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Business and Management
Risk Analysis and Management

Operational Risk under the Basel II Capital Adequacy Framework

Profile image of Renzo Chavez ChavezRenzo Chavez Chavez

Abstract

The Basel II capital adequacy framework constitutes a very comprehensive regulatory approach to risk assessment in banks. It is far more detailed and sophisticated than the first Basel accord. A special feature is that the new accord is not only targeting banks' financial risk exposures in terms of credit risks and market risks. The scope has been widened to also explicitly incorporate banks' exposure to operational risks in the capital adequacy requirement. For banks this novelty means a major change. Unless they choose to use the highly unsophisticated ‗basic indicator approach' or the ‗standardized approach' proposed in the new Basel accord, it will put significant pressure on them to develop and design appropriate internal risk information models and systems. In this paper we explore banks' operational risk assessment under Basel II in Sweden, where all banks-regardless of size-have to comply with the new regulatory framework. The overall aim is to provide deeper insights into the capability of banks to identify and measure exposures to operational risk and their choice of method for calculating regulatory capital against such exposures.

Figures (8)
Table 1 Business lines and beta factors under the Standardized A pproach Although SA is slightly more sophisticated than BIA, Bonson et al (2007) argue that also a bank that uses this approach is more or less quantifying operational risk with ‘eyes closed’. In fact, they were not able to find any significant positive relationship between operational losses and the gross income of different business lines in their study concerming Spanish banks. Still, this approach is most likely to be adopted by many retail banks as retail banking has been given a # factor below average. Evidently, a lower factor is motivated even though operational loss events occur very frequently in retail banking since the severity of each event is only marginal for the single bank (Fontnouvelle et al, 2006; Garrity, 2007). The picture seems to be the opposite for trading and sales. There are few loss events but occasionally (and unexpectedly) a loss may be extremely high for the bank.
Table 1 Business lines and beta factors under the Standardized A pproach Although SA is slightly more sophisticated than BIA, Bonson et al (2007) argue that also a bank that uses this approach is more or less quantifying operational risk with ‘eyes closed’. In fact, they were not able to find any significant positive relationship between operational losses and the gross income of different business lines in their study concerming Spanish banks. Still, this approach is most likely to be adopted by many retail banks as retail banking has been given a # factor below average. Evidently, a lower factor is motivated even though operational loss events occur very frequently in retail banking since the severity of each event is only marginal for the single bank (Fontnouvelle et al, 2006; Garrity, 2007). The picture seems to be the opposite for trading and sales. There are few loss events but occasionally (and unexpectedly) a loss may be extremely high for the bank.
Figure 1 Operational risk capital under the advanced measurement approach Source: J obst (2007:328) Banks’ internal assessment of operational risk exposures under A MA is based on bot qualitative and quantitative criteria. Qualitative criteria are the main basis for th regulator’s recurring reviews and controls of the accuracy and credibility of the bank’ internal operational risk measurement system, whereas quantitative criteria lay th foundation for a more accurate determination of regulatory capital. However, thes criteria are not specified what regards “the approach or distributional assumption used to generate the operational risk measure for regulatory capital purposes” (BIS 2006:151). The emphasis is instead on banks’ capability to demonstrate that thei internal measurement systems can effectively capture expected and unexpected non frequent but occasionally very severe loss events due to their exposures to operationé risks. A 99.9" percentile confidence interval is stipulated. As is illustrated in Figure 1 this means that a bank’s exposure to a very extreme loss event may fall outside th capital charge. However, the bank is expected to hold capital to cover potential losse from all remaining exposure to operational risk as a consequence of the overa objective to seek to align regulatory capital with economic capital. Given accurate los probability distributions, an adequate capital charge may be derived by summarizin the value at risk (VaR’) of each business line i at the specified confidence level a:
