Capital is the fuel for any business be it banking or otherwise. An organization requires capital for a variety of purposes including:
1. Exploring new business opportunities
2. Maintaining a strong balance sheet position
3. Regulatory requirements
4. Overcoming market stresses to continue as a going concern
The above mentioned are just a few purposes, but there could be more reasons as to why a business should be well capitalized.
We know that the Basel capital requirements govern the minimum capital adequacy requirements for banks. Basel guidelines specifically talk about the capital requirements for:
o Credit Risk
o Market Risk
o Operational Risk
Banks are expected to maintain this minimum level of capital as required by Basel guidelines at all times. Most of the Banking Regulators globally use the Basel guideline as a template and make small tweaks to the same to make it more relatable with their respective countries’ market.
In this article we will discuss the capital requirement for Operational Risk for a bank. We will follow a step-by-step approach beginning with:
a. Understanding the meaning of operational risk
b. Review various sources from where operational risk emanates
c. Capital calculation methodologies for operational risk capital
What is Operational Risk?
By definition, Operational risk is linked to the losses derived from various operations conducted by the firm as a part of its business as usual (BAU) activities.
A few typical examples of Operational Risk include:
- Cyber risk
- Rogue trading
- Operational failure
- Systems failure
- Regulatory fines etc.
If we review Basel committees definition of operational risk we observe that it covers Legal Risk. However, it ignores Strategic Risk and Reputational Risk for banks. As a result management of the aforesaid two risks that are ignored have to be handled by the bank’s management internally. Management pays special attention to these excluded risks as they have a long-term impact on the firm’s growth as well as its relationship with its customers and counterparties.
Various Sources of Operational Risk:
Basel framework describes Operational Risk Events that banks can use for a robust operational risk framework. A few of the events are enlisted below:
In the Basel framework, there are a few more Risk Events in addition to the ones mentioned above. Interested readers may refer to the Basel guideline to go through the entire list of operational risk events.
Capital Calculation Models for Operational Risk:
1. Basic Indicator Approach (BIA):
This is the easiest way to calculate operational risk capital. Its given by the following simple formula:
An average of 3-year gross income is considered for the capital calculation. Under the BIA approach, we ignore any years of negative gross income. Below is a simple example explaining this approach
2. Advanced Measurement Approach (AMA):
This is a comparatively a complicated approach. Bank uses internal models approved by regulators to compute 1-year VaR like measure of operational risk loss at 99.9% confidence level. It is combined with internal loss data, external loss data, scenario analysis, internal control factors, business & economic environment factors etc.
Capital under AMA = 1-year 99.9% operational risk loss — Expected operational risk loss
There are a few drawbacks of the AMA approach which has rendered it un-usable from a regulatory monitoring perspective. Couple of drawbacks are namely:
- AMA approach involves complex calculations, the approach followed by various banks differs (there is no uniformity). Even if the banks used the exact same set of data, they may still arrive at different capital requirements depending on the assumptions and methodology built into their models
- Also, operational risk capital forms a large portion of the total regulatory capital allocation as required by banks. Also, internal loss data required under AMA approach is subjected to heavy fines in case of non-compliance with regulations
In view of the above drawbacks of the AMA regulators have suggested moving to other approaches. Therefore, an approach called as the Standardized Approach (SA) for operational risk capital calculation has come into use. Let’s discuss a few of its key features below.
3. Standardized Approach (SA)
This SA approach has its roots in the Standardized Measurement Approach (SMA). In this article, we will discuss the Standardized Approach (SA) only.
Standardized approach is based on 3 tenets namely:
With the view of keeping this article simple to understand for all, we have dropped the intricate formulas that go into the calculation of the capital under the Standardized Approach. However, key points to remember about the components of SA include:
a. Banks will be grouped into three buckets based on the size of their BI
b. BIC is calculated by multiplying the BI with marginal coefficient denoted by alpha (α)
c. ILM is a combination of the Loss Component (LC) and the BIC
Operational Risk Capital requirement (ORC) is given as:
ORC = BIC * ILM
Risk Weighted Assets (RWA) for operational risk is equal to 12.5 times ORC
RWA is the number that every bank will calculate on a daily basis. This is a regulatory requirement, and regulators have the authority to ask any bank in their jurisdiction to present their workings for the ORC and RWA mentioned above. Most banks have the capital models implemented in their Treasury Management system which will be triggered at specific time of the day to calculate the Operational Risk Capital and the related RWA for risk management and reporting purposes.
This completes a brief review of the idea of operational risk capital for banks. Specific details pertaining to other aspects of Operational Risk can be looked up in the Basel guidelines. Also, each bank will have an Organizational Policy describing the way the bank views and manages operational risk for its business.
Hope you enjoyed reading this article. Feel free to let me know your thoughts. Happy Learning!