Calculating operational risk capital charges

OPERATIONAL RISK
Operational risk is defined as the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events.

There are three methods for calculating operational risk capital charges –
(I)    The Basic Indicator Approach  (II)  The standardised approach and
(III) The Advanced measurement Approach.

A – The Basic Indicator Approach

Banks have to hold capital for operational risk equal to the fixed percentage (Alpha) of average annual gross income over the previous three years.

        K BIA    =    GI  
Where
K BIA = the capital charge under the Basic Indicator Approach
GI      = average annual gross