL OPERATIONAL RISK & BASEL II
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- 8. AU3813_title page 9/23/05 3:26 PM Page 1 Boca Raton New York GUIDE TO OPTIMAL OPERATIONAL RISK & BASEL II Ioannis S. Akkizidis Vivianne Bouchereau
- 9. Published in 2005 by Auerbach Publications Taylor & Francis Group 6000 Broken Sound Parkway NW, Suite 300 Boca Raton, FL 33487-2742 © 2005 by Taylor & Francis Group, LLC Auerbach is an imprint of Taylor & Francis Group No claim to original U.S. Government works Printed in the United States of America on acid-free paper 10 9 8 7 6 5 4 3 2 1 International Standard Book Number-10: 0-8493-3813-1 (Hardcover) International Standard Book Number-13: 978-0-8493-3813-7 (Hardcover) This book contains information obtained from authentic and highly regarded sources. Reprinted material is quoted with permission, and sources are indicated. A wide variety of references are listed. Reasonable efforts have been made to publish reliable data and information, but the author and the publisher cannot assume responsibility for the validity of all materials or for the consequences of their use. No part of this book may be reprinted, reproduced, transmitted, or utilized in any form by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying, microfilming, and recording, or in any information storage or retrieval system, without written permission from the publishers. For permission to photocopy or use material electronically from this work, please access www.copyright.com (http://www.copyright.com/) or contact the Copyright Clearance Center, Inc. (CCC) 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400. CCC is a not-for-profit organization that provides licenses and registration for a variety of users. For organizations that have been granted a photocopy license by the CCC, a separate system of payment has been arranged. Trademark Notice: Product or corporate names may be trademarks or registered trademarks, and are used only for identification and explanation without intent to infringe. Library of Congress Cataloging-in-Publication Data Catalog record is available from the Library of Congress Visit the Taylor & Francis Web site at http://www.taylorandfrancis.com and the Auerbach Publications Web site at http://www.auerbach-publications.com Taylor & Francis Group is the Academic Division of T&F Informa plc.
- 10. Dedication This book is dedicated to My father (Ioannis Akkizidis) My family (Vivianne Bouchereau)
- 12. vii Contents Preface ............................................................................................................. xv Acknowledgments......................................................................................... xxv About the Authors ...................................................................................... xxvii Part I Operational Risk and Its Management Chapter 1, Operational Risks in Financial Organizations.............................. 1 Chapter 2, Main Aspects of Operational Risk Management ......................... 1 1 Operational Risks in Financial Organizations .......................... 3 Introduction....................................................................................................... 3 Operational Risks in Financial Organizations................................................. 7 Defining Operational Risks ......................................................................... 8 Existence of Operational Risks in Financial Organizations.................... 10 1. Organization...................................................................................... 12 2. Processes and Policies...................................................................... 13 3. Systems and Technology.................................................................. 13 4. People................................................................................................ 14 5. External Events ................................................................................. 15 Interactions between Operational Risks................................................... 17 Characteristics of Operational Risks .............................................................. 18 Operational Risk Event Types ....................................................................... 21 Employee Risks in Banking Organizations................................................... 26 Operational Risks and IT ............................................................................... 31 IT Security................................................................................................... 36 Summary.......................................................................................................... 39 References........................................................................................................ 40 2 Main Aspects of Operational Risk Management ..................... 43 Introduction..................................................................................................... 43 Main Aspects of Operational Risk Management .......................................... 45 Operational Risk Management Best Practices ......................................... 48
- 13. viii Guide to Optimal Operational Risk and Basel II 1. Setting Policies.................................................................................. 49 2. Operational Risk Identification........................................................ 51 3. Business Processes ........................................................................... 52 4. Operational Risk Measurement ....................................................... 52 5. Operational Risk Evaluation and Optimization Analysis .............. 53 6. Economic Capital.............................................................................. 54 7. Reporting ......................................................................................... 54 8. Exposure Management..................................................................... 56 Top-Down versus Bottom-Up Operational Risk Management Approaches ............................................................................................ 56 Value Added in Managing Operational Risks.......................................... 59 Operational Risk Management Framework................................................... 61 Quantification of Operational Risks .............................................................. 63 Loss Events ................................................................................................. 67 Operational Risk Data........................................................................... 68 Testing and Verification.................................................................................. 70 Operational Risk Management Audits ...................................................... 71 Operational Risk Management Reviews................................................... 72 Operational Risk Management Back Testing and Stress Testing ........... 73 Enterprisewide Risk Management.................................................................. 75 Operational Risk Management Concerns...................................................... 76 Business Continuity Planning.................................................................... 78 Customer Complaints................................................................................. 78 Outsourcing ................................................................................................ 79 Money Laundering ..................................................................................... 79 Fraud ........................................................................................................... 79 Settlement Risk........................................................................................... 79 Communication .......................................................................................... 80 Key Players and Elements for Implementing Effective Operational Risk Management .................................................................................................... 80 Summary.......................................................................................................... 85 References........................................................................................................ 87 Part II Operational Risk and Basel II Chapter 3, Operational Risk in Basel II........................................................ 89 Chapter 4, Advanced Measurement Approach............................................. 89 3 Operational Risk in Basel II ...................................................... 91 Introduction..................................................................................................... 91 The 1988 Basel Accord versus the Basel II Accord .................................... 93 Operational Risk Management According to Basel II ................................. 97 Main Objectives, Key Drivers, and Benefits of Basel II......................... 99 The Three Pillars of Basel II........................................................................ 102 Pillar 1: Minimum Capital Requirements .................................................... 103 Measurement Approaches for Operational Risks .................................. 104 The Basic Indicator Approach ........................................................... 104 The Standardized Approach............................................................... 105
- 14. Contents ix The Alternative Standardized Approach (ASA)................................. 108 Advanced Measurement Approach.................................................... 108 Qualifying Criteria for Operational Risk Capital Calculation ............... 109 Basic Indicator Approach ................................................................... 109 Standardized Approach....................................................................... 109 Advanced Measurement Approach.................................................... 110 Factors in Selecting an Approach........................................................... 110 Supervisory Review Process......................................................................... 110 The Supervisory Assessment................................................................... 111 Enhanced Disclosure — Market Discipline ................................................ 114 Qualitative and Quantitative Disclosures ............................................... 115 The Ten Principles of Basel II..................................................................... 117 Appropriate Risk Management Environment......................................... 117 Risk Management..................................................................................... 119 Role of Supervisors.................................................................................. 119 Role of Disclosure.................................................................................... 119 Principle 1................................................................................................. 119 Principle 2................................................................................................. 121 Principle 3................................................................................................. 121 Principle 4................................................................................................. 123 Principle 5................................................................................................. 124 Principle 6................................................................................................. 125 Principle 7................................................................................................. 126 Principle 8................................................................................................. 126 Principle 9................................................................................................. 127 Principle 10............................................................................................... 127 The Pillars’ Action Points ............................................................................. 128 Pillar 1: Capital Requirement — Action Points ..................................... 128 Pillar 2: Supervisory Review — Action Points ...................................... 128 Pillar 3: Market Discipline — Action Points.......................................... 129 Summary........................................................................................................ 129 References...................................................................................................... 130 4 Advanced Measurement Approach ......................................... 133 Introduction................................................................................................... 133 Advanced Measurement Approach.............................................................. 134 AMA Measuring System................................................................................ 137 Quantitative Standards of the AMA........................................................ 137 Internal Measurement Approaches (IMAs)........................................ 139 Loss Distribution Approaches (LDAs) ............................................... 140 Scorecard Approaches ........................................................................ 141 AMA Framework ........................................................................................... 143 Elements of an AMA Framework ........................................................... 145 Internal Operational Risk Loss Event Data....................................... 145 Relevant External Operational Risk Loss Event Data....................... 147 Scenario Analysis................................................................................. 148 Supervisory Standards of the AMA.............................................................. 149
- 15. x Guide to Optimal Operational Risk and Basel II Qualifying Criteria for Risk Capital Calculation ......................................... 150 Use of Insurance under the AMA ............................................................... 153 Summary........................................................................................................ 158 References...................................................................................................... 159 Part III Frameworks for Designing Efficient Operational Risk Assessment Chapter 5, Operational Risk Identification, Measurement, Modeling, and Monitoring Analysis............................................................................... 161 Chapter 6, Operational Risk Assessment via Evaluation Analysis............ 161 Efficient Operational Risk Assessment, Control, and Management ..... 161 Key Elements of Efficient Operational Risk Assessment ...................... 164 5 Operational Risk Identification, Measurement, Modeling, and Monitoring Analysis ......................................................... 167 Introduction................................................................................................... 167 Operational Risk Identification .................................................................... 168 Operational Risk and Operations Process Mapping ............................. 170 Operational Risk and Performance Measurements .................................... 170 Qualitative Performance .......................................................................... 174 Quantitative Performance........................................................................ 174 Defining Key Performance Indicators for Operations .......................... 174 Qualitative Operational Risks.................................................................. 176 Quantitative Operational Risks................................................................ 176 Defining Key Operational Risk Indicators ............................................. 176 Constructing Functions for KRIs ........................................................ 182 Constructing the Matrix of KRIs ........................................................ 183 Tracking and Monitoring Operational Risk and Performance Information ............................................................................................... 185 Minimizing Assumptions.......................................................................... 186 The Matrix of Measurements .................................................................. 186 The Matrix of Causes, Events, and Consequences .......................... 188 Losses from Causes, Events, and Consequences .................................. 188 Operational Risk Modeling........................................................................... 191 Efficient Operational Risk Modeling through Correlation Analysis ..... 191 Operational Risk Monitoring........................................................................ 197 Efficient Operational Risks Monitoring through Correlation Analysis.... 197 Mapping the Operational and Operational Risks Topography............ 198 Thresholds in Monitoring Systems.......................................................... 203 Mapping the Correlations between the Operations and Risks ............ 204 Essential Guides for Operational Risk Monitoring Management ......... 209 Summary........................................................................................................ 211 References...................................................................................................... 212 6 Operational Risk Assessment via Evaluation Analysis ......... 213 Introduction................................................................................................... 213 Operational Risk Evaluation Analysis.......................................................... 215
- 16. Contents xi Evaluating the Degree of Significance and Actual Values of Operational Risks ............................................................................................................... 216 Significance Value of a Cause................................................................. 216 Actual Value of a Cause .......................................................................... 217 Levels of Acceptance for Causes ............................................................ 218 Significance Value of an Event ............................................................... 218 Actual Value of an Event......................................................................... 220 Levels of Acceptance for Events............................................................. 220 Significance Value of a Consequence .................................................... 220 Actual Value of a Consequence.............................................................. 221 Levels of Acceptance for Consequences................................................ 222 Measurements Values and Scales for Causes, Events, and Consequences................................................................................................ 222 Data Normalization ....................................................................................... 223 Estimating the Significance and Actual Value of an Operation................ 224 Beta Point for an Operational Risk or an Operation ................................ 225 Estimating the Significance and Actual Value of a Beta ...................... 225 Illustrating the Significance and Actual Values........................................... 227 Cluster Analysis as a Tool in the Evaluation Process................................ 228 Definition of Clusters for Operational Risk and Affected Operations ................................................................................................ 229 Data Used for Clustering Analysis.......................................................... 230 Clustering Approaches in Operational Risk................................................ 231 Fuzzy C-Means Clustering Approach ..................................................... 233 Inner-Product Norms ............................................................................... 234 Extensions of the Fuzzy C-Means Algorithm Using Fuzzy Covariance Matrix .................................................................................... 236 Determination of the Number of Clusters ............................................. 237 Normalization in Clustering Analysis...................................................... 238 Equilibrium Identification Analysis for Operational Risk Management.... 238 Trend Analysis for Operational Risk ........................................................... 240 Trend Accumulation for the Operational Risks and Affected Operations ................................................................................................ 241 Evaluating the Severity of Operational Risks and Affected Operations... 244 Distribution Analysis ................................................................................ 244 Mountain Surface Evaluation (MSE) Methodology................................ 245 Resulting Views from Distribution Analysis........................................... 247 Estimating and Evaluating Economic Capital Reserves ............................. 250 Unexpected Losses Relating to People .................................................. 251 Unexpected Losses Related to Systems.................................................. 254 Unexpected Losses Related to Processes............................................... 254 Identifying Potential Losses.......................................................................... 255 Defining Potential Losses ........................................................................ 255 Potential Losses from Influences of Direct Operational Risks ........ 256 Potential Losses from Indirect Operational Risk Influences............ 257 Representing Unexpected Performances................................................ 258
- 17. xii Guide to Optimal Operational Risk and Basel II Estimation of the Economic Capital of Operational Risks Using the Operational VaR ....................................................................................... 260 Extreme Value Theory to Operational Risk................................................ 261 Extreme Value Theory Approaches............................................................. 261 Block Maxima Approach......................................................................... 263 Peaks over Threshold (POT) Approach................................................. 264 Semi-parametric POT............................................................................... 264 Unconditional Parametric POT ............................................................... 265 Conditional Parametric Approach........................................................... 266 Summary........................................................................................................ 267 References...................................................................................................... 271 Part IV Frameworks for Designing and Implementing Efficient Operational Risk Control and Management Systems Chapter 7, Operational Risk Profiling ......................................................... 273 Chapter 8, Operational Risk Optimization.................................................. 273 Chapter 9, Framework for Decision Making and Designing Optimal Risk Policies........................................................................................................... 273 Controlling and Managing Operational Risks........................................ 274 7 Operational Risk Profiling ...................................................... 277 Introduction................................................................................................... 277 Operational Risk Profiling............................................................................ 278 Defining the Value of Operational Risk Probability .................................. 279 Operational Risk Probability ................................................................... 280 Defining the Value of Operational Risk Impact......................................... 282 Operational Risk Impact.......................................................................... 284 Impact Initiated from Operational Risk Cause ................................. 284 Impact Initiated from Operational Risk Events ................................ 286 Impact Initiated from Operational Risk Consequences ................... 287 The Exposure of Operations to Operational Risks.................................... 288 The Operational Risk Profiling Matrix ........................................................ 289 Operational Risk Probability, Impact, and Exposure Analysis.................. 290 Values for Monitoring the Operational Risk Profile.............................. 293 Aspects for Consideration in Operational Risk Profiling...................... 293 Dividing the Risk Profile .................................................................... 293 Defining the Elements of Risk Profiling Analysis............................. 294 Controllable Zones and Distribution Tails ........................................ 294 Modeling and Monitoring the Operational Risk Profile ............................ 294 Clustering Analysis in Risk Profiling Analysis ............................................ 295 Mountain Surfaces in Operational Risk Profiling .................................. 295 Centroids of Operational Risk Profiling Clusters................................... 296 Projection of Cluster Centers and Variances.......................................... 296 Fuzzy Set Theory and Membership Functions ...................................... 297 Advanced Approaches for Decision Making Using Risk Profiling Analysis.......................................................................................................... 298
