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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:where: 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:
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: 
where:
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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