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Basel ii Operational Risk
Definition of operational risk
Operational risk is defined as the risk of loss resulting from
inadequate or failed internal processes, people and systems or
from external events.
This definition
includes legal risk, but excludes strategic and reputational risk.
The measurement methodologies
The framework outlined below presents three methods for
calculating operational risk capital charges in a continuum of
increasing sophistication and risk sensitivity:
(i) the Basic
Indicator Approach;
(ii) the
Standardised Approach; and
(iii) Advanced
Measurement Approaches (AMA).
Banks are encouraged to move along the spectrum of available
approaches as they develop more sophisticated operational risk
measurement systems and practices. Qualifying criteria for the
Standardised Approach and AMA are presented below.
Internationally active banks and banks with significant
operational risk exposures (for example, specialised processing
banks) are expected to use an approach that is more sophisticated
than the Basic Indicator Approach and that is appropriate for the
risk profile of the institution.
A bank will be permitted to use the Basic
Indicator or Standardised Approach for some parts of its
operations and an AMA for others provided certain minimum criteria
are met.
A bank will not be allowed to choose to revert to a simpler
approach once it has been approved for a more advanced approach
without supervisory approval. However, if a supervisor determines
that a bank using a more advanced approach no longer meets the
qualifying criteria for this approach, it may require the bank to
revert to a simpler approach for some or all of its operations,
until it meets the conditions specified by the supervisor for
returning to a more advanced approach.
The Basic Indicator Approach
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.
The charge may be
expressed as follows:
KBIA = the capital charge under the Basic Indicator Approach
GI = annual gross income, where positive, over the previous three
years
N = number of the previous three years for which gross income is
positive
α = 15%, which is set by the Committee, relating the industry wide
level of required capital to the industry wide level of the
indicator.
Gross income is defined as net interest income plus net
non-interest income.
It is intended that
this measure should:
(i) be gross of any
provisions (e.g. for unpaid interest);
(ii) be gross of operating expenses, including fees paid to
outsourcing service providers;
(iii) exclude realised profits/losses from the sale of securities
in the banking book; and
(iv) exclude extraordinary or irregular items as well as income
derived from insurance.
As a point of entry for capital calculation, no specific criteria
for use of the Basic
Indicator Approach are set out in this Framework. Nevertheless,
banks using this approach
are encouraged to comply with the Committee’s guidance on Sound
Practices for the
Management and Supervision of Operational Risk, February 2003.
The Standardised Approach
In the Standardised Approach, banks’ activities are divided into
eight business lines:
-
corporate finance
-
trading & sales
-
retail banking,
-
commercial banking
-
payment &settlement
-
agency services
-
asset management
-
retail brokerage
Within each
business line, gross income is a broad indicator that serves as a
proxy for the scale of business operations and thus the likely
scale 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 (denoted beta) assigned to that business line.
Beta serves as a
proxy 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.
It should be noted
that in the Standardised Approach gross income is measured for
each business line, not the whole institution, i.e. in corporate
finance, the indicator is the gross income generated in the
corporate finance business line.
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, negative capital charges (resulting from
negative gross income) in any business line may offset positive
capital charges in other business lines without limit.
However, where the aggregate capital charge across all business
lines within a given year is negative, then the input to the
numerator for that year will be zero.
The total capital
charge may be expressed as:
KTSA = the capital charge under the Standardised Approach
GI1-8 = annual gross income in a given year, as defined above in
the Basic Indicator Approach, for each of the eight business lines
β1-8 = a fixed percentage, set by the Committee, relating the
level of required capital to the level of the gross income for
each of the eight business lines.
Advanced Measurement Approaches (AMA)
Under the AMA, the regulatory capital requirement will equal the
risk measure generated by the bank’s internal operational risk
measurement system using the quantitative and qualitative criteria
for the AMA discussed below.
Use of the AMA is
subject to supervisory approval.