- 18. Contents xiii Representations of Operational Risk Profile............................................... 301 Summary........................................................................................................ 307 References...................................................................................................... 312 8 Operational Risk Optimization ............................................... 313 Introduction................................................................................................... 313 Operational Risk Optimization..................................................................... 314 Optimizing Operational Risks Based on Exposure-Correlation-Significant Analysis.......................................................................................................... 315 Optimization Techniques in Operational Risk Control and Management .................................................................................................. 319 Derivative-Based Optimization Methods for Operational Risks........... 320 Gradient-Based Optimization ............................................................. 321 Steepest Descent Method ................................................................... 322 Newton’s Method ................................................................................ 323 Rules in Designing Risk Optimization Techniques .......................... 324 Termination Rules for Optimization Algorithms............................... 324 In Summary ......................................................................................... 325 Derivative-Free Optimization Methods................................................... 325 In Summary ......................................................................................... 327 The Resulting Optimal Matrix................................................................. 327 Illustrating the Optimal Values of Operational Risks............................ 328 Defining the Cost for Optimal Operational Risk Management................. 331 Optimizing Resource Allocation for Operational Risk Management ........ 334 Illustrating the Optimal Allocation of Resources................................... 336 Unconstrained and Constrained Optimization Analysis............................. 337 Constraints to Modify Operational Risks Levels.................................... 341 Tuning, Adaptation, and Robustness of Optimal Operational Risk Systems .......................................................................................................... 342 Summary........................................................................................................ 342 References...................................................................................................... 343 9 Framework for Decision Making and Designing Optimal Risk Policies .............................................................................. 345 Introduction................................................................................................... 345 Planning and Scheduling Operational Risk Actions and Policies............. 346 Planning Activities.................................................................................... 348 Scheduling Actions and Policies for Operational Risks........................ 348 Operational Risk Research.................................................................. 348 Operational Risk Acceptance ............................................................. 349 Operational Risk Avoidance............................................................... 349 Operational Risk Transfer................................................................... 350 Operational Risk Mitigation................................................................ 350 Insurance as Operational Risk Mitigant ............................................ 352 Scenario Analysis...................................................................................... 353 Controlling Operational Risks ...................................................................... 354 Controlling Operational Risks for Prevention and Improvements....... 354
- 19. xiv Guide to Optimal Operational Risk and Basel II Controlling Operational Risks after the Thresholds Have Been Activated............................................................................................... 355 Effective Communication to Control Operational Risks .................. 355 Internal Operational Risk Control ............................................................... 356 Guidance for Internal Control............................................................ 358 Business Continuity or Contingency Planning through Optimization...... 359 Business Impact Analysis ........................................................................ 362 Recovery Strategy Formulation ............................................................... 364 What Is the Worst-Case Scenario?...................................................... 364 What Operations and People Are Essential, and When?................. 364 Development of the Business Continuity Plan...................................... 365 Establishment of Alternate Sites.............................................................. 366 Testing, Maintenance, Updating, and Implementation of the BCP ..... 366 Thresholds in Designing Business Continuity Plans............................. 367 Time and Frequency of Threshold Activation.................................. 368 Effectiveness of the Business Continuity Plan....................................... 368 Operational Risk Reporting.......................................................................... 368 Main Aspects of an Operational Risk Management Report ................. 371 Levels of Operational Risks and Performances................................ 372 Operational Risk Trends..................................................................... 372 Operational Risk Distribution............................................................. 372 Operational Risk Probability, Impact, and Exposure....................... 372 Optimal Values of Operational Risks ................................................ 372 Operational Risk Management Actions ............................................. 373 Ongoing Review of the Thresholds .................................................. 373 Reviews ................................................................................................ 373 Decision and Dynamic Management .......................................................... 373 Capturing New Operational Risk Successfully ...................................... 374 Operational Risk Review Meetings......................................................... 374 Operational Risk Knowledge Base......................................................... 375 Summary........................................................................................................ 375 References...................................................................................................... 376 10 Concluding Remarks ................................................................ 379 Appendix ........................................................................................... 391 Index .................................................................................................. 395
- 20. xv Preface Risk creates value and profits come from taking risks. —Ulrich Doerig Businesses are becoming more and more competitive and managing risk continues to be at the heart of financial organizations’ activities. Risk management was in its elementary stages until the 1980s. It was not recognized as part of business management processes, but only as a method of taking precautionary measures when business went wrong. In recent years, managerial practices are recognizing the importance of enterprisewide risk management and trying to strategically analyze cor- porate activities. Organizations are realizing the need to properly under- stand their risks due to various actions as well as interrelations of the risks within the organization. New disciplines are emerging for risk management, as well as a new focus on operational risk management. Operational risks have existed as financial organizations evolved. However, as a separate discipline, oper- ational risk management surfaced only in recent years. Compliance reg- ulations, such as Basel II, mandate a focus on operational risks, and have forced the market to evaluate the implications these regulations will have on procedures and strategies in coming years. Of all the different types of risks that can affect financial organizations, operational risks can be among the most devastating and the most difficult to anticipate. Operational risk continues to receive heightened attention among market participants and regulators, prompting dialogues and debates on the best ways to identify, measure, evaluate, control, and manage this important type of risk. This recognition has led to an increased emphasis on the importance of sound operational risk management in financial organizations and, to a greater extent, operational risks in banks’ internal capital assessment and allocation
- 21. xvi Guide to Optimal Operational Risk and Basel II processes. Operational risk management is one of the most complex and fastest growing areas in financial organizations today. As one of the most heavily regulated industries, financial organizations are often required to set the ball rolling with regard to rules and guidelines, while other industries follow suit. As the pace of change inside and outside financial organizations continues to increase exponentially and as the marketplace becomes more and more complex due to technological advancement and innovations, the management of operational change and operational risks has become a critical success factor. For the first time, the Basel Committee has proposed to establish capital charges for operational risks, in exchange for lowering them on market and credit risk. This new accord, aiming for a closer correspondence between the capital that banks hold and the risks they take, should lead to more stable, efficiently run financial organiza- tions. Thus operational risk management has been placed high on the agenda for financial organizations. Incentives to comply with Basel II allow banks that can prove they have effective and sophisticated opera- tional risk management systems to reduce their level of protective capital buffer, freeing potentially millions of dollars for investment in profitable activities. Efficient operational risk management is a decisive competitive advantage. It helps to maintain stability and continuity and supports revenue and earnings, a process for which senior management and boards of directors are increasingly called upon to ensure. Business operations will need to be as efficient as possible to deliver reliable services to customers. Operational risk management frameworks and practices will need to mature to satisfy all stakeholders versus shareholders, employees, government, regulators, and society as a whole. The Basel II Capital Accord marks a significant shift in the philosophy of capital regulation and the supervision of banks. Although numerical minimum capital requirements remain, they are embedded deep within Basel II’s mathematical structure, a structure that places much more emphasis on the range of capital that may be required for specific operational risks faced by each bank. Basel II clearly lays down that financial organizations need to focus on loss data collection of three to five years varying according to different lines of business. It also stresses more effective ways to track, monitor, analyze, and report operational risk data. The Basel II Accord is all about bringing together the world’s financial organizations under a common regulatory framework, although the way to manage operational risk is different for each financial organization. Financial organizations could improve their operational risk management in a way that would have a bottom-line impact even without Basel II. Still, there are important reasons to go all the way: financial organizations certified as Basel II compliant could benefit from lower capital charges
- 22. Preface xvii and the enhanced reputation that would come from the regulators’ seal of approval. Applying the Basel II requirements will take financial orga- nizations to, or close to, best practices in operational risk management. Significant operational losses in recent years in the banking industry have highlighted that operational risks can arise from internal and external fraud, failure to comply with employment laws or meet workplace safety standards, policy breaches, compliance breaches, key personnel risks, damage to physical assets, business disruptions and system failures, trans- action processing failures, information security breaches, and so on. Finan- cial organizations such as banks, security companies, and insurance companies have particularly been adversely affected by operational risks in recent years. The list of cases involving catastrophic consequences of procedural and operational momentary failure is long and unfortunately growing. To see the implications of operational risk events, one need only look at the devastating $691 million rogue trading loss at Allfirst Financial, the $484 million settlement due to misleading sales practices at Household Finance, the $1.3 billion loss of Barings Bank as a result of rogue trading operation, and the loss arising from the September 11, 2001, terrorist attack on the World Trade Center, which is estimated to be about $16.9 billion. However, the terrorist attack that took place in Madrid on March 11, 2004 had significantly fewer losses, and the most recent in London on July 7, 2005 found financial organizations worldwide more mature, and thus their financial losses are expected to be respectively less. This is because financial organizations have more knowledge on such risks and are designing and implementing more effective operational risk management frameworks. Concerning the London attack, the market also expects that there will be a big investment for designing and implementing effective operational risk management systems for many operations supporting business sectors that will be part of the upcoming Olympic games in London in the year 2012. Losses such as those that were initiated from the natural disasters of an earthquake and its associated tsunamis that hit the Indian Ocean on December 26, 2004, was one of the most devastating operational risks that are classified in the group of ‘external risks’ in these last few years. The terrible loss of human lives is estimated at over 200,000. The financial loss is yet unknown. This event illustrates how external calamities can affect and disrupt organizations’ normal day-to-day operational activities. One highly visible operational risk event can suddenly end the life of a financial organization. Moreover, many, almost-invisible individual errors of persistent operational risk events over a period of time can strain the resources of the financial organization. Whereas a fundamentally strong organization can often recover from market risk and credit risk events, it may be almost impossible to recover from certain operational risk events. The extent of potential operational risk losses will increase in the future
- 23. xviii Guide to Optimal Operational Risk and Basel II as global financial organizations specialize in unpredictable new products and services, mergers and acquisitions, and outsourcing, to name just a few. For effective operational risk assessment, control, and management, it is vital to identify, measure, model, monitor, evaluate, and determine the operational risk profile, but more important to optimize the implications of the operational risks in operational business performances. This ensures an alignment of these operational risks to the business/strategic objectives, planning process, decision making, practices, and quality initiatives. More- over, strategic and planning policies on when and how to accept, avoid, or mitigate operational risks according to their actual probability, impact, and exposure should be defined. This definition must be consistent with the optimal levels of operational risks. Apart from the underlying approaches, the provision of sound practical tools is essential for efficient operational risk management. This book presents all the key aspects of operational risk management that are also aligned with the Basel II requirements. More important, it gives detailed guidance for the design and implementation of efficient operational risk management systems. Thus, all the elements of the assessment anal- ysis, including the operational risk identification analysis, measurement, modeling, and monitoring analysis, together with the evaluation analysis and the estimation of capital requirements, make up a great part of this book. Additionally, a significant part of this book addresses managing and controlling operational risks, which includes operational risk profiling, optimization, decision making, and design of optimal risk policies. Several novel approaches that combine aspects of advanced mathematical algo- rithmic modeling with business intelligent techniques together with total quality management are outlined in the book. Moreover, a forward-looking design of sound practical tools to drive optimal bottom-line results is highlighted. Practical examples of the approaches are presented to support the guidelines of the book. Because one picture is worth a thousand words, this book contains specially designed graphics to help readers visualize as many ideas and concepts as possible. The graphical output results for the case studies illustrated in the book originate from a software tool that the reader can access at www.crcpress.com/e_products/downloads/ download.asap?cat_no=AU3813. The software tool supports the applica- bility of the material of the book. For more details about the software and any feedback related to the subject of this book, please contact the authors or visit http://www.riskoptimisation.com. Audience This book is intended for practitioners or those who have an interest in learning about operational risk management and its role in the Basel II
- 24. Preface xix Accord. It is particularly suitable for those seeking to grasp the more advanced approaches of assessing, controlling, and managing operational risk in financial organizations. It also serves as a guide to understand the fundamentals of operational risk management and the Basel II operational risk management principles. More important, it serves as a guide for implementing optimal operational risk management systems. Potential readers of the book include but are not limited to: Operational risk managers/chief risk officers/risk analysts Operational risk consultants Operations and business line managers Chief security officers Financial risk managers Chief information officers Actuaries Auditors Compliance officers Insurers University lecturers in risk management subjects Postgraduate students in financial and banking undertaking subjects related to banking processes, management, and risks Financial project managers Organization of This Book The book is divided into four parts. The first part introduces the idea of operational risks and how they affect financial organizations. It also focuses on the main aspects of managing operational risks in financial organizations. Part II focuses on the requirements of an operational risk management framework according to the Basel II Accord. Part III and Part IV of this book give overview guidelines on how to design an efficient framework for operational risk management systems in accordance with Basel II requirements. Whereas Part III concentrates notably on the operational risk assessment phase, Part IV focuses on the controlling and managing of these operational risks. All these stages combine to implement efficient and optimal operational risk management systems. The book is organized as shown in Figure 0.1 Chapter 1: Operational Risks in Financial Organizations This chapter introduces several topics that form the basis of the subsequent chapters. It attempts to show the multifaceted definition of operational risk and highlights some of its major concerns. Examples of operational
- 25. xx Guide to Optimal Operational Risk and Basel II losses in various organizations around the globe are highlighted to put in perspective the need to manage these risks. The characteristics of oper- ational risks are generally discussed, and then the chapter examines the effect of IT and IT security in the realism of operational risks. Chapter 2: Main Aspects of Operational Risk Management This chapter contains a discussion of the main aspects of operational risk management (ORM). Furthermore, effective operational risk management frameworks are outlined. The quantification of operational risks and the testing and verification of the operational risk management framework are then discussed. Enterprisewide risk management, which aims to inte- grate the management of the different types of risks faced by financial organizations, is introduced, together with some main operational risk management concerns. Finally some key players for implementing effec- tively operational risk management frameworks are listed. Figure 0.1 Organization of the book. Main Aspects of ORM Operational Risks Basel II AMA Identification Measurement Guide to Optimal Operational Risk and Basel II Operational Risk Policies Modeling Monitoring Evaluation Analysis Operational Risk Profile Concluding Remarks Optimization Analysis
- 26. Preface xxi Chapter 3: Operational Risk in Basel II This chapter introduces the Basel II Accord, briefly comparing it with its predecessor. The chapter then highlights the meaning of operational risk in Basel II and lists some of the main objectives and targets of the Basel II Accord. A discussion of the three pillars of the accord is also included. The calculation of the minimum capital requirements is subsequently discussed in relation to which of the three proposed Basel II approaches is implemented. The qualifying criteria for operational risk capital calcu- lation are then highlighted with reference to the main factors in selecting an appropriate approach. Finally, Chapter 3 introduces the ten principles of the accord with some action points concerning the three pillars of Basel II, to consider in preparation for an efficient operational risk management framework. Chapter 4: Advanced Measurement Approach Chapter 4 focuses on the advanced measurement approach (AMA) pro- posed by Basel II. It discusses the quantitative standards of the AMA, including the three broad AMA approaches proposed by Basel II. It then discusses the qualifying criteria for operational risk capital calculation using the AMA. In addition, this chapter introduces the supervisory standards for the AMA. Finally, it discusses the use of insurance as an operational risk mitigation strategy under the AMA. Chapter 5: Operational Risk Identification, Measurement, Modeling, and Monitoring Analysis This chapter deals with the framework of methodologies for operational risk identification, measurement, modeling, and monitoring analysis. The chapter gives guidelines on when and how to define key performance and risk indicators and how to measure these indicators, for the informa- tion data extraction process related to operational risk causes, events, and consequences. It also shows how to model and monitor efficiently both operational risks and affected operations based on correlation analysis defined from multidimensional operational risk parameters. Results that illustrate the mapping of the pattern or contour topography of the oper- ational risks and affected operations are presented. Advanced graphical representation using three-dimensional surface illustrations shows the correlation models for both operational risk and affected operations.
