Question:

In the last three years, our bank recorded gross income = {-$10 million, +$8 million, +$13 million).

(i) If alpha = 15%, what is the required capital under the Basic Indicator Approach (BIA) to Oprisk in Basel II?
(ii) Without giving a numeric answer, explain how would this change under Standardized Approach.
(iii) Under the ASA? Why is there an ASA approach?
(iv) If the bank were to adopt an ADVANCED MEASUREMENT APPROACH (AMA), which criteria (requirement) do you think would be most difficult to meet?
(v) In quantitative terms (VaR confidence and holding period), how does the AMA approach require the bank to adequately cover extreme (tail) losses? How does this compare to market risk?

Answer:

(i) Under BIA the capital requirement = $1.575 million = 15% * AVERAGE ($8 MM, $13 MM).

Para 649: “Banks using the Basic Indicator Approach must hold capital for operational risk equal to the average over the previous three years of a fixed percentage (denoted alpha) of positive annual gross income. Figures for any year in which annual gross income is negative or zero should be excluded from both the numerator and denominator when calculating the
average.”

(ii) Instead of alpha (15%) multiplied by the entire bank’s GROSS OPERATING INCOME, the GROSS INCOME for EACH of EIGHT BUSINESS LINES is multiplied by a beta factor of 12% (e.g., retail) to 18% (e.g., trading & sales). In this way the requirement ends up being a weighted average, weighted by business line (i.e., nearer to 18% of gross income if mix of businesses is riskier, nearer to 12% if mix is less risky)

(iii) Under ASA, two business lines (retail banking and commercial banking) do not use gross income as the exposure indicator. Instead, they use outstanding loans. The rationale is that, for these businesses, gross income is distorted and higher gross income does not necessarily correspond to greater operational risk. For example, higher gross income may merely represent riskier loans (as gross is not net of charge offs, it is higher due to higher interest rates) but that risk should already be counted in the credit charge.

(iv) This is just to provoke thinking.

(v) Basel II does not require a particular approach but the QUANTITATIVE CRITERIA say the measure must be consistent with parameters established for the internal ratings-based approach (IRB) for credit risk, which is a confidence of 99.9% and a one-year holding period. Market risk, however, requires 99% confidence over a 10-day holding period.