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P2.T7.20.12. Standardized Measurement Approach (SMA) to operational risk capital

Nicole Seaman

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Learning objectives: Explain the elements of the new standardized approach to measure operational risk capital, including the business indicator, internal loss multiplier and loss component and calculate the operational risk capital requirement for a bank using this approach. Compare the Standardized Measurement Approach (SMA) to earlier methods of calculating operational risk capital, including the Advanced Measurement Approaches (AMA). Describe general and specific criteria recommended by the Basel Committee for the identification, collection and treatment of operational loss data


20.12.1. Basel III's Standardized Measurement Approach (SMA) to operational risk multiplies a Business Indicator Component (BIC) by an Internal Loss Multiplier (ILM) in order to generate the operational risk capital. The BIC is a function of the Business Indicator (BI). In turn, the BI is a financial statement-based proxy for operational risk consisting of three components, each calculated as the average over three years. Each of the following is a component of the Business Indicator (BI) EXCEPT which is not?

a. The financial component (FC) includes net profit/loss on the trading and banking books
b. The services component (SC) includes other operating income/expenses and fee income/expenses
c. The administrative component (AC) includes insurance premiums paid/received, recognized changes in goodwill, and the maximum of (staff expenses; or outsourcing fees)
d. The interest, leases and dividend component (ILDC) adds average dividend income to the minimum of (average net interest income; or a percentage of interest earning assets)

20.12.2. Acme Financial is a large bank whose Business Indicator (BI), for purposes of operational risk capital under the standardized measurement approach (SMA), is well in excess of EUR 1.0 billion. Therefore, Acme is required to use loss data as a direct input into its operational risk capital calculations. In regard to the general and/or specific criteria recommended by the Basel Committee, which of the following is TRUE about the identification, collection, or treatment of operational loss data?

a. P&L provisions or reserves against potential loss impacts are included in the gross loss computation
b. All internal loss events must be included in the gross loss computation regardless of the size of the loss
c. Legal expenses are excluded from the gross loss computation in the operational loss data because they represent the realization of legal risk
d. Receivables (a short-term asset) should be counted as recoveries unless the particular receivable causes the current ratio to exceed an internal limit

20.12.3. Under the standardized measurement approach (SMA) to operational risk capital, Acme Bank determines that its Business Indicator is EUR 56.0 billion. Further, the ratio of its Loss Component to its Business Indicator Component (LC/BIC) is 44.0% such that its Internal Loss Multiplier (ILM) is 0.8050. See the charts below (the blue dot represents the ILM of 0.8050).

Which is nearest to Acme's operational risk capital (ORC) charge?

a. EUR 6.72 billion (RWA are equal to 84.0 billion)
b. EUR 7.37 billion (RWA are equal to 92.1 billion)
c. EUR 45.08 billion (RWA are equal to 663.5 billion)
d. EUR 56.81 billion (RWA are equal to 710.1 billion)

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