- 27. xxii Guide to Optimal Operational Risk and Basel II Chapter 6: Operational Risk Assessment via Evaluation Analysis This chapter focuses on the evaluation process for both operational risks and affected operations. The evaluation is based on significance analysis referring to cause, events, and consequences. Clustering approaches based on fuzzy logic theory are presented to show their implementation for the operational risk evaluation analysis. The identification of the equilibrium points referring to operational risk and affected operations based on two different methods are presented in this chapter. A method called “mountain surface evaluation,” which is based on advanced algorithmic analysis and graphical representation, is also discussed extensively in this chapter. Finally, the estimation and evaluation of the economical capital reserves using the operational VaR and the application of extreme value theory are described in this chapter. Chapter 7: Operational Risk Profiling This chapter gives guidance on how to estimate the probability and impact based on the analysis of the operational risk causes, events, and conse- quences. This analysis is mainly focused on the correlations, significances, actual, and loss values of operational risks. Furthermore, the modeling and monitoring of the operational risk profile, based on fuzzy clustering and fuzzy logic techniques and methodologies, are discussed. These advanced approaches for decision making are applied to different case studies of operational risks in banking organizations. Advanced graphical representation of the results are presented and discussed extensively to show the applicability of the approaches. Chapter 8: Operational Risk Optimization This chapter presents operational risk optimization by means of optimizing the levels of operational risk parameters to minimize the overall value of risks and their effect on the operations. Moreover, techniques of optimizing the resources that should be allocated to manage these risks are also discussed in this chapter. Different optimization techniques and methodolo- gies that can be used for designing effective and optimal operational risk management systems are introduced with a focus on significance–expo- sure– correlation optimization. Results coming from the optimization anal- ysis are also presented and discussed.
- 28. Preface xxiii Chapter 9: Framework for Decision Making and Designing Optimal Risk Policies This chapter provides guidance on how financial organizations should plan their actions and policies for designing efficient operational risk management frameworks. This includes the policies of when to accept, avoid, or transfer/mitigate operational risks. Scenarios used for risk analysis are also presented. Business impact analysis for designing the “worst-case scenario” is also discussed. Moreover, this chapter gives guidelines for designing business continuity plans to deal with operational risks that are severe. The main guidelines for undertaking internal control, in relation to Basel II’s requirements, are also presented. Finally, the importance of reporting tools that banking organizations must have in place to manage the vast amount of information data gathered from operational risk man- agement systems is discussed. All these analyses present a solid platform for effective decision making concerning the assessment, control, and management of operational risks. Chapter 10: Concluding Remarks This chapter offers some concluding remarks and discusses future direc- tions of operational risk management. References are given at the end of every chapter for those interested in strengthening their knowledge beyond the scope of this book. All referenced documents written by the Basel Committee on Banking Super- vision are available fr ee of charge from their Web site at http://www.bis.org/bcbs/publ.htm. A list of acronyms is given in the appendix to ease understanding of the terms used throughout the book.
- 30. xxv Acknowledgments The authors would like to especially thank all those who supported them in various ways to enable them to complete this book. These include, first of all, their individual families, Athena Akkizidou and Nikos Akkizidis. Special thanks go to Vasilios Masmanidis and Christos Ventiadis for their support, Helen Sjöberg for her inspiration, and Maja Kotzmuth-Clarke and Stelios Apostolopoulos for their constant encouraging words. They would also like to thank Dr. Lampros Kalyvas for the valuable participation in discussions, feedback, and small contributions for the material of this book. Finally, the authors would like to mention the country of Sweden, always open to new ideas, which gave them the opportunity to first implement their ideas. They would also like to thank CRC Press and Auerbach Publications, members of The Taylor Francis Group, for giving them the opportunity to publish their work.
- 32. xxvii About the Authors Ioannis Akkizidis, Ph.D. is a business and risk analyst and the main architect of the approaches presented in this book. He has been developing and applying advanced mathematical algorithmic theories and practices to identify, model, map, evaluate, and optimize complex operational risks for banking organizations and big enterprises. He has extensive academic knowledge through his master’s (M.Sc.) in control systems analysis and Ph.D. in artificial intelligence and applied mathematics. He has published several scientific and working papers from journals to newspapers, has presented at several international conferences, and has given ample talks on the subject of operational risk optimization and management. He has worked world- wide for many years in business and risk analysis and has designed and implemented advanced software tools for large organizations and financial organizations. Vivianne Boucher eau, Ph.D. is a business and risk analyst. She has undertaken projects in the field of business performance, operational risk analysis, and optimization, as well as quality management. She has con- tributed to the design of the various methodologies on operational risk assessment, control, and management presented in this book. She has given seminars and talks on operational risk management and Basel II and has several years of working experience in the quality engineering field. She is also a qualified lead quality auditor for ISO 9001: 2000, has written numerous papers on the subject of total quality management, and has been a presenter at numerous international seminars and conferences. She has extensive academic background and working knowledge in this field. She obtained her combined bachelor’s and master’s degree (M.Eng.) in electronic and electrical engineering and her Ph.D. in quality engineering.
- 33. xxviii Guide to Optimal Operational Risk and Basel II Contacting the Authors The authors are pleased to have any feedback and are open to any discussion referring to the subject and material presented in this book. Please contact them via e-mail at: i.akkizidis@optimisation4business.com (Ioannis S. Akkizidis) v.bouchereau@optimisation4business.com (Vivianne Bouchereau)
- 34. I OPERATIONAL RISK AND ITS MANAGEMENT Chapter 1, Operational Risks in Financial Organizations Chapter 2, Main Aspects of Operational Risk Management This first part of this book, which consists of Chapters 1 and 2, introduces the idea of operational risks and how they affect financial organizations. It also focuses on the main aspects of managing operational risks in financial organizations.
- 36. 3 Chapter 1 Operational Risks in Financial Organizations Where there is money, there is risk. —Paul Getty Introduction Managing risk is an old habit of human beings. In their day-to-day lives, people always seem to be worried about future risks. As a result, they end up investing in insurance or other investment methods to secure themselves against unforeseen risks. Accidents, environmental disasters, bankruptcy, and loss of business are risks that have plagued the human race since time began. Generally, no complete protection exists against every potential risk, but appropriate proactive measures to mitigate certain risks can be adopted. The same concept also applies to financial organizations. Under- standing risks has always been a fundamental, if only implicit, management process in financial organizations. What is new is the following: The increased explicit awareness and consciousness of managers and senior management of risk issues The explicit and analytical approaches
- 37. 4 Guide to Optimal Operational Risk and Basel II The greater awareness to direct an organization’s risk profile toward those risks for which it has a comparative advantage in managing The pressure to allocate resources more consciously Risk management was in its elementary stages until the 1980s. It was not recognized as part of the business management process but only as a method of taking precautionary measures when business went wrong. The concept was, “Do business and then measure the risks,” whereas in today’s economy, the concept is, “Measure the risk first, then do business.” Thus, during the late 1980s and early 1990s, apart from profit-making goals, organizations were faced with other goals, such as accountability, transparency, and performance, as demanded by their investors. Risk management has always been a fundamental management process in financial organizations. It is a well-known fact that where there is money, a certain amount of risk must be involved. In the realm of the financial domain today, the term “risk” is being used more frequently. It is recom- mended that operations integrate risk management into decision making in the same way it has already integrated such critical factors as time, money, and labor. Managing risks effectively has become the duty of everyone involved in financial organizations. Nowadays, however, there is more pressure to avoid things going wrong while continuing to improve corporate performance. By monitoring risk more closely, financial orga- nizations can minimize the required amount of reserve capital and max- imize their profitability. Good risk management is a decisive competitive advantage. It helps to maintain stability and continuity, and it supports revenue and earnings, a process for which senior management and boards of directors are increasingly called upon to ensure. The Basel Committee on Banking Supervision created the first Basel Accord in 1988 (as discussed in Chapter 3) to ensure capital allocation by examining market risk and credit risk within banking organizations. The new version, Basel II, finalized in June 2004, is set to modify its evaluation of credit risk and, more importantly, seeks to assess operational risk, an area previously not clearly defined in the financial services marketplace. It will give banks more flexibility in weigh- ing those risks by providing several new options for calculating credit and operational risks. The bottom-line, less-risky loans should require less capital. The Basel Committee itself does not actually have any authority to impose capital-reserve requirements on the world’s banks; instead, it formulates broad supervisory standards and recommends best practices, which it then turns over to regulatory authorities in its 13 member countries for implementation. The 13 members include the G10 plus Luxembourg and Spain (G10: Canada, Belgium, Germany, Italy, Japan, the Netherlands,
- 38. Operational Risks in Financial Organizations 5 Sweden, Switzerland, United Kingdom, United States). Many nonmember countries are also seeking to comply with its recommendations. Operational risk has existed as financial organizations evolved. Oper- ational risk management in financial organizations as discussed throughout this book is preventive rather than reactive. It is based on the philosophy that it is irresponsible and wasteful to wait for an accident to happen and then figure out how to prevent it from happening again. Over the past several years, financial organizations have focused on developing sophis- ticated tools to measure market risk and credit risk. Today, operational risk has become another critical aspect in risk capital allocation. Unlike with market risk and credit risk, which mainly involve only risks associated with trading and lending, everyone in the organization can be a source of operational risk. The new Basel II Accord instigated by the Bank of International Settlement is undertaking a major effort to fundamentally increase the quantification of operational risk. Operational risk as the most recent area of risk management is therefore all set to face formal quan- tification through the regulatory process. The Basel Committee has observed through various surveys1 that the current measurement of oper- ational risk by banks is relatively undefined and qualitative in nature. Comprehensive, enterprisewide strategy and tactics toward risk can no longer be achieved by applying common sense only — although common sense remains crucial. There is a need for credible and relevant method- ologies to define, identify, assess, measure, analyze, control, and manage risks. Operational risks are highly multifaceted, complex, and often inter- linked. Although not avoidable, operational risks are manageable. Finan- cial organizations and regulators and supervisors should be aware of the cost-benefit relationship of setting in place the quantification of operational risk, which involves data gathering, models, procedures, systems, and staff. The value of financial organizations increasingly lies in its intangible assets, such as data, knowledge, skills, people, network, reputation, and brand. These assets are bundled together in the organization and can also reflect in operational risks. Although operational risk is not a new risk, deregulation and global- ization of financial services, together with the growing sophistication of financial technologies, new business activities, and delivery channels, are making organizations’ operational risk profiles (i.e., the level of operational risk’s probability, impact, and exposure across an organization’s activities and risk categories) more complex. Regulators are currently examining operational and compliance risks under the Bank Secrecy Act,2 USA Patriot Act,3 Gramm–Leach–Bliley Act,4 Basel II Accord,27 Sarbanes–Oxley,31 and Federal Financial Institutions Examination Council (FFIEC) guidelines.5 The Bank Secrecy Act and the
- 39. 6 Guide to Optimal Operational Risk and Basel II USA Patriot Act require programs to be in place for anti-money-laundering, reporting of suspicious activity, large cash transactions, customer identifi- cation, and more. The Gramm–Leach–Bliley Act requires safeguards for customer information, privacy, and information security. The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) and Sarbanes–Oxley both require internal controls review across most depart- ments, which are a subset of the bankwide risk assessment process. FFIEC information technology (IT) handbooks direct senior management and the board of directors to manage IT risks, including information security, business continuity, and disaster recovery. Three excellent reasons for a banking organization to advance its operational risk program are as follows: 1. Regulators are going to require the organization to do so over time. 2. Taking a proactive attitude means doing it according to the orga- nization’s own timelines and on its own terms. 3. The organization’s shareholders expect the organization to add value to its bank. Financial organizations should not accept operational risks simply as fate but should deal with them intentionally. Financial organizations are thus challenged to do the following: Meet their compliance commitment. Employ best practices such as Basel II. Build an appropriate and effective operational risk management system. Assess, measure, analyze, and report operational risks. Design strategies to align and manage operational risks across the organization. Have timely and accurate reporting, tracking, and control of oper- ational risks. Maximize the potential benefits of freeing up capital charge. This chapter introduces several topics that form a basis for subsequent chapters. It begins by defining operational risks and why financial orga- nizations should be concerned about them. This leads to a presentation of where operational risks exist in financial organizations, with concrete examples of where operational risks have caused major catastrophes in financial organizations in the past. Next, causes of operational risks in financial organizations are examined. The characteristics of operational risks are generally discussed; then further details are presented of how operational risk affects, or is affected by, IT. Finally, this chapter looks briefly at IT security. The layout of this chapter is presented pictorially in Figure 1.1.