Figure 1 Operational risk capital under the advanced measurement approach Source: J obst (2007:328) Banks’ internal assessment of operational risk exposures under A MA is based on bot qualitative and quantitative criteria. Qualitative criteria are the main basis for th regulator’s recurring reviews and controls of the accuracy and credibility of the bank’ internal operational risk measurement system, whereas quantitative criteria lay th foundation for a more accurate determination of regulatory capital. However, thes criteria are not specified what regards “the approach or distributional assumption used to generate the operational risk measure for regulatory capital purposes” (BIS 2006:151). The emphasis is instead on banks’ capability to demonstrate that thei internal measurement systems can effectively capture expected and unexpected non frequent but occasionally very severe loss events due to their exposures to operationé risks. A 99.9" percentile confidence interval is stipulated. As is illustrated in Figure 1 this means that a bank’s exposure to a very extreme loss event may fall outside th capital charge. However, the bank is expected to hold capital to cover potential losse from all remaining exposure to operational risk as a consequence of the overa objective to seek to align regulatory capital with economic capital. Given accurate los probability distributions, an adequate capital charge may be derived by summarizin the value at risk (VaR’) of each business line i at the specified confidence level a:
Source: Bankféreningen, ”Bank- and finansstatistik 2007 ver I” and Statistics Sweden, ’Bankernas tillgangar och skulder efter bank”. Table 2 The Swedish banking industry at the end of 2007 As shown in Table 2 the size of the industry, in terms of total assets, was almost SEK 3.7b, where commercial ban ks held more than 75 per cent of the assets. Fou commercial banks, Nordea, SEB, SHB and Swedbank, dominate the industry, witt over 70 per cent of the total assets, and may be referred to as ‘the big four’. The independent savings banks (ISBs) are the dominants in terms of number of banks (more than 50 per cent), but these banks are generally small in size. Their operations
Source: Bankféreningen, ”Bank- and finansstatistik 2007 ver I” and Statistics Sweden, ’Bankernas tillgangar och skulder efter bank”. Table 2 The Swedish banking industry at the end of 2007 As shown in Table 2 the size of the industry, in terms of total assets, was almost SEK 3.7b, where commercial ban ks held more than 75 per cent of the assets. Fou commercial banks, Nordea, SEB, SHB and Swedbank, dominate the industry, witt over 70 per cent of the total assets, and may be referred to as ‘the big four’. The independent savings banks (ISBs) are the dominants in terms of number of banks (more than 50 per cent), but these banks are generally small in size. Their operations
Table 3 Approaches used by Swedish banks for calculating regulatory capital against operational risk Evidently, the vast majority of the banks have chosen to use the default approach. This is hardly unexpected since many banks are small in size. The number of banks using the standardized approach (SA) is increasing, though. This is partly explained by the fact that several of the banks that initially did not report their exposure to operational risk have later on chosen to report in accordance with SA.° Also a few banks that at the beginning used BIA have changed to report in accordance with SA, but at the end of 2007 still 80 per cent of the banks used BIA.° The three banks that had not yet
Table 3 Approaches used by Swedish banks for calculating regulatory capital against operational risk Evidently, the vast majority of the banks have chosen to use the default approach. This is hardly unexpected since many banks are small in size. The number of banks using the standardized approach (SA) is increasing, though. This is partly explained by the fact that several of the banks that initially did not report their exposure to operational risk have later on chosen to report in accordance with SA.° Also a few banks that at the beginning used BIA have changed to report in accordance with SA, but at the end of 2007 still 80 per cent of the banks used BIA.° The three banks that had not yet
Both the average and median size ind has affected its choice of approach operational risk exposure. The much hi exes strongly suggest that the size of the bank for calculating regulatory capital against its gher median values indicate that there may be a bias due to the substantially much larger size of the big four. When cleaning for the big four, the average size index is s respectively. The indication of a size ef “ill 81 and 201 for banks using BIA and SA, ffect thus remains, albeit the banking groups are less polarized when excluding the big f rOuUr. Table 4 Swedish banks’ use of measuring approach with respect to bank size at the end of 2007
Both the average and median size ind has affected its choice of approach operational risk exposure. The much hi exes strongly suggest that the size of the bank for calculating regulatory capital against its gher median values indicate that there may be a bias due to the substantially much larger size of the big four. When cleaning for the big four, the average size index is s respectively. The indication of a size ef “ill 81 and 201 for banks using BIA and SA, ffect thus remains, albeit the banking groups are less polarized when excluding the big f rOuUr. Table 4 Swedish banks’ use of measuring approach with respect to bank size at the end of 2007
