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Basel II's Three Approaches to Operational Risk Management
The operational risk requirements of Basel II proposes three
measurement methodologies for calculating the operational risk
capital charges. These are the Basic Indicator Approach, the
Standardized Approach and the Advanced Measurement Approach.
Under the Basic Indicator Approach banks must hold capital for
operational risk equal to the average over the previous three
years of a fixed percentage (15% for this approach) of positive
annual gross income (figures in respect of any year in which
annual gross income was negative or zero are excluded).
Although no specific criteria are set out for use of the Basic
Indicator Approach, banks using this method are encouraged to
comply with the Committee's guidance on "Sound Practices for the
Management and Supervision of Operational Risk" (BIS; February
2003). These principles require: * A hands on approach in the
creation of an appropriate risk management environment,
* Positive actions in the identification, assessment, monitoring
and control of operational risk,
* Adequate public disclosure.
Under the Standardized Approach a bank's activities are divided
into eight business lines. Within each business line, gross
income is a broad indicator that serves as a stand-in for the
level of business operations and therefore the probable size of
operational risk exposure within each of these business lines.
The capital charge for each business line is calculated by
multiplying gross income by a factor (called the "beta")
assigned to that business line. The beta serves as a substitute
for the industry-wide relationship between the operational risk
loss experience for a given business line and the aggregate
level of gross income for that business line. The business lines
and the beta factors range from 12% for "retail banking", "asset
management" and "retail brokerage"; 15% for "commercial banking"
and "agency services" to 18% for "corporate finance", "trading &
sales" and "payment & settlement".
The total capital charge is calculated as the three-year average
of the simple summation of the regulatory capital charges across
each of the business lines in each year. In any given year, a
negative capital charges (as a result of negative gross income)
in any business line may offset positive capital charges in
other business lines without limit.
At national supervisory level, the supervisor can choose to
allow a bank to use the Alternative Standardized Approach (ASA)
provided the bank is able to satisfy its supervisor that this
alternative approach provides an improved basis for measurement
of risks. Under the ASA, the operational risk capital
charge/methodology is the same as for the Standardized Approach
except that two business lines - "retail banking" and
"commercial banking" where a fixed factor 'm' - replaces gross
income as the exposure indicator and is related to the extent of
loans granted in these areas.
Under the Advanced Measurement Approaches (AMA) the regulatory
capital requirement equals the risk measure generated by the
bank's internal operational risk measurement system using
specific quantitative and qualitative criteria. Use of the AMA
is subject to supervisory approval.
Supervisory approval has to be conditional on the bank being
able to show to the satisfaction of the supervisory authority
that the allocation mechanism for these subsidiaries is
appropriate and can be supported empirically. The quantitative
standards that apply to internally generated operational risk
measures for purposes of calculating the regulatory minimum
capital charge are that any internal operational risk
measurement system must be consistent with the definition of
operational risk and a range of defined loss event types
(covering all operational aspects such as fraud, employee
practices, workplace safety, business practices, processing
practices, business disruption and loss of physical assets).
To qualify for use of the Advanced Measurement Approaches (AMA),
a bank must satisfy its supervisor that,
* The banks board of directors and senior management, are
actively involved in the oversight of the operational risk
management framework;
* The bank has an operational risk management system that is
conceptually sound and which includes an independent operational
risk management function that is responsible for the design and
implementation of the bank's operational risk management
framework;
* The bank has It has sufficient resources to use this approach
in the major business lines as well as the control and audit
areas.
A bank using the AMA will be subject to a period of initial
monitoring by its supervisor before it can be used for
regulatory purposes. This period will allow the supervisor to
determine if the approach is credible and appropriate. The
bank's internal measurement system must be able to reasonably
estimate unexpected losses based on the combined use of internal
and relevant external loss data, scenario analysis and
bank-specific business environment and internal control factors.
The bank's measurement system must also be capable of
supporting an allocation of economic capital for operational
risk across business lines in a manner that creates incentives
to improve business line operational risk management.
Additionally, * The operational risk management function is
responsible for documenting policies and procedures concerning
operational risk management and controls, designing and
implementing the bank's operational risk measurement
methodology, designing and implementing a risk-reporting system
for operational risk, and developing strategies to identify,
measure, monitor and control/mitigate operational risk,
* The bank's internal operational risk measurement system must
be closely integrated into the day-to-day risk management
processes of the bank and its output must be an integral part of
the
process of monitoring and controlling the bank's operational
risk profile. This information must play a major role in risk
reporting, management reporting, internal capital allocation,
and risk analysis.