- 40. Operational Risks in Financial Organizations 7 Operational Risks in Financial Organizations Of all the different types of risks that affect financial organizations, oper- ational risks can be among the most destructive and most difficult to foresee. Operational risks continue to receive keen attention among market participants and regulators, triggering dialogues and debates on the best ways to identify, measure, and manage this important risk. This recognition has led to an increased prominence of the importance of sound operational risk management in financial organizations and, to a greater degree, oper- ational risk in banks’ internal capital assessment and allocation processes. In fact, the banking industry is currently undergoing a surge of innovation and development in these areas. The extraordinary demands of setting up a robust yet sensible and practical operational risk management system are puzzling risk professionals in every industry, and even more in financial organizations, where the regulators set out very detailed requirements. The Basel II Accord focuses on bringing together the world’s financial organizations under a common regulatory framework, although the way to manage operational risk is different for each financial organization; after all, there are over 30,000 banks and an estimated 20,000 insurance companies worldwide. Basel II will enable banks to align r egulatory requirements more closely with their internal risk measurement and to improve operational processes. Forward-thinking organizations recognize that the accord also provides a unique opportunity to modernize and upgrade their overall risk practices and risk infrastructure, specifically for credit and operational risk. For these banks, Basel II means more than Figure 1.1 Layout of Chapter 1. Operational Risks in Financial Organizations OR in Financial Organizations OR Event Types Characteristics of OR OR and IT Operational Risk and its Management
- 41. 8 Guide to Optimal Operational Risk and Basel II compliance; rather, it denotes the opportunity to achieve distinct compet- itive advantage in a tight global market. Some banking organizations have begun developing processes required by Basel II, but few if any organi- zations have made the operational risk framework a practical tool to drive bottom-line results by enhancing operational and performance effectiveness. Management of risk in operations is not a new practice in banking; it has always been essential to prevent fraud, maintain internal controls, and reduce errors in transaction processing. In the past, however, banks relied on internal controls within business lines, supplemented by the audit function, to manage operational risk. By supplementing internal control with monitoring and managing operational risks more closely, financial organizations can minimize the required amount of capital reserve and maximize their profitability. Defining Operational Risks So far, this chapter has discussed operational risk without actually defining what it means. A definition of operational risk is thus needed. A common definition of operational risk has to be understood, accepted, and identical across a financial organization. A common practical definition of operational risk does not exist in literature or in the industry. Operational risk encom- passes various risks inherent in business activities across an organization, and consequently, its losses have the potential to be of much greater magnitude. Operational risk is a broader risk discipline and recognizes that there are components of operational risks that underlie all other risks. The term “operational risk” itself has been defined only in the past few years, although this type of risk has been around for hundreds of years. As opposed to the definitions of “market risk” and “credit risk,” which are relatively clear, the definition of operational risk has evolved rapidly over the past few years. At first, it was commonly defined as every type of nonquantifiable risk faced by a bank. However, further analysis has refined the definition considerably. Theoretically, there are as many definitions as there are financial organizations. The British Bankers’ Association (BBA) survey in 19996 showed that, although there is a broad agreement on the general concept of operational risk, diversity in some detailed aspects will continue to exist. Some definitions of operational risks are reproduced here: “Operational Risk is the risk of everything other than credit and market risk.” (This is the definition of 15 percent of the 55 orga- nizations surveyed.)6 “Operational Risks are events, activities, or circumstances that can affect an organization and the achievement of business/quality objectives.”
- 42. Operational Risks in Financial Organizations 9 “Operational Risk is the risk that deficiencies in information systems or internal controls will result in unexpected loss. The risk is associated with human error, systems failure and inadequate pro- cedures or controls” (Bank for International Settlements [BIS]).7 “Operational Risk is the risk of losses resulting from inadequate or failed processes, people, and system or from external events.”8 A survey conducted in June 2000 by the Risk Management Group (RMG) of the Basel Committee, through its Other Risks Technical Working Group (ORTWG),9 indicated that although a range of definitions is pres- ently used, there has been a high degree of convergence during the past one to two years. The following definition of operational risk, or close variants of it, is used by a large number of banks: “the risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and systems or from external events.” Although some banks included legal risk in their definitions, almost all organizations reject the idea of including strategic and business risk in a regulatory capital charge (although many allocate economic capital for this). Operational risks are only eliminated if a bank ceases to exist; and although market and credit risks are revenue driven, operational risks are not. Credit and market risks originate from outside the bank. In contrast, operational risks originate primarily from within the specific bank, except risks in the category “external” as discussed in the subsequent section. Losses from external events, such as a natural disaster that damages an organization’s physical assets or electrical or telecommunications failures that disrupt the business, are somewhat easier to define than losses from internal problems, such as employees’ fraud and product flaws. Because the risks from internal problems will be closely tied to a bank’s specific products and business lines, they should be more organization specific than the risks due to external events. Because operational risks exist in the natural course of corporate activity, there is a great emphasis on process orientation in the operational risk concept, which positions the definition of operational risk manage- ment closer to “total quality management.” In the banking sector, opera- tional risk resembles similar risks in industry more closely than it resembles market or credit risks in a bank. Operational risk should be managed whenever the way something is usually done is modified, to make the chances of success as great as possible, while making the chances of failure, injury, or loss as small as possible. It is a common-sense approach to balancing the risks against the benefits to be gained in a situation and then choosing the most effective course of action. To further understand operational risks, it is important to view this type of risk in the context of the other risks that affect financial organi- zations. These risks are generally defined as follows:
- 43. 10 Guide to Optimal Operational Risk and Basel II Credit risk Market risk Business risk, which is the risk of losses from business volume changes Insurance underwriting risk, which is the risk of losses from unex- pected insurance claims volume Reputation risk, which is the risk of losses by not meeting stake- holders’ expectations Strategy risk, which is the risk of losses from not choosing “to do the right thing” The characteristics of operational risks are clearly different from other risks: market and credit risks are — with relatively objective market prices or ratings — willingly taken for revenue’s sake. Operational risks are usually not willingly incurred and not priced in the market. Checks and controls of the market and reputation aspects cause every bank not to sustain operational losses because they increase expenses or affect the share prices. Operational risk, simply put, is the risk associated with everyday activities of an organization, which involves the management of the performance of its processes, its people, and its systems to reach the expected business performance, targets, and objectives. Banks can tune their processes to reduce human errors and operational failures, and develop contingency plans for problems such as system breakdowns. Under new regulatory rules, each bank will be allowed to adopt its own definition of operational risk. These individual definitions are subject to the requirement that they provide a clear understanding of what is meant by operational risk, consider the full range of operational risks facing the bank, and capture the most significant causes of severe oper- ational losses. In arriving at the definition, the regulators recognize that the exact approach for operational risk management that a bank chooses “will depend on a range of factors, including its size and sophistication and the nature and complexity of its activities.” Notwithstanding individual differences, the new Basel II Accord demands clearly documented strat- egies and oversight by the board and senior management, a str ong operational risk culture, and internal control culture (including, among other things, clear lines of responsibility and segregation of duties), effective internal escalation, reporting, and contingency planning. Existence of Operational Risks in Financial Organizations In the financial world, operational risks have always been present, and a newly established bank is confronted with operational risks even before
- 44. Operational Risks in Financial Organizations 11 it decides on its first credit transaction or market position. Operational risks are primarily internal risks or “bank made.” External risks must be handled differently and are largely insurable, or will increasingly become insurable. Operational risks include breakdowns in internal controls and corporate governance. These kinds of breakdowns can lead to financial losses through slip-ups, frauds, or failure to carry out operations in a timely manner. It might lead to a situation where the interests of the bank are compromised in some ways; for example, its dealers, lending officers, or other staff exceeding their authority or conducting business in an unscru- pulous or hazardous manner. Other aspects of operational risks include major failure of IT systems or events such as natural mishaps, major fires, or other disasters. Operational risk surfaced in financial organizations since the 1990s as a chain of operational catastrophes affecting numerous financial organizations around the globe. The entire last decade of the twentieth century and the early part of the twenty-first century witnessed news of banking failures as front-page headlines all around the world. One such event took place in late January 2003, when a computer worm called Sapphire spread quickly throughout the Internet and over- whelmed business computers with data. It was a nightmare for business operations, shutting down automatic teller machines (ATMs), congesting online ticketing systems, and blacking out an emergency call center in Seattle, Washington. It highlighted a fear of corporate managers and directors everywhere of operational risk. Operational failures such as those caused by Sapphire can result in huge financial losses and a damaged reputation. In 2001, Deutsche Bank and JPMorgan Chase disclosed large economic capital in insurance premiums for operational risks.10,11 Table 1.4, later in this chapter, highlights further some operational risks that financial organizations have suffered in the past. The increasing number of high-profile operational risk cases has left no doubt in the minds of bank managers and regulators that risk systems and risk-adjusted performance measures are potentially unreliable if they ignore operational risk. Shareholders, employees, rating agencies, equity analysts, and other stakeholders are demanding more focused operational risk information. Each financial organization has its own individual and unique opera- tional settings. Thus, being able to manage operational risk might require tailoring its definition to the organization’s specific settings. Operational risks may tangibly reveal themselves in the likes of business disruption, control failures, errors, misdeeds, or external events and can be captured in five major operational risk categories, which are depicted in Figure 1.2: 1. Organization 2. Processes and Policies
- 45. 12 Guide to Optimal Operational Risk and Basel II 3. Systems and Technology 4. People 5. External Events These five categories can be further expanded. 1. Organization Whatever the reason for a change in business strategy, most major oper- ational risk incidents happen during a period of change in the organization of the business. This could result in a change in staffing levels, a significant change in volumes of transactions as a result of a merger, new product or service launches, or the introduction of new computer programs. The banking history is littered with cases where merger strategies have gone horribly wrong and integration problems far exceeded the expected ben- efits of integration. In the 1980s and early 1990s many European banks sought their fortunes by buying into the U.S. market only to find that the crisis in the residential real estate market and the economy generally forced them to reverse their strategies. These types of risks also arise from such issues as project management, corporate culture and communication, responsibilities, allocation of resources, and business continuity planning. Furthermore, operational risks brought on by the risks embedded in the Figure 1.2 Sources of operational risk in financial organizations. External Events People Systems and Technology Processes and Policies Organization Sources of Operational Risks
- 46. Operational Risks in Financial Organizations 13 governance and structure, outsourcing, and security of the organization form part of this type of risk. 2. Processes and Policies Financial organizations use a huge number of processes to deliver their products and services to their customers. Process and policy risks can arise at any stage in the value chain. For example, marketing material can be mailed to the wrong customers; account opening and transactions can be processed incorrectly. Changes in legislation can render processes that were previously compliant out of compliance. Pension legislation changes in the United Kingdom caused a number of companies to mis-sell pension funds due to a lack of training in new procedures. The total cost to the financial services sector in the United Kingdom to rectify the problem was estimated in excess of £10bn.13 Unexpected volumes of new businesses can also be a source of operational risk. There are numerous examples of new product and service launches that either failed or were seriously compromised due to the bank not being able to cope with the demands for its new product and services. In the urgency to get to market, key processing requirements can be overlooked. In brief, process and policy risks are related to the execution and maintenance of transactions, and to the various aspects of running a business. This includes risks such as mergers and acquisitions, new products and services risks, errors and omissions, inadequate or problematic security, inadequate quality control, and so forth. These stem from risks arising from such issues as model or methodology errors, design errors, and workflows with ambiguously defined process steps. It also includes risks arising from weaknesses in processes such as settlement and payment, noncompliance with internal policies or external regulations, or failures in products or in dealing with clients. Inconsistent or badly documented processes can put the business at risk even if they are followed perfectly. There are three organizational dimensions of internal processes where operational risks should be assessed, controlled, and managed. These dimensions are interrelated: 1. Business-line processes, including their functions 2. Corporate functions (IT, Human Resources, Finance, Legal, etc.) 3. General management 3. Systems and Technology The growing dependency of financial organizations on IT systems is a key source of operational risk. Data corruption problems, whether accidental
- 47. 14 Guide to Optimal Operational Risk and Basel II or deliberate, are regular sources of embarrassing and costly operational mistakes. One bank made payments in excess of $150 million before a computer program patch involving a change in decimal points was found to have been incorrectly tested.13 Another example of a system risk failure was discovered in February 2003 by staff at Provident Financial Group when they were testing the installation of a new financial model. As a result, Provident was forced to subtract $70.3 million from earnings state- ments released in the previous six years.13 On November 20, 1985, the clearing operation of the Bank of New York (BNY) handled more than 32,000 Treasury security trades for the first time. This record volume triggered a software problem, preventing the organization from delivering Treasuries to buyers. The next morning was settlement day, and BNY began accumulating undelivered securities, which had to be financed by borrowings at the discount window of the New York Federal Reserve. BNY had to borrow a staggering $23 billion by the end of the day.13 The following morning, with the software still malfunctioning, dealers were told not to deliver more Treasuries through the affected clearer, which led to a broadening of the disruption. Fortunately, the software was corrected later that day and clearing normalized. Because of a high concentration in the market for clearing services, a single malfunction in a single organization’s system led to an expensive crisis. General technology problems (operational errors that are technology related, unauthorized use or misuse of technology, etc.); hardware (equip- ment failure, inadequate or unavailable hardware, etc.); security (hacking, firewall failure, external disruption, etc.); software (computer viruses, programming bugs, etc.); systems (system failures, system maintenance, etc.); and telecommunications (telephone, fax, e-mails, etc.) are increasingly great sources of operational risks. The IT staff may precisely follow a perfectly designed process, yet fail to meet business goals because of problems with the hardware or software. Only IT people (who are sometimes far removed from the banking business) understand the tech- nologies behind many new banking systems. 4. People Risks arising from people are the most dynamic of all sources of opera- tional risks. Internal controls are often blamed for operational breakdowns, whereas the true causes of many operational losses can be traced back to human failure. Every chief executive officer (CEO) has argued that people are the most important resource in their banks, yet the difficulty in measuring and modeling people risks has often led management to shy away from the problem when it comes to evaluating this aspect of
- 48. Operational Risks in Financial Organizations 15 operational risk. Operational risk losses can occur due to workers’ com- pensation claims, violation of employee health and safety rules, organized labor activities, and discrimination claims. People risks can also include inadequate training and management, human error, lack of segregation, reliance on key individuals, lack of integrity, and lack of honesty. These operational risks may be intensified by poor training, inadequate controls, poor staffing resources, or other factors. These types of operational risks cover losses intentionally or unintentionally caused by an employee, that is, employee errors (general transaction errors, incorrect routing of trans- action, etc.), employee misdeeds, or that involve employees, such as in the area of employment disputes, human resource issues (employee unavailability, hiring or firing, etc.), personal injuries, physical injury (bodily injury, health and safety, etc.), and wrongful acts (fraud, unlawful trading, etc.). In a people operational risk case, the United Kingdom’s Financial Services Authority (FSA) fined ABN Amro £900,000 in April 200312 for “serious compliance failures.” According to the FSA, the compliance envi- ronment within a financial organization is a fundamental protection against the spread of poor standards of conduct. ABN Amro failed to provide adequate resources for its compliance function, which resulted in the absence of robust compliance. In July 2003, JPMorgan Chase agreed to pay €135 million and Citigroup agreed to pay €120 million to the Securities and Exchange Commission for their roles in Enron’s manipulation of its financial statements.13 These are operational risks arising from fraud or incompetence, allowed by control weaknesses in processes or systems, failure of employees or the employer due to conflict of interest or from other internal fraudulent behavior. It is well known in most financial organizations that fraud is initiated from people and is one of the most important risks with unknown further implications. Human processing errors (for example, mishandling of software applications, reports contain- ing incomplete information, payments made to incorrect parties without recovery, unnecessary rejection of a profitable trade or improper trading strategy due to incomplete information) are all examples of operational risk resulting from people. Even if an organization’s processes and tech- nology are flawless, human actions (whether accidental or deliberate) can put a business at risk. 5. External Events Banks tend to have the least control over this source of operational risk, yet it still needs to be managed. External risks can arise from unexpected legislative changes, such as consumer affairs, and from physical threats,
- 49. 16 Guide to Optimal Operational Risk and Basel II such as bank robberies, terrorist attacks, and natural disasters. The most striking example of external operational risk on a financial organization is the effects of the terrorist attack on the Bank of New York in September 2001. In addition to the lost lives, the total lost output to the New York City economy from the World Trade Center attack is estimated at $16.9 billion.14 These losses included the cost of business disruption, a combi- nation of lost revenues due to market closure, and dislocation expenses. Although the aggregate losses were manageable in this incidence, many individual financial services organizations experienced a devastating loss of life and intellectual capital. Some factors are beyond the organization’s control, but can still affect the infrastructure in a way that harms the business. Natural events such as earthquakes and floods also fall into this category, which can cause damage to physical property or assets. A more recent act of operational risk took place only last year. This time, it was from an external event. On December 26, 2004, an undersea earthquake hit the Indian Ocean. The earthquake generated a tsunami that was among the deadliest disasters in modern history. At a magnitude of 9.0, it was one of the lar gest earthquakes to hit in modern times. The loss of human lives is estimated at more than 200,000.15 But some economists believe that damage to the affected countries' economies will be minor because losses in the tourism and fishing industries are a relatively small percentage of the gross domestic product (GDP). Tourism is likely to recover quickly because tourist operators and tourists are largely insured for loss.16 However, others caution that damage to infrastructure is an overriding factor. In some areas, drinking water supplies and farm fields may have been contaminated for years by saltwater from the ocean.17 Beyond the heavy toll on human lives, the Indian Ocean earthquake has caused an enormous environmental impact that will affect the region for many years to come. It is important to understand that natural disasters on this scale have less visible, but critically important, economywide (macroeconomic) effects. This is because of the impact of damage to productive sectors (fishing, tourism) that generate jobs, tax revenue, and foreign exchange, but also because government expenditure must be diverted from other uses. Furthermore, externally generated, man-made problems such as civil unrest, strikes, and demonstrations fall into this category. There can even be strategic risks such as taxation or political risks under this group of operational risks. This category also includes the risk presented by actions of external parties, such as fraud, or in the case of regulators, the execution of change that would alter the organization’s ability to continue operating in certain markets. These also include operational risks arising from fraud or legal actions by parties external to the organization, as well as lack of physical security for the organization and its representatives.
