Oct 16

Basel II: Operational Risk

by David Harper, CFA, FRM, CIPM

FRM |

operationalRiskIntro

Learning Outcomes (LO 68.14 & LO 68.15)

  • Discuss the three methods for addressing operational risk under the Basel II Accord.
  • Discuss the “evolutionary aspect” of the risk measurement procedures addressed in the Basel II Accord.

Three approaches to operational risk. BIA and SA are top-down (% of gross income), AMA is bottom-up

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Basel II allows three ways to calculate a capital charge for operational risk:

  1. Basic indicator approach (BA)
  2. Standardized approach (SA), including an Alternative Standardized approach (ASA)
  3. Advanced measurement approach (AMA)

The evolutionary aspect of Basel II refers to the idea that banks are "encouraged to move along the spectrum of available approaches" as they develop more sophisticated risk measures and supporting systems. This evolutionary idea extends throughout. There is an evolution in credit risk (from standardized to IRB approach), market risk (from standardized to IMA) and operational risk (from BA to AMA). In each case, the basic trade-off is: if the bank meets tougher sets of qualitative and quantitative standards (i.e., which presumably reflect greater accuracy in risk estimation), they will enjoy generally lower capital charges.

 

Basic indicator approach (BIA)

This method is simple and easy to criticize: the charge is a fixed percentage (currently set at 15%) of the bank's three-year average gross income (negatives years excluded from the average):

bia2

 

Standardized approach (SA)

The standardized approach is similar, except it is an weighted average of gross income where the weighted average depends on the bank's business lines.

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The eight business lines, in order from lower risk to higher risk, are:

  • Business lines that earn a 12% beta factor (multiplier), deemed less operationally risky: Retail banking, Asset management,and Retail brokerage
  • Business lines that earn a 15% beta factor:  Commercial banking, Agency services,
  • Business lines that earn an 18% beta factor, deemed more operationally risky: Corporate finance, Trading and sales,and Payment & settlement

In other words, a bank that mostly engages in retail banking or brokerage would be charged nearer to 12% of gross income; a bank that engaged mostly in corporate finance would be charged nearer to 18%.

 

Alternative Standardized approach (SA)

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The alternative standardized approach makes just two changes to the standardized approach (SA): for retail banking and commercial banking business lines, portfolio volume is the operational risk exposure indicator, instead of gross income. For example, in the case of retail banking, instead of a charge based on 12% of retail banking's gross income (GI), the charge is equal to 12% of 3.5% total, 3-year average outstanding retail loans (and advances).

 

Advanced measurement approach (AMA)

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The AMA approach is not an incremental approach, it is an entirely different approach. The other methods merely charge a percentage of gross income. They could also be called top-down approaches. Under AMA, the bank directly estimates its operational risk exposure from a bottom-up perspective. AMA is flexible, if several requirements are satisfied (see "must have" requirements and "should have" recommendations above). There are three proposed sub-approaches:

  • Internal measurement approach (IMA)
  • Loss distribution approach (LDA)
  • Scorecard approaches

The internal measurement approach (IMA) is very similar to the internal ratings-based approach (IMA) under credit risk. The required capital is a function of operational risk exposure indicators (EI), probability of a loss event (PE), and losses given the events (LGE). That is, expected operational losses are equal to EI x PE x LGE much like expected credit losses are equal to EAD x PD x LGD. Regulators supply the gamma 'multiplier:' the translates an expected loss into a unexpected loss (i.e., value at risk minus expected loss). So, normally expected loss (EL) will be covered by the bank's internal process (just like expected credit losses should be covered by loan provisions and reflected in higher interest rates). But if they are not, the operational risk charge must include them.

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