* Operational risk exposures and loss experience must be
reported regularly to business unit management, senior
management, and to the board of directors.
* The bank's operational risk management system must be well
documented and the bank must have a routine in place for
ensuring compliance with a documented set of internal policies,
controls and procedures concerning the operational risk
management system, which must include policies for the treatment
of noncompliance issues.
* Internal and/or external auditors must perform regular reviews
of the operational risk management processes and measurement
systems. This review must include both the activities of the
business units and of the independent operational risk
management function.
* The validation of the operational risk measurement system by
external auditors and/or supervisory authorities must include
the verification that the internal validation processes are
operating in a satisfactory manner; and making sure that data
flows and processes associated with the risk measurement system
are transparent and accessible. In particular, it is necessary
that auditors and supervisory authorities are in a position to
have easy access, whenever they judge it necessary and under
appropriate procedures, to the system's specifications and
parameters.
Because the analytical approaches for operational risk continue
to evolve the approach or distributional assumptions used to
generate the operational risk measure for regulatory capital
purposes is not being specified by the Basel Committee. A bank
must however be able to show that its approach captures
potentially severe 'tail' loss events. Irrespective of the
approach is used, a bank must demonstrate that its operational
risk measure meets a soundness standard comparable to that of
the internal ratings-based approach for credit risk.
Based on this, bank supervisors will require the bank to
calculate its regulatory capital requirement as the sum of
expected loss (EL) and unexpected loss (UL), unless the bank can
demonstrate that it is adequately capturing EL in its internal
business practices (to base the minimum regulatory capital
requirement on UL alone, the bank must be able to demonstrate to
the satisfaction of its national supervisor that it has measured
and accounted for its EL exposure).
A bank needs to have a credible, transparent, well-documented
and verifiable approach for weighting these basic elements in
its overall operational risk measurement system.
Internal loss data is critical to linking a bank's risk
estimates to its actual loss experience. Such data is most
relevant when it is clearly linked to a bank's current business
activities, technological processes and risk management
procedures. To do this a bank must have documented procedures
for assessing the on-going relevance of historical loss data,
including those situations in which judgment overrides or other
adjustments may be used, to what extent they may be used and who
is authorized to make such decisions. Internally generated
operational risk measures used for regulatory capital purposes
must be based on a minimum five-year observation period of
internal loss data. However, when the bank first moves to the
AMA, a three-year historical data window is acceptable.
To qualify for regulatory capital purposes, a bank's internal
loss collection processes must be able to map its historical
internal loss data into the relevant supervisory categories as
are defined in detail in the Basel II Annexes. The bank must
have documented objective criteria for allocating losses to the
specified business lines and event types. A bank's internal loss
data must be comprehensive. It must capture all material
activities and exposures from all appropriate sub-systems and
geographic locations. The bank must be able to justify that any
excluded activities or exposures, both individually and in
combination would not significantly impact the overall risk
estimates. This should be based on an appropriate minimum gross
loss threshold for internal loss data collection. Additionally,
a bank should collect information relating the date of the
event, any recoveries of loss amounts, as well as descriptive
information about the drivers or causes of the loss event. The
level of detail in any descriptive information should be
appropriate to the size of the gross loss amount.
Operational risk losses that are related to credit risk and have
traditionally been included in banks' credit risk databases
(e.g. collateral management failures) must continue to be
treated as credit risk for the purposes of calculating minimum
regulatory capital. It follows that such losses will not be
subject to the operational risk capital charge. Nevertheless,
for the purposes of internal operational risk management, banks
must identify all material operational risk losses consistent
with the scope of the definition of operational risk and the
defined event types, including those related to credit risk.
A bank's operational risk measurement system must use pertinent
external data (either public data and/or pooled industry data),
especially when there is any possibility to believe that the
bank is potentially exposed to severe losses, however
infrequent. Additionally a bank must use scenario analysis of
expert opinion in conjunction with external data to evaluate its
exposure to high-severity events.
About the author:
Stanley Epstein is a Principal Associate and Director of Citadel
Advantage Ltd., a consultancy dealing in bank operations and
specializing in Operations Risk and Payment Systems. Further
information and details can be found at
http://www.citadeladvantage.com
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