- 50. Operational Risks in Financial Organizations 17 The exposure of an organization to operational risk may increase during times of significant changes to its business, infrastructure, and business operating environment (for example, following a corporate restructure or changes in regulatory requirements). Before, during, and after expected changes, an organization should assess and monitor their effect on its operational risk profile.18 Operational irregularities tend to happen more often in branches or remote subsidiaries than at head offices. Senior management and boards of directors have to take their supervisory function seriously and invest time in it. This often requires a personal follow-up, no hesitation in being more demanding on details, as well as a sharing of the personal assessment of the situation with colleagues. Interactions between Operational Risks The categories described thus far are broad, and there is a certain amount of overlap or interaction (Figure 1.3) between the individual components that should form the characteristics of an effective operational risk man- agement system. The intertwined relationship among them may be very complex. This interactive relationship must somehow be understood. From an internal perspective, people and systems and technology interact to produce a successful process (or, sometimes, an unsuccessful one). The organization provides the procedures, standards, rules, and controls that govern the interactions between the other elements. When an operation is unsuccessful or an incident occurs, the opera- tional risk management system must be analyzed and the inputs and Figure 1.3 Operational risks are related to a certain degree. Organization Processes Systems and Technology People External Events Op Risk
- 51. 18 Guide to Optimal Operational Risk and Basel II interaction among the elements must be thoroughly reassessed. The orga- nization is often the controlling factor in operational success or failure. People are the area of greatest variability and, as a result, the sources of the majority of operational risks. For example, if a newly hired operator undergoes training on the backup software and a week later makes a mistake that causes the backup to fail, is the source of operational risk “people” or “process”? It is recommended that the organization look for root causes as opposed to effect. When a risk event is formulating, the causes or originating source of it must be identified as well as what consequences it will have and the resulting effect it will have on other risks. The resulting consequences if the risk is to be “accepted,” “avoided,” or “mitigated” must also be understood. It is important that this categori- zation relies on a root cause analysis, that is, causes of operational risk loss events, which are captured in the loss event database. Identifying root causes can help to identify additional, related risks. By linking causation to relevant business activities, through correlation analysis, this structure is intended to be used as a tool with which to act upon operational risks. This provides management with an effective operational risk management framework. The structure also lends itself to quantification of operational risks by drawing on data sources relevant for modeling. Such a structure is discussed more thoroughly in later chapters, but Figure 1.4 shows a brief example of the sequence of events, consequences, and effects of an operational risk such as “Network Con- nection Failure.” Realistically, some operational risks must be accepted. How much is accepted, or not accepted, mainly depends on the operational risk impact and internal policies of the organization. Operational risks with a high degree of impact should not be accepted even if their probability is low. The decision to accept operational risk is affected by many inputs and policies. As trade-offs are considered and operation planning progresses, it may become evident that some of the safety parameters are forcing higher risk to successful operation completion. When a manager decides to accept operational risks, the decision should be coordinated whenever practical with the affected personnel and organizations, and then docu- mented so that in the future everyone will know and understand the elements of the decision and why it was made. Characteristics of Operational Risks Some of the major reasons and concerns why operational risks have recently surfaced in the financial world are outsourcing, deregulation and
- 52. Operational Risks in Financial Organizations 19 Figure 1.4 A chain of operational risk events. Event Non-accessibility of trading information Consequence A Trading Service desk unable to configure dial up connections Consequence B High number of instances of remote connectivity is logged Consequence C Time-consuming process and high cost to resolve Effect A Some users experience connection problems Effect B Unable to establish remote network links Effect C Unable to access corporate intranet applications Cause Network Connection Failure Solution A Mitigate the impact or probability of event by running two ISP services in parallel for a limited period and setting a deadline for users to manually configure their dial-up connections Effect D Monetary loss Consequence D Loss of remote trading capability Solution B If event is unavoidable, contingency plan should assign local service desks to guide users through manually making and checking the configuration needed to reconnect
- 53. 20 Guide to Optimal Operational Risk and Basel II globalization, regulations, mergers and acquisitions, E-commerce, techno- logical innovations, and terrorism, to name just a few. These are depicted in Figure 1.5. Developments such as the use of more highly automated technology, the growth of E-commerce, and large-scale mergers and acquisitions test the viability of newly integrated systems. The increased popularity of outsourcing and the greater use of financing techniques that reduce credit and market risk, but that create increased operational risk all suggest that operational risk exposures may be substantial and growing. The emer- gence of banks acting as large-volume service providers creates the need for continual maintenance of high-grade internal controls and backup systems. Although globalization has many advantages for the stakeholders of a modern organization, it usually adds complexity and diversity of cultures, management, and staff. The growing sophistication of financial technology makes the activities of banks and their risk profiles more complex by operating in different markets, using different operations, different systems, and different laws. Large-scale acquisitions, mergers, and alliances, as well as de-mergers and consolidations, test the capability of new or newly integrated systems, processes, and people. The two major drivers — globalization and Internet-related technolo- gies — will challenge financial organizations to take on additional and partly new operational risks. Operational risks are primarily driven by the following factors: Figure 1.5 Reasons for increased operational risks. Terrorism Outsourcing Operational Risk Deregulation and Globalization Regulations Mergers and Acquisitions Competition Technological Innovations E-commerce Corporate Governance Large Number of Services Shareholders Requirements
- 54. Operational Risks in Financial Organizations 21 New products Product sophistication New distribution channels New markets New technology Complexity (IT interdependencies, data structures) E-commerce Processing speed Business volume New legislation Globalization Shareholder and other stakeholder pressure Regulatory pressure Mergers and acquisitions Reorganizations Staff turnover Cultural diversity of staff and clients Faster aging of know-how Rating agencies Insurance companies Capital markets Operational risks mostly affect business lines that have: High-volume transactions High turnover (transactions/time) A high degree of structural change Complex systems One such business line is trading activities. Table 1.1 lists certain characteristics of operational risks and their challenges. Operational risk deficiencies appear in every bank, almost daily. The magnitude of the impact of such risks can be categorized into different levels, such as High, Medium, and Low, as shown in Table 1.2. The table also shows the impact definition in terms of business disturbances and losses. Operational Risk Event Types Table 1.3 is an adapted list of the types of operational risk events identified as having the potential to result in substantial losses. A more explicit detail
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- 56. that we utterly repudiated that damnable doctrine of Metellus Numidicus. My father, wholly unmoved, as soon as a sullen silence was established, recommenced—Do not think, ladies, said he, that you were without advocates at that day: there were many Romans gallant enough to blame the Censor for a mode of expressing himself which they held to be equally impolite and injudicious. 'Surely,' said they, with some plausibility, 'if Numidicus wished men to marry, he need not have referred so peremptorily to the disquietudes of the connection, and thus have made them more inclined to turn away from matrimony than given them a relish for it.' But against these critics one honest man (whose name of Titus Castricius should not be forgotten by posterity) maintained that Metellus Numidicus could not have spoken more properly; 'For remark,' said he, 'that Metellus was a censor, not a rhetorician. It becomes rhetoricians to adorn, and disguise, and make the best of things; but Metellus, sanctus vir—a holy and blameless man, grave and sincere to wit, and addressing the Roman people in the solemn capacity of Censor—was bound to speak the plain truth, especially as he was treating of a subject on which the observation of every day, and the experience of every life, could not leave the least doubt upon the mind of his audience.' Still Riccabocca, having decided to marry, has no doubt prepared himself to bear all the concomitant evils—as becomes a professed sage; and I own I admire the art with which Pisistratus has drawn the precise woman likely to suit a philosopher. Pisistratus bows, and looks round complacently; but recoils from two very peevish and discontented faces feminine. Mr. Caxton (completing his sentence.)—Not only as regards mildness of temper and other household qualifications, but as regards the very person of the object of his choice. For you evidently remembered, Pisistratus, the reply of Bias, when asked his opinion
- 57. on marriage: Ητοι καλην ἑξεις, η αισχραν· και ει καλην, ἑξεις κοινην· ει δη αισχραν ἑξεις ποινην. Pisistratus tries to look as if he had the opinion of Bias by heart, and nods acquiescingly. Mr. Caxton.—That is, my dears, 'The woman you would marry is either handsome or ugly; if handsome, she is koiné, viz., you don't have her to yourself; if ugly, she is poiné—that is, a fury.' But, as it is observed in Aulus Gellius (whence I borrow this citation), there is a wide interval between handsome and ugly. And thus Ennius, in his tragedy of Menalippus, uses an admirable expression to designate women of the proper degree of matrimonial comeliness, such as a philosopher would select. He calls this degree stata forma—a rational, mediocre sort of beauty, which is not liable to be either koiné or poiné. And Favorinus, who was a remarkably sensible man, and came from Provence—the male inhabitants of which district have always valued themselves on their knowledge of love and ladies—calls this said stata forma the beauty of wives—the uxorial beauty. Ennius says that women of a stata forma are almost always safe and modest. Now Jemima, you observe, is described as possessing this stata forma; and it is the nicety of your observation in this respect, which I like the most in the whole of your description of a philosopher's matrimonial courtship, Pisistratus, (excepting only the stroke of the spectacles) for it shows that you had properly considered the opinion of Bias, and mastered all the counter logic suggested in Book v. Chapter xi., of Aulus Gellius. For all that, said Blanche, half-archly, half-demurely, with a smile in the eye, and a pout of the lip, I don't remember that Pisistratus, in the days when he wished to be most complimentary, ever assured me that I had a stata forma—a rational, mediocre sort of beauty. And I think, observed my uncle, that when he comes to his real heroine, whoever that may be, he will not trouble his head much about either Bias or Aulus Gellius.