According to Table 5, the relative capital adequacy requirement of all banks fo covering operational risk exposures was ju 2007 and did almost not vary at all over st below twelve per cent in each quarter 0: the year. Then the variation over time wa higher for banks using SA, but the variation within this group in terms of standarc deviation was much lower than the variation in between banks using BIA. Th relatively lower capital requirements displayed by banks using SA are in line with th regulatory idea that a more sophisticated approach should lead to a lower capita charge. The figures in Table 5 are clearly indicating a 22 to 30 per cent higher average value for the default approach. However, the difference would be even mor pronounced if taken into consideration that the total capital adequacy requirement, i.e the denominator, is also affected when a bank uses a more sophisticated approach tha lowers its capital charge against its exposure to operational risks. Table 5 Share of regulatory operational risk capital to total risk capital in Swedish banks during 2007
According to Table 5, the relative capital adequacy requirement of all banks fo covering operational risk exposures was ju 2007 and did almost not vary at all over st below twelve per cent in each quarter 0: the year. Then the variation over time wa higher for banks using SA, but the variation within this group in terms of standarc deviation was much lower than the variation in between banks using BIA. Th relatively lower capital requirements displayed by banks using SA are in line with th regulatory idea that a more sophisticated approach should lead to a lower capita charge. The figures in Table 5 are clearly indicating a 22 to 30 per cent higher average value for the default approach. However, the difference would be even mor pronounced if taken into consideration that the total capital adequacy requirement, i.e the denominator, is also affected when a bank uses a more sophisticated approach tha lowers its capital charge against its exposure to operational risks. Table 5 Share of regulatory operational risk capital to total risk capital in Swedish banks during 2007
Table 6 Operational risk management in the big four banks according to annual reports of 2007 In an attempt to complement the studies of the big four, we conducted a questionnaire based survey in the mid of 2007 to find out the experience of operational risk assessment within Swedish savings banks. The questionnaire was mailed to 80 banks; 68 ISBs and twelve former savings banks that recently converted to limited banks, referred to as commercial banks in Table 2. As shown in Table 7, the response rate was 33.8 per cent or 27 banks of which 22 ISBs and five former savings banks. Also shown in the table, the distribution of the responding banks matches the total population rather well. The size of the ISBs seems to be somewhat higher amongst the responding banks, whereas the average size of the former savings banks is higher for the total population.
Table 6 Operational risk management in the big four banks according to annual reports of 2007 In an attempt to complement the studies of the big four, we conducted a questionnaire based survey in the mid of 2007 to find out the experience of operational risk assessment within Swedish savings banks. The questionnaire was mailed to 80 banks; 68 ISBs and twelve former savings banks that recently converted to limited banks, referred to as commercial banks in Table 2. As shown in Table 7, the response rate was 33.8 per cent or 27 banks of which 22 ISBs and five former savings banks. Also shown in the table, the distribution of the responding banks matches the total population rather well. The size of the ISBs seems to be somewhat higher amongst the responding banks, whereas the average size of the former savings banks is higher for the total population.
In the questionnaire the respondents were asked to express their opinion about the new regulatory framework with respect to its impact on the bank’s capital adequacy requirement and operational risk assessment as well as the reason for the bank’s choice of approach for calculating reg Starting with the respondents claim is not worth the e operational risks. bank was either i that the ban ffort to make In three of th n alliance w a more sophisticated analysis of the bank’s exposure e five banks using SA, the respondent declared that thus former savin gs banks that the two ISB’s choice of using SA were similar. One of the respondents motivated had converted into limited banks. The reasons beh ulatory capital against its exposure to operational risk. atter, most banks have chosen BIA because it is easy to use. Many k does not require any sophisticated method and that it to the ith, or partly owned by, Swedbank. These banks were ind the Table 7 Characteristics of responding banks and banks in the total population
In the questionnaire the respondents were asked to express their opinion about the new regulatory framework with respect to its impact on the bank’s capital adequacy requirement and operational risk assessment as well as the reason for the bank’s choice of approach for calculating reg Starting with the respondents claim is not worth the e operational risks. bank was either i that the ban ffort to make In three of th n alliance w a more sophisticated analysis of the bank’s exposure e five banks using SA, the respondent declared that thus former savin gs banks that the two ISB’s choice of using SA were similar. One of the respondents motivated had converted into limited banks. The reasons beh ulatory capital against its exposure to operational risk. atter, most banks have chosen BIA because it is easy to use. Many k does not require any sophisticated method and that it to the ith, or partly owned by, Swedbank. These banks were ind the Table 7 Characteristics of responding banks and banks in the total population