A bank adopting the AMA may, with the approval of its host
supervisors and the support of its home supervisor, use an
allocation mechanism for the purpose of determining the regulatory
capital requirement for internationally active banking
subsidiaries that are not deemed to be significant relative to the
overall banking group but are themselves subject to this Framework
in accordance with Part 1.
Supervisory
approval would be conditional on the bank demonstrating to the
satisfaction of the relevant supervisors that the
allocationmechanism for these subsidiaries is appropriate and can
be supported empirically.
The board of
directors and senior management of each subsidiary are responsible
for conducting
their own assessment of the subsidiary’s operational risks and
controls and ensuring the
subsidiary is adequately capitalised in respect of those risks.
Subject to supervisory approval the
incorporation of a well-reasoned estimate of diversification
benefits may be factored in at the group-wide level or at the
banking subsidiary level.
However, any
banking subsidiaries whose host supervisors determine that they
must calculate stand-alone capital requirements may not
incorporate group-wide diversification benefits in their AMA
calculations (e.g. where an internationally active banking
subsidiary is deemed to be significant, the banking subsidiary may
incorporate the diversification benefits of its own operations —
those arising at the sub-consolidated level — but may not
incorporate the diversification benefits of the parent).
The appropriateness of the allocation methodology will be reviewed
with consideration given to the stage of development of
risk-sensitive allocation techniques and the extent to which it
reflects the level of operational risk in the legal entities and
across the banking group.
Supervisors expect
that AMA banking groups will continue efforts to develop
increasingly risk-sensitive operational risk allocation
techniques, notwithstanding initial approval of techniques based
on gross income or other proxies for operational risk.
Observed range of
practice in key elements of Advanced Measurement Approaches (AMA)
October 2006
The work of the Accord Implementation Group's Operational Risk
Subgroup (AIGOR) focuses on the practical challenges associated
with the development, implementation and maintenance of an
operational risk management framework meeting the requirements of
Basel II , particularly as they relate to the Advanced
Measurement Approaches (AMA).
The AIGOR has been specifically
mandated to, among other things, exchange and catalogue subgroup
members' views on operational risk implementation issues and the
range of acceptable bank practices for measuring and managing
operational risk under the AMA.
In recognition of the evolutionary nature of operational risk
management as a risk management discipline, the Basel II Framework
intentionally provides a significant degree of flexibility for
banks in the development of an operational risk management
framework under the AMA.
It is not surprising, therefore, that the
range of practice that has emerged in relation to any given issue
tends to be quite broad.
The flexibility provided banks in the development of an AMA,
however, should not be interpreted to suggest a lesser standard of
supervisory review and assessment or that supervisors are prepared
to accept as reasonable any and all responses to the challenges
banks face in this area.
On the contrary, prudential supervisors
have an interest in identifying and encouraging bank operational
risk practices that are consistent with safety and soundness and
level playing field objectives.
Furthermore, at various times the
industry has encouraged the AIG and its subgroups to establish and
maintain high standards for what constitutes acceptable practice
and to publish "sound practice" papers to communicate those
standards and promote consistency across jurisdictions.
The
Accord Implementation Group (AIG)
was established to share information and thereby promote
consistency in implementation of the Basel II Framework. While the
AIG provides a forum for discussing members' approaches to
implementing Basel II, it is not intended to mandate uniformity of
application of the Framework.
Currently the AIG has two subgroups that share information and
discuss specific issues related to Basel II implementation. The
Validation Subgroup (AIGV) explores issues related to the
validation of systems used to generate the ratings and parameters
that serve as inputs into the internal ratings-based approaches to
credit risk. The AIGV is chaired by Mr Maarten Gelderman, Head of
Quantitative Risk Management at the Netherlands Bank.
The Operational Risk Subgroup (AIGOR) addresses issues related
primarily to banks' implementation of advanced measurement
approaches for operational risk. Mr Kevin Bailey, Deputy
Comptroller, Office of the Comptroller of the Currency, United
States, chairs the group.
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