- 58. CHAPTER II. Matrimony is certainly a great change in life. One is astonished not to find a notable alteration in one's friend, even if he or she have been only wedded a week. In the instance of Dr. and Mrs. Riccabocca the change was peculiarly visible. To speak first of the lady, as in chivalry bound, Mrs. Riccabocca had entirely renounced that melancholy which had characterized Miss Jemima: she became even sprightly and gay, and looked all the better and prettier for the alteration. She did not scruple to confess honestly to Mrs. Dale, that she was now of opinion that the world was very far from approaching its end. But, in the mean while, she did not neglect the duty which the belief she had abandoned serves to inculculate—She set her house in order. The cold and penurious elegance that had characterized the Casino disappeared like enchantment—that is, the elegance remained, but the cold and penury fled before the smile of woman. Like Puss-in-Boots after the nuptials of his master, Jackeymo only now caught minnows and sticklebacks for his own amusement. Jackeymo looked much plumper, and so did Riccabocca. In a word, the fair Jemima became an excellent wife. Riccabocca secretly thought her extravagant, but, like a wise man, declined to look at the house bills, and ate his joint in unreproachful silence. Indeed, there was so much unaffected kindness in the nature of Mrs. Riccabocca—beneath the quiet of her manner there beat so genially the heart of the Hazeldeans—that she fairly justified the favorable anticipations of Mrs. Dale. And though the Doctor did not noisily boast of his felicity, nor, as some new married folks do, thrust it insultingly under the nimis unctis naribus—the turned-up noses of your surly old married folks, nor force it gaudily and glaringly on the envious eyes of the single, you might still see that he was a more cheerful and light-hearted man than before. His smile was less ironical, his politeness less distant. He did not study Machiavelli so intensely—and he did not return to the spectacles; which last was an
- 59. excellent sign. Moreover, the humanizing influence of the tidy English wife might be seen in the improvement of his outward or artificial man. His clothes seemed to fit him better; indeed, the clothes were new. Mrs. Dale no longer remarked that the buttons were off the wristbands, which was a great satisfaction to her. But the sage still remained faithful to the pipe, the cloak, and the red silk umbrella. Mrs. Riccabocca had (to her credit be it spoken) used all becoming and wife-like arts against these three remnants of the old bachelor Adam, but in vain, Anima mia—soul of mine, said the Doctor, tenderly, I hold the cloak, the umbrella, and the pipe, as the sole relics that remain to me of my native country. Respect and spare them. Mrs. Riccabocca was touched, and had the good sense to perceive that man, let him be ever so much married, retains certain signs of his ancient independence—certain tokens of his old identity, which a wife, the most despotic, will do well to concede. She conceded the cloak, she submitted to the umbrella, she concealed her abhorrence of the pipe. After all, considering the natural villainy of our sex, she confessed to herself that she might have been worse off. But, through all the calm and cheerfulness of Riccabocca, a nervous perturbation was sufficiently perceptible; it commenced after the second week of marriage—it went on increasing, till one bright sunny afternoon, as he was standing on his terrace gazing down upon the road, at which Jackeymo was placed—lo, a stage-coach stopped! The Doctor made a bound, and put both hands to his heart as if he had been shot; he then leapt over the balustrade, and his wife from her window beheld him flying down the hill, with his long hair streaming in the wind, till the trees hid him from her sight. Ah, thought she with a natural pang of conjugal jealousy, henceforth I am only second in his home. He has gone to welcome his child! And at that reflection Mrs. Riccabocca shed tears. But so naturally amiable was she, that she hastened to curb her emotion, and efface as well as she could the trace of a stepmother's
- 60. grief. When this was done, and a silent, self-rebuking prayer murmured over, the good woman descended the stairs with alacrity, and, summoning up her best smiles, emerged on the terrace. She was repaid; for scarcely had she come into the open air, when two little arms were thrown round her, and the sweetest voice that ever came from a child's lips, sighed out in broken English, Good mamma, love me a little. Love you? with my whole heart! cried the stepmother, with all a mother's honest passion. And she clasped the child to her breast. God bless you, my wife! said Riccabocca, in a husky tone. Please take this, too, added Jackeymo, in Italian, as well as his sobs would let him—and broke off a great bough full of blossoms from his favorite orange-tree, and thrust it into his mistress's hand. She had not the slightest notion what he meant by it! CHAPTER III. Violante was indeed a bewitching child—a child to whom I defy Mrs. Caudle herself (immortal Mrs. Caudle!) to have been a harsh stepmother. Look at her now, as, released from those kindly arms, she stands, still clinging with one hand to her new mamma, and holding out the other to Riccabocca—with those large dark eyes swimming in happy tears. What a lovely smile!—what an ingenuous candid brow! She looks delicate—she evidently requires care—she wants the mother. And rare is the woman who would not love her the better for that! Still, what an innocent infantine bloom in those clear smooth cheeks! —and in that slight frame, what exquisite natural grace!
- 61. And this, I suppose, is your nurse, darling? said Mrs. Riccabocca, observing a dark foreign-looking woman, dressed very strangely— without cap or bonnet, but a great silver arrow stuck in her hair, and a filagree chain or necklace resting upon her kerchief. Ah, good Annetta, said Violante in Italian. Papa, she says she is to go back; but she is not to go back—is she? Riccabocca, who had scarcely before noticed the woman, started at that question—exchanged a rapid glance with Jackeymo—and then, muttering some inaudible excuse, approached the Nurse, and, beckoning her to follow him, went away into the grounds. He did not return for more than an hour, nor did the woman then accompany him home. He said briefly to his wife that the Nurse was obliged to return at once to Italy, and that she would stay in the village to catch the mail; that indeed she would be of no use in their establishment, as she could not speak a word of English; but that he was sadly afraid Violante would pine for her. And Violante did pine at first. But still, to a child it is so great a thing to find a parent—to be at home—that, tender and grateful as Violante was, she could not be inconsolable while her father was there to comfort. For the first few days, Riccabocca scarcely permitted any one to be with his daughter but himself. He would not even leave her alone with his Jemima. They walked out together—sat together for hours in the Belvidere. Then by degrees he began to resign her more and more to Jemima's care and tuition, especially in English, of which language at present she spoke only a few sentences (previously, perhaps, learned by heart), so as to be clearly intelligible. CHAPTER IV. There was one person in the establishment of Dr. Riccabocca, who was satisfied neither with the marriage of his master nor the arrival
- 62. of Violante—and that was our friend Lenny Fairfield. Previous to the all-absorbing duties of courtship, the young peasant had secured a very large share of Riccabocca's attention. The sage had felt interest in the growth of this rude intelligence struggling up to light. But what with the wooing, and what with the wedding, Lenny Fairfield had sunk very much out of his artificial position as pupil, into his natural station of under-gardener. And on the arrival of Violante, he saw, with natural bitterness, that he was clean forgotten, not only by Riccabocca, but almost by Jackeymo. It was true that the master still lent him books, and the servant still gave him lectures on horticulture. But Riccabocca had no time nor inclination now to amuse himself with enlightening that tumult of conjecture which the books created. And if Jackeymo had been covetous of those mines of gold buried beneath the acres now fairly taken from the Squire (and good-naturedly added rent-free, as an aid to Jemima's dower), before the advent of the young lady whose future dowry the produce was to swell—now that she was actually under the eyes of the faithful servant, such a stimulus was given to his industry, that he could think of nothing else but the land, and the revolution he designed to effect in its natural English crops. The garden, save only the orange-trees, was abandoned entirely to Lenny, and additional laborers were called in for the field-work. Jackeymo had discovered that one part of the soil was suited to lavender, that another would grow chamomile. He had in his heart apportioned a beautiful field of rich loam to flax; but against the growth of flax the Squire set his face obstinately. That most lucrative, perhaps, of all crops, when soil and skill suit, had, it would appear, been formerly attempted in England much more commonly than it is now; since you will find few old leases which do not contain a clause prohibitory of flax, as an impoverishment of the land. And though Jackeymo learnedly endeavored to prove to the Squire that the flax itself contained particles which, if returned to the soil, repaid all that the crop took away, Mr. Hazeldean had his old-fashioned prejudices on the matter, which were insuperable. My forefathers, quoth he, did not put that clause in their leases without good cause; and as the Casino
- 63. lands are entailed on Frank, I have no right to gratify your foreign whims at his expense. To make up for the loss of the flax, Jackeymo resolved to convert a very nice bit of pasture into orchard ground, which he calculated would bring in £10 net per acre by the time Miss Violante was marriageable. At this, the Squire pished a little; but as it was quite clear that the land would be all the more valuable hereafter for the fruit trees, he consented to permit the grass land to be thus partially broken up. All these changes left poor Lenny Fairfield very much to himself—at a time when the new and strange devices which the initiation into book knowledge creates, made it most desirable that he should have the constant guidance of a superior mind. One evening after his work, as Lenny was returning to his mother's cottage very sullen and very moody, he suddenly came in contact with Sprott the tinker. CHAPTER V. The tinker was seated under a hedge, hammering away at an old kettle—with a little fire burning in front of him—and the donkey hard by, indulging in a placid doze. Mr. Sprott looked up as Lenny passed —nodded kindly, and said: Good evenin', Lenny: glad to hear you be so 'spectably sitivated with Mounseer. Ay, answered Lenny, with a leaven of rancor in his recollections, You're not ashamed to speak to me now, that I am not in disgrace. But it was in disgrace, when it wasn't my fault, that the real gentleman was most kind to me.
- 64. Ar—r, Lenny, said the Tinker, with a prolonged rattle in that said Ar —r, which was not without great significance. But you sees the real gentleman who han't got his bread to get, can hafford to 'spise his cracter in the world. A poor tinker must be timbersome and nice in his 'sociations. But sit down here a bit, Lenny; I've summat to say to ye! To me— To ye. Give the neddy a shove out i' the vay, and sit down, I say. Lenny rather reluctantly, and somewhat superciliously, accepted this invitation. I hears, said the Tinker in a voice made rather indistinct by a couple of nails which he had inserted between his teeth; I hears as how you be unkimmon fond of reading. I ha' sum nice cheap books in my bag yonder—sum as low as a penny. I should like to see them, said Lenny, his eyes sparkling. The Tinker rose, opened one of the panniers on the ass's back, took out a bag which he placed before Lenny, and told him to suit himself. The young peasant desired no better. He spread all the contents of the bag on the sward, and a motley collection of food for the mind was there—food and poison—serpentes avibus—good and evil. Here, Milton's Paradise Lost, there The Age of Reason—here Methodist tracts, there True Principles of Socialism—Treatises on Useful Knowledge by sound learning actuated by pure benevolence— Appeals to Operatives by the shallowest reasoners, instigated by the same ambition that had moved Eratosthenes to the conflagration of a temple; works of fiction admirable as Robinson Crusoe, or innocent as the Old English Baron, beside coarse translations of such garbage as had rotted away the youth of France under Louis Quinze. This miscellany was an epitome, in short, of the mixed World of Books, of that vast City of the Press, with its palaces and hovels, its aqueducts and sewers—which opens all alike to the naked eye and the curious
- 65. mind of him to whom you say, in the Tinker's careless phrase, suit yourself. But it is not the first impulse of a nature, healthful and still pure, to settle in the hovel and lose itself amid the sewers; and Lenny Fairfield turned innocently over the bad books, and selecting two or three of the best, brought them to the Tinker and asked the price. Why, said Mr. Sprott, putting on his spectacles, you has taken the werry dearest: them 'ere be much cheaper, and more hinterestin'. But I don't fancy them, answered Lenny; I don't understand what they are about, and this seems to tell one how the steam-engine is made, and has nice plates; and this is Robinson Crusoe, which Parson Dale once said he would give me—I'd rather buy it out of my own money. Well, please yourself, quoth the Tinker; you shall have the books for four bob, and you can pay me next month. Four bobs—four shillings? it is a great sum, said Lenny, but I will lay by, as you are kind enough to trust me; good evening, Mr. Sprott. Stay a bit, said the Tinker; I'll just throw you these two little tracks into the barging; they be only a shilling a dozen, so 'tis but tuppence—and ven you has read those, vy, you'll be a reglar customer. The Tinker tossed to Lenny Nos. 1 and 2 of Appeals to Operatives, and the peasant took them up gratefully. The young knowledge-seeker went his way across the green fields, and under the still autumn foliage of the hedgerows. He looked first at one book, then at another; he did not know on which to settle.
- 66. The Tinker rose and made a fire with leaves and furze and sticks, some dry and some green. Lenny has now opened No. 1 of the tracts: they are the shortest to read, and don't require so much effort of the mind as the explanation of the steam-engine. The Tinker has now set on his grimy glue-pot, and the glue simmers. CHAPTER VI. As Violante became more familiar with her new home, and those around her became more familiar with Violante, she was remarked for a certain stateliness of manner and bearing, which, had it been less evidently natural and inborn, would have seemed misplaced in the daughter of a forlorn exile, and would have been rare at so early an age among children of the loftiest pretensions. It was with the air of a little princess that she presented her tiny hand to a friendly pressure, or submitted her calm clear cheek to a presuming kiss. Yet withal she was so graceful, and her very stateliness was so pretty and captivating, that she was not the less loved for all her grand airs. And, indeed, she deserved to be loved; for though she was certainly prouder than Mr. Dale could approve of, her pride was devoid of egotism; and that is a pride by no means common. She had an intuitive forethought for others; you could see that she was capable of that grand woman-heroism, abnegation of self; and though she was an original child, and often grave and musing, with a tinge of melancholy, sweet, but deep in her character, still she was not above the happy genial merriment of childhood—only her silver laugh was more attuned, and her gestures more composed than those of children, habituated to many playfellows, usually are. Mrs. Hazeldean liked her best when she was grave, and said she would become a very sensible woman. Mrs. Dale liked her best when she was gay, and said, she was born to make many a heart ache; for
- 67. which Mrs. Dale was properly reproved by the Parson. Mrs. Hazeldean gave her a little set of garden tools; Mrs. Dale a picture- book and a beautiful doll. For a long time the book and the doll had the preference. But Mrs. Hazeldean having observed to Riccabocca that the poor child looked pale, and ought to be a good deal in the open air, the wise father ingeniously pretended to Violante that Mrs. Riccabocca had taken a great fancy to the picture book, and that he should be very glad to have the doll, upon which Violante hastened to give them both away, and was never so happy as when mamma (as she called Mrs. Riccabocca) was admiring the picture-book, and Riccabocca with austere gravity dandled the doll. Then Riccabocca assured her that she could be of great use to him in the garden; and Violante instantly put into movement her spade, hoe, and wheelbarrow. This last occupation brought her into immediate contact with Mr. Leonard Fairfield; and that personage one morning, to his great horror, found Miss Violante had nearly exterminated a whole celery- bed, which she had ignorantly conceived to be a crop of weeds. Lenny was extremely angry. He snatched away the hoe, and said, angrily, You must not do that, Miss. I'll tell your papa if you— Violante drew herself up, and never having been so spoken to before, at least since her arrival in England, there was something comic in the surprise of her large eyes, as well as something tragic in the dignity of her offended mien. It is very naughty of you, Miss, continued Leonard, in a milder tone, for he was both softened by the eyes and awed by the mien, and I trust you will not do it again. Non capisco (I don't understand), murmured Violante, and the dark eyes filled with tears. At that moment up came Jackeymo; and Violante, pointing to Leonard, said, with an effort not to betray her emotion, Il fanciullo e molto grossolano (he is a very rude boy).