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Carolyn Currie

SSRN Electronic Journal, 2005

Most problematic of the Basel II capital adequacy requirements is the subset of Pillar I, requiring provision for operational risk (OR) as distinct from credit and market risk. Previous tests of the strategic effect of this new regulation from three prior Quality Impact Studies (QIS) conducted in G10 countries under the guidance of the Bank for International Settlements, have concluded that OR requirements poses difficulties of definition, implementation, and strategic planning. Anticipated strategic effects include dramatic changes to product development, investment and asset mix, as well as the necessity to rapidly develop new risk rating models and techniques, together with vastly expanded internal and external audit compliance routines. Unlike QIS1, 2 and 3, QIS4 focuses on operational risk, but still has drawbacks. This paper discusses its approach, in view of the ongoing difficulties that banks are experiencing with operational risk, particularly in the construction of a database. It concludes by listing the unanswered questions that have not even been addressed in four studies of the strategic impact of Basel II's OR requirements. It also suggests that many smaller banks and emerging nations may not be able to use the sophisticated approaches and hence will suffer a competitive disadvantage. Hence in view of drawbacks in the simpler approaches such as lack of correlation of operational risk and revenue, other indicators such as the standard deviation of efficiency measures are suggested.

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An Alternative Operational Risk Framework OpRisk Partnership Response to a proposal for a New Basel Capital Accord published by the Basel Committee on Banking Supervision
Tim Jaggs

This paper is a response to the proposal of the Basel Committee for Banking Supervision for a New Capital Adequacy framework that was published on 16 th January 2001. It aims to contribute to the discussion about the capital charge for operational risk by addressing the issue from an alternative perspective. The authors believe that there is an inherent contradiction at the core of the operational risk controversy. The definition of operational risk is cause-based as it defines operational risk as losses caused by specific, if broadly defined, causes whereas systemic safety requires effect-based protection that deals with all operational losses whatever their cause. The operational risk capital buffer is designed to protect institutions from the effects of operational losses. If the causes to which the buffer will respond are specified, institutions will not be protected from effects resulting from unspecified causes. However, in the response the authors do not focus on the definition of operational risk, instead the aim is to present a more constructive approach. The paper develops a viable mechanism for operational risk assessment, measurement, modelling, pricing, rating and transfer. It addresses the issues of economic incentives for banks to comply with the proposed regulatory framework, measurement and modelling in the context of a collaborative framework, the cost of capital and the need for consistency and global standards. The concepts underpinning its conclusions are based on the importance of incentive-compatibility in a regulatory framework and the effective use of market discipline. First, the section on regulation briefly examines the rationale for banking regulation, followed by a section on securitisation that explores alternative sources of operational risk capital. The section on modelling places the measurement and assessment of operational risk into a collaborative framework and the section on disclosure addresses the need for operational loss data for the purposes of modelling as well as market discipline.

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Related topics

  • Operational Risk
  • Capital Adequacy
  • Market Risk
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