- 68. Jackeymo turned to Leonard with the look of an enraged tiger. How you dare, scum of de earth that you are, cried he,[13] how you dare make cry the signorina? And his English not supplying familiar vituperatives sufficiently, he poured out upon Lenny such a profusion of Italian abuse, that the boy turned red and white in a breath with rage and perplexity. Violante took instant compassion upon the victim she had made, and, with true feminine caprice, now began to scold Jackeymo for his anger, and, finally approaching Leonard, laid her hand on his arm, and said with a kindness at once childlike and queenly, and in the prettiest imaginable mixture of imperfect English and soft Italian, to which I can not pretend to do justice, and shall therefore translate: Don't mind him. I dare say it was all my fault, only I did not understand you: are not these things weeds? No, my darling signorina, said Jackeymo, in Italian, looking ruefully at the celery-bed, they are not weeds, and they sell very well at this time of the year. But still, if it amuses you to pluck them up, I should like to see who's to prevent it. Lenny walked away. He had been called the scum of the earth, by a foreigner, too! He had again been ill-treated for doing what he conceived his duty. He was again feeling the distinction between rich and poor, and he now fancied that that distinction involved deadly warfare, for he had read from beginning to end those two damnable tracts which the Tinker had presented to him. But in the midst of all the angry disturbance of his mind, he felt the soft touch of the infant's hand, the soothing influence of her conciliating words, and he was half ashamed that he had spoken so roughly to a child. Still, not trusting himself to speak, he walked away, and sat down at a distance. I don't see, thought he, why there should be rich and poor, master and servant. Lenny, be it remembered, had not heard the Parson's Political Sermon.
- 69. An hour after, having composed himself, Lenny returned to his work. Jackeymo was no longer in the garden; he had gone to the fields; but Riccabocca was standing by the celery-bed, and holding the red silk umbrella over Violante as she sat on the ground, looking up at her father with those eyes already so full of intelligence, and love, and soul. Lenny, said Riccabocca, my young lady has been telling me that she has been very naughty, and Giacomo very unjust to you. Forgive them both. Lenny's sullenness melted in an instant; the reminiscences of tracts Nos. 1 and 2, Like the baseless fabrics of a vision, Left not a wreck behind. He raised eyes, swimming with all his native goodness, toward the wise man, and dropped them gratefully on the face of the infant peacemaker. Then he turned away his head and fairly wept. The Parson was right: O ye poor, have charity for the rich; O ye rich, respect the poor. CHAPTER VII. Now from that day the humble Lenny and the regal Violante became great friends. With what pride he taught her to distinguish between celery and weeds—and how proud too, was she when she learned that she was useful! There is not a greater pleasure you can give to children, especially female children, than to make them feel they are already of value in the world, and serviceable as well as protected. Weeks and months rolled away, and Lenny still read, not only the books lent him by the Doctor, but those he bought of Mr. Sprott. As for the bombs and shells against religion which the Tinker carried in
- 70. his bag, Lenny was not induced to blow himself up with them. He had been reared from his cradle in simple love and reverence for the Divine Father, and the tender Saviour, whose life beyond all records of human goodness, whose death beyond all epics of mortal heroism, no being whose infancy has been taught to supplicate the Merciful and adore the Holy, yea, even though his later life may be entangled amidst the thorns of some desolate Pyrrhonism, can ever hear reviled and scoffed without a shock to the conscience and a revolt of the heart. As the deer recoils by instinct from the tiger, as the very look of the scorpion deters you from handling it, though you never saw a scorpion before, so the very first line in some ribald profanity on which the Tinker put his slack finger, made Lenny's blood run cold. Safe, too, was the peasant boy from any temptation in works of a gross and licentious nature, not only because of the happy ignorance of his rural life, not because of a more enduring safeguard—genius! Genius, that, manly, robust, healthful as it be, is long before it lose its instinctive Dorian modesty: shame-faced, because so susceptible to glory—genius, that loves indeed to dream, but on the violet bank, not the dunghill. Wherefore, even in the error of the senses, it seeks to escape from the sensual into worlds of fancy, subtle and refined. But apart from the passions, true genius is the most practical of all human gifts. Like the Apollo, whom the Greek worshiped as its type, even Arcady is its exile, not its home. Soon weary of the dalliance of Tempé, its ascends to its mission—the Archer of the silver bow, the guide of the car of light. Speaking more plainly, genius is the enthusiasm for self-improvement; it ceases or sleeps the moment it desists from seeking some object which it believes of value, and by that object it insensibly connects its self- improvement with the positive advance of the world. At present Lenny's genius had no bias that was not to the Positive and Useful. It took the direction natural to his sphere, and the wants therein, viz., to the arts which we call mechanical. He wanted to know about steam-engines and Artesian wells; and to know about them it was necessary to know something of mechanics and hydrostatics; so he bought popular elementary works on those mystic sciences, and set all the powers of his mind at work on experiments.
- 71. Noble and generous spirits are ye, who with small care for fame, and little reward from pelf, have opened to the intellects of the poor the portals of wisdom! I honor and revere ye; only do not think ye have done all that is needful. Consider, I pray ye, whether so good a choice from the Tinker's bag would have been made by a boy whom religion had not scared from the Pestilent, and genius had not led to the Self-improving. And Lenny did not wholly escape from the mephitic portions of the motley elements from which his awakening mind drew its nurture. Think not it was all pure oxygen that the panting lip drew in. No; there were still those inflammatory tracts. Political I do not like to call them, for politics mean the art of government, and the tracts I speak of assailed all government which mankind has hitherto recognized. Sad rubbish, perhaps, were such tracts to you, O sound thinker, in your easy-chair! Or to you, practiced statesman, at your post on the Treasury Bench—to you, calm dignitary of a learned Church—or to you, my lord judge, who may often have sent from your bar to the dire Orcus of Norfolk's Isle the ghosts of men whom that rubbish, falling simultaneously on the bumps of acquisitiveness and combativeness, hath untimely slain. Sad rubbish to you! But seems it such rubbish to the poor man, to whom it promises a paradise on the easy terms of upsetting a world? For ye see, these Appeals to Operatives represent that same world-upsetting as the simplest thing imaginable—a sort of two-and-two-make-four proposition. The poor have only got to set their strong hands to the axle, and heave-a-hoy! and hurrah for the topsy-turvy! Then, just to put a little wholesome rage into the heave-a-hoy! it is so facile to accompany the eloquence of Appeals with a kind of stir-the-bile-up statistics—Abuses of the Aristocracy—Jobs of the Priesthood—Expenses of Army kept up for Peers' younger sons—Wars contracted for the villainous purpose of raising the rents of the landowners—all arithmetically dished up, and seasoned with tales of every gentleman who has committed a misdeed, every clergyman who has dishonored his cloth; as if such instances were fair specimens of average gentlemen and ministers of religion! All this passionately advanced, (and observe, never answered, for that literature admits no
- 72. controversialists, and the writer has it all his own way), may be rubbish; but it is out of such rubbish that operatives build barricades for attack, and legislators prisons for defense. Our poor friend Lenny drew plenty of this stuff from the Tinker's bag. He thought it very clever and very eloquent; and he supposed the statistics were as true as mathematical demonstrations. A famous knowledge-diffuser is looking over my shoulder, and tells me, Increase education, and cheapen good books, and all this rubbish will disappear! Sir, I don't believe a word of it. If you printed Ricardo and Adam Smith at a farthing a volume, I still believe they would be as little read by the operatives as they are nowadays by a very large proportion of highly-cultivated men. I still believe that while the press works, attacks on the rich, and propositions for heave-a-hoys, will always form a popular portion of the Literature of Labor. There's Lenny Fairfield reading a treatise on hydraulics, and constructing a model for a fountain into the bargain; but that does not prevent his acquiescence in any proposition for getting rid of a National Debt, which he certainly never agreed to pay, and which he is told makes sugar and tea so shamefully dear. No. I tell you what does a little counteract those eloquent incentives to break his own head against the strong walls of the Social System —it is, that he has two eyes in that head, which are not always employed in reading. And, having been told in print that masters are tyrants, parsons hypocrites or drones in the hive, and landowners vampires and bloodsuckers, he looks out into the little world around him, and, first he is compelled to acknowledge that his master is not a tyrant (perhaps because he is a foreigner and a philosopher, and, for what I and Lenny know, a republican). But then Parson Dale, though High Church to the marrow, is neither hypocrite nor drone. He has a very good living, it is true—much better than he ought to have, according to the political opinions of those tracts; but Lenny is obliged to confess that, if Parson Dale were a penny the poorer, he would do a pennyworth's less good; and, comparing one parish with another, such as Rood Hall and Hazeldean, he is dimly aware that
- 73. there is no greater CIVILIZER than a parson tolerably well off. Then, too, Squire Hazeldean, though as arrant a Tory as ever stood upon shoe-leather, is certainly not a vampire nor bloodsucker. He does not feed on the public; a great many of the public feed upon him: and, therefore, his practical experience a little staggers and perplexes Lenny Fairfield as to the gospel accuracy of his theoretical dogmas. Masters, parsons, landowners! having, at the risk of all popularity, just given a coup de patte to certain sages extremely the fashion at present, I am not going to let you off without an admonitory flea in the ear. Don't suppose that any mere scribbling and typework will suffice to answer scribbling and typework set at work to demolish you—write down that rubbish you can't—live it down you may. If you are rich, like Squire Hazeldean, do good with your money; if you are poor, like Signor Riccabocca, do good with your kindness. See! there is Lenny now receiving his week's wages; and though Lenny knows that he can get higher wages in the very next parish, his blue eyes are sparkling with gratitude, not at the chink of the money, but at the poor exile's friendly talk on things apart from all service; while Violante is descending the steps from the terrace, charged by her mother-in-law with a little basket of sago, and suchlike delicacies, for Mrs. Fairfield, who has been ailing the last few days. Lenny will see the Tinker as he goes home, and he will buy a most Demosthenean Appeal—a tract of tracts, upon the Propriety of Strikes, and the Avarice of Masters. But, somehow or other, I think a few words from Signor Riccabocca, that did not cost the Signor a farthing, and the sight of his mother's smile at the contents of the basket, which cost very little, will serve to neutralize the effects of that Appeal, much more efficaciously than the best article a Brougham or a Mill could write on the subject.
- 74. CHAPTER VIII. Spring had come again; and one beautiful May-day, Leonard Fairfield sate beside the little fountain which he had now actually constructed in the garden. The butterflies were hovering over the belt of flowers which he had placed around his fountain, and the birds were singing overhead. Leonard Fairfield was resting from his day's work, to enjoy his abstemious dinner, beside the cool play of the sparkling waters, and, with the yet keener appetite of knowledge, he devoured his book as he munched his crusts. A penny tract is the shoeing-horn of literature: it draws on a great many books, and some too tight to be very useful in walking. The penny tract quotes a celebrated writer, you long to read him; it props a startling assertion by a grave authority, you long to refer to it. During the nights of the past winter, Leonard's intelligence had made vast progress: he had taught himself more than the elements of mechanics, and put to practice the principles he had acquired, not only in the hydraulical achievement of the fountain, nor in the still more notable application of science, commenced on the stream in which Jackeymo had fished for minnows, and which Lenny had diverted to the purpose of irrigating two fields, but in various ingenious contrivances for the facilitation or abridgment of labor, which had excited great wonder and praise in the neighborhood. On the other hand, those rabid little tracts, which dealt so summarily with the destinies of the human race, even when his growing reason, and the perusal of works more classical or more logical, had led him to perceive that they were illiterate, and to suspect that they jumped from premises to conclusions with a celerity very different from the careful ratiocination of mechanical science, had still, in the citations and references wherewith they abounded, lured him on to philosophers more specious and more perilous. Out of the Tinker's bag he had drawn a translation of Condorcet's Progress of Man, and another of Rousseau's Social Contract. These had induced him to select from the tracts in the Tinker's miscellany those which abounded most in professions of philanthropy, and predictions of
- 75. some coming Golden Age, to which old Saturn's was a joke—tracts so mild and mother-like in their language, that it required a much more practical experience than Lenny's to perceive that you would have to pass a river of blood before you had the slightest chance of setting foot on the flowery banks on which they invited you to repose—tracts which rouged poor Christianity on the cheeks, clapped a crown of innocent daffodillies on her head, and set her to dancing a pas de zephyr in the pastoral ballet in which St. Simon pipes to the flock he shears; or having first laid it down as a preliminary axiom, that The cloud-capt towers, the gorgeous palaces, The solemn temples, the great globe itself— Yea, all which it inherit, shall dissolve, substituted in place thereof Monsieur Fourier's symmetrical phalanstere, or Mr. Owen's architectural parallelogram. It was with some such tract that Lenny was seasoning his crusts and his radishes, when Riccabocca, bending his long dark face over the student's shoulder, said abruptly— Diavolo, my friend! What on earth have you got there? Just let me look at it, will you? Leonard rose respectfully, and colored deeply as he surrendered the tract to Riccabocca. The wise man read the first page attentively, the second more cursorily, and only ran his eye over the rest. He had gone through too vast a range of problems political, not to have passed over that venerable Pons Asinorum of Socialism, on which Fouriers and St. Simons sit straddling and cry aloud that they have arrived at the last boundary of knowledge! All this is as old as the hills, quoth Riccabocca irreverently; but the hills stand still, and this—there it goes! and the sage pointed to a cloud emitted from his pipe. Did you ever read Sir David Brewster
- 76. on Optical Delusions? No! Well, I'll lend it to you. You will find therein a story of a lady who always saw a black cat on her hearth- rug. The black cat existed only in her fancy, but the hallucination was natural and reasonable—eh—what do you think? Why, sir, said Leonard, not catching the Italian's meaning, I don't exactly see that it was natural and reasonable. Foolish boy, yes! because black cats are things possible and known. But who ever saw upon earth a community of men such as sit on the hearth-rugs of Messrs. Owen and Fourier? If the lady's hallucination was not reasonable, what is his, who believes in such visions as these? Leonard bit his lip. My dear boy, cried Riccabocca kindly, the only thing sure and tangible to which these writers would lead you, lies at the first step, and that is what is commonly called a Revolution. Now, I know what that is. I have gone, not indeed through a revolution, but an attempt at one. Leonard raised his eyes toward his master with a look of profound respect, and great curiosity. Yes, added Riccabocca, and the face on which the boy gazed exchanged its usual grotesque and sardonic expression for one animated, noble, and heroic. Yes, not a revolution for chimeras, but for that cause which the coldest allow to be good, and which, when successful, all time approves as divine—the redemption of our native soil from the rule of the foreigner! I have shared in such an attempt. And, continued the Italian mournfully, recalling now all the evil passions it arouses, all the ties it dissolves, all the blood that it commands to flow, all the healthful industry it arrests, all the madmen that it arms, all the victims that it dupes, I question whether one man really honest, pure, and humane, who has once gone through such an ordeal, would ever hazard it again, unless he
- 77. was assured that the victory was certain—ay, and the object for which he fights not to be wrested from his hands amidst the uproar of the elements that the battle has released. The Italian paused, shaded his brow with his hand, and remained long silent. Then, gradually resuming his ordinary tone, he continued — Revolutions that have no definite objects made clear by the positive experience of history; revolutions, in a word, that aim less at substituting one law or one dynasty for another, than at changing the whole scheme of society, have been little attempted by real statesmen. Even Lycurgus is proved to be a myth who never existed. They are the suggestions of philosophers who lived apart from the actual world, and whose opinions (though generally they were very benevolent, good sort of men, and wrote in an elegant poetical style) one would no more take on a plain matter of life, than one would look upon Virgil's Eclogues as a faithful picture of the ordinary pains and pleasures of the peasants who tend our sheep. Read them as you would read poets, and they are delightful. But attempt to shape the world according to the poetry—and fit yourself for a madhouse. The farther off the age is from the realization of such projects, the more these poor philosophers have indulged them. Thus, it was amidst the saddest corruption of court manners that it became the fashion in Paris to sit for one's picture with a crook in one's hand, as Alexis or Daphne. Just as liberty was fast dying out of Greece, and the successors of Alexander were founding their monarchies, and Rome was growing up to crush, in its iron grasp, all states save its own, Plato withdraws his eyes from the world, to open them in his dreamy Atlantis. Just in the grimmest period of English history, with the ax hanging over his head, Sir Thomas More gives you his Utopia. Just when the world is to be the theatre of a new Sesostris, the dreamers of France tell you that the age is too enlightened for war, that man is henceforth to be governed by pure reason and live in a paradise. Very pretty reading all this to a man like me, Lenny, who can admire and smile at it. But to you, to the
- 78. man who has to work for his living, to the man who thinks it would be so much more pleasant to live at his ease in a phalanstere than to work eight or ten hours a day; to the man of talent, and action, and industry, whose future is invested in that tranquillity, and order of a state, in which talent, and action and industry are a certain capital; why, Messrs. Coutts, the great bankers, had better encourage a theory to upset the system of banking! Whatever disturbs society, yea, even by a causeless panic, much more by an actual struggle, falls first upon the market of labor, and thence affects, prejudicially, every department of intelligence. In such times the arts are arrested; literature is neglected; people are too busy to read any thing save appeals to their passions. And capital, shaken in its sense of security, no longer ventures boldly through the land, calling forth all the energies of toil and enterprise, and extending to every workman his reward. Now, Lenny, take this piece of advice. You are young, clever, and aspiring: men rarely succeed in changing the world; but a man seldom fails of success if he lets the world alone, and resolves to make the best of it. You are in the midst of the great crisis of your life; it is the struggle between the new desires knowledge excites, and that sense of poverty, which those desires convert either into hope and emulation, or into envy and despair. I grant that it is an up-hill work that lies before you; but don't you think it is always easier to climb a mountain than it is to level it? These books call on you to level the mountain; and that mountain is the property of other people, subdivided among a great many proprietors, and protected by law. At the first stroke of the pick-ax, it is ten to one but what you are taken up for a trespass. But the path up the mountain is a right of way uncontested. You may be safe at the summit, before (even if the owners are fools enough to let you) you could have leveled a yard. Cospetto! quoth the Doctor, it is more than two thousand years ago since poor Plato began to level it, and the mountain is as high as ever! Thus saying, Riccabocca came to the end of his pipe, and, stalking thoughtfully away, he left Leonard Fairfield trying to extract light from the smoke.
- 79. CHAPTER IX. Shortly after this discourse of Riccabocca's, an incident occurred to Leonard that served to carry his mind into new directions. One evening, when his mother was out, he was at work on a new mechanical contrivance, and had the misfortune to break one of the instruments which he employed. Now it will be remembered that his father had been the Squire's head-carpenter; the widow had carefully hoarded the tools of his craft, which had belonged to her poor Mark; and though she occasionally lent them to Leonard, she would not give them up to his service. Among these, Leonard knew that he should find the one that he wanted; and being much interested in his contrivance, he could not wait till his mother's return. The tools, with other little relics of the lost, were kept in a large trunk in Mrs. Fairfield's sleeping room; the trunk was not locked, and Leonard went to it without ceremony or scruple. In rummaging for the instrument, his eye fell upon a bundle of MSS.; and he suddenly recollected that when he was a mere child, and before he much knew the difference between verse and prose, his mother had pointed to these MSS. and said, One day or other, when you can read nicely, I'll let you look at these Lenny. My poor Mark wrote such verses—ah, he was a scollard! Leonard, reasonably enough, thought that the time had now arrived when he was worthy the privilege of reading the paternal effusions, and he took forth the MSS. with a keen but melancholy interest. He recognized his father's handwriting, which he had often seen before in account-books and memoranda, and read eagerly some trifling poems, which did not show much genius, nor much mastery of language and rhythm— such poems, in short as a self-educated man, with poetic taste and feeling, rather than poetic inspiration or artistic culture, might compose with credit, but not for fame. But suddenly, as he turned over these Occasional Pieces, Leonard came to others in a different handwriting—a woman's handwriting—small, and fine, and exquisitely formed. He had scarcely read six lines of these last,
- 80. before his attention was irresistibly chained. They were of a different order of merit from poor Mark's; they bore the unmistakable stamp of genius. Like the poetry of women in general, they were devoted to personal feeling—they were not the mirror of a world, but reflections of a solitary heart. Yet this is the kind of poetry most pleasing to the young. And the verses in question had another attraction for Leonard: they seemed to express some struggle akin to his own—some complaint against the actual condition of the writer's life, some sweet melodious murmurs at fortune. For the rest, they were characterized by a vein of sentiment so elevated that, if written by a man, it would have run into exaggeration; written by a woman, the romance was carried off by so many genuine revelations of sincere, deep, pathetic feeling, that it was always natural, though true to a nature from which you would not augur happiness. Leonard was still absorbed in the perusal of these poems, when Mrs. Fairfield entered the room. What have you been about, Lenny? searching in my box? I came to look for my father's bag of tools, mother, and I found these papers, which you said I might read some day. I doesn't wonder you did not hear me when I came in, said the widow sighing. I used to sit still for the hour together, when my poor Mark read his poems to me. There was such a pretty one about the 'Peasant's Fireside,' Lenny—have you got hold of that? Yes, dear mother; and I remarked the allusion to you: it brought tears to my eyes. But these verses are not my father's—whose are they? They seem a woman's hand. Mrs. Fairfield looked—changed color—grew faint—and seated herself. Poor, poor Nora! said she, faltering. I did not know as they were there; Mark kep 'em; they got among his—
- 81. Leonard.—Who was Nora! Mrs. Fairfield.—Who?—child—who? Nora was—was my own—own sister. Leonard (in great amaze, contrasting his ideal of the writer of these musical lines, in that graceful hand, with his homely uneducated mother, who can neither read nor write).—Your sister—is it possible? My aunt, then. How comes it you never spoke of her before? Oh! you should be so proud of her, mother. Mrs. Fairfield (clasping her hands).—We were proud of her, all of us —father, mother—all! She was so beautiful and so good, and not proud she! though she looked like the first lady in the land. Oh! Nora, Nora! Leonard (after a pause).—But she must have been highly educated? Mrs. Fairfield.—'Deed she was! Leonard.—How was that? Mrs. Fairfield (rocking herself to and fro in her chair.)—Oh! my Lady was her godmother—Lady Lansmere I mean—and took a fancy to her when she was that high! and had her to stay at the Park, and wait on her ladyship; and then she put her to school, and Nora was so clever that nothing would do but she must go to London as a governess. But don't talk of it, boy! don't talk of it! Leonard.—Why not, mother? what has become of her? where is she? Mrs. Fairfield (bursting into a paroxysm of tears.)—In her grave—in her cold grave! Dead, dead! Leonard was inexpressibly grieved and shocked. It is the attribute of the poet to seem always living, always a friend. Leonard felt as if
- 82. some one very dear had been suddenly torn from his heart. He tried to console his mother; but her emotion was contagious, and he wept with her. And how long has she been dead? he asked at last, in mournful accents. Many's the long year, many; but, added Mrs. Fairfield, rising, and putting her tremulous hand on Leonard's shoulder, you'll just never talk to me about her—I can't bear it—it breaks my heart. I can bear better to talk of Mark—come down stairs—come. May I not keep these verses, mother? Do let me. Well, well, those bits o' paper be all she left behind her—yes, keep them, but put back Mark's. Are they all here?—sure? And the widow, though she could not read her husband's verses, looked jealously at the MSS. written in his irregular large scrawl, and, smoothing them carefully, replaced them in the trunk, and resettled over them some sprigs of lavender, which Leonard had unwittingly disturbed. But, said Leonard, as his eye again rested on the beautiful handwriting of his lost aunt—but you call her Nora—I see she signs herself L. Leonora was her name. I said she was my Lady's god-child. We called her Nora for short— Leonora—and I am Leonard—is that how I came by the name? Yes, yes—do hold your tongue, boy, sobbed poor Mrs. Fairfield; and she could not be soothed nor coaxed into continuing or renewing a subject which was evidently associated with insupportable pain.
- 83. CHAPTER X. It is difficult to exaggerate the effect that this discovery produced on Leonard's train of thought. Some one belonging to his own humble race had, then, preceded him in his struggling flight toward the loftier regions of Intelligence and Desire. It was like the mariner amidst unknown seas, who finds carved upon some desert isle a familiar household name. And this creature of genius and of sorrow —whose existence he had only learned by her song, and whose death created, in the simple heart of her sister, so passionate a grief, after the lapse of so many years—supplied to the romance awaking in his young heart the ideal which it unconsciously sought. He was pleased to hear that she had been beautiful and good. He paused from his books to muse on her, and picture her image to his fancy. That there was some mystery in her fate was evident to him; and while that conviction deepened his interest, the mystery itself, by degrees, took a charm which he was not anxious to dispel. He resigned himself to Mrs. Fairfield's obstinate silence. He was contented to rank the dead among those holy and ineffable images which we do not seek to unvail. Youth and Fancy have many secret hoards of idea which they do not desire to impart, even to those most in their confidence. I doubt the depth of feeling in any man who has not certain recesses in his soul into which none may enter. Hitherto, as I have said, the talents of Leonard Fairfield had been more turned to things positive than to the ideal; to science and investigation of fact than to poetry, and that airier truth in which poetry has its element. He had read our greater poets, indeed, but without thought of imitating; and rather from the general curiosity to inspect all celebrated monuments of the human mind, than from that especial predilection for verse which is too common in childhood and youth to be any sure sign of a poet. But now these melodies, unknown to all the world beside, rang in his ear, mingled with his thoughts—set, as it were, his whole life to music. He read poetry with a different sentiment—it seemed to him that he had discovered
- 84. its secret. And so reading, the passion seized him, and the numbers came. To many minds, at the commencement of our grave and earnest pilgrimage, I am Vandal enough to think that the indulgence of poetic taste and reverie does great and lasting harm; that it serves to enervate the character, give false ideas of life, impart the semblance of drudgery to the noble toils and duties of the active man. All poetry would not do this—not, for instance, the Classical, in its diviner masters—not the poetry of Homer, of Virgil, of Sophocles —not, perhaps, even that of the indolent Horace. But the poetry which youth usually loves and appreciates the best—the poetry of mere sentiment—does so in minds already over predisposed to the sentimental, and which require bracing to grow into healthful manhood. On the other hand, even this latter kind of poetry, which is peculiarly modern, does suit many minds of another mould—minds which our modern life, with its hard positive forms, tends to produce. And as in certain climates plants and herbs, peculiarly adapted as antidotes to those diseases most prevalent in the atmosphere, are profusely sown, as it were, by the benignant providence of nature—so it may be that the softer and more romantic species of poetry, which comes forth in harsh, money-making, unromantic times, is intended as curatives and counter-poisons. The world is so much with us, nowadays, that we need have something that prates to us, albeit even in too fine an euphuism, of the moon and stars. Certes, to Leonard Fairfield, at that period of his intellectual life, the softness of our Helicon descended as healing dews. In his turbulent and unsettled ambition, in his vague grapple with the giant forms of political truths, in his bias toward the application of science to immediate practical purposes, this lovely vision of the Muse came in the white robe of the Peacemaker; and with upraised hand, pointing to serene skies, she opened to him fair glimpses of the Beautiful, which is given to Peasant as to Prince—showed to him that on the
- 85. surface of earth there is something nobler than fortune—that he who can view the world as a poet is always at soul a king; while to practical purpose itself, that larger and more profound invention, which poetry stimulates, supplied the grand design and the subtle view—leading him beyond the mere ingenuity of the mechanic, and habituating him to regard the inert force of the matter at his command with the ambition of the Discoverer. But, above all, the discontent that was within him finding a vent, not in deliberate war upon this actual world, but through the purifying channels of song— in the vent itself it evaporated, it was lost. By accustoming ourselves to survey all things with the spirit that retains and reproduces them only in their lovelier or grander aspects, a vast philosophy of toleration for what we before gazed on with scorn or hate insensibly grows upon us. Leonard looked into his heart after the enchantress had breathed upon it; and through the mists of the fleeting and tender melancholy which betrayed where she had been, he beheld a new sun of delight and joy dawning over the landscape of human life. Thus, though she was dead and gone from his actual knowledge, this mysterious kinswoman—a voice and nothing more—had spoken to him, soothed, elevated, cheered, attuned each discord into harmony; and, if now permitted from some serener sphere to behold the life that her soul thus strangely influenced, verily, with yet holier joy, the saving and lovely spirit might have glided onward in the Eternal Progress. We call the large majority of human lives obscure. Presumptuous that we are! How know we what lives a single thought retained from the dust of nameless graves may have lighted to renown? CHAPTER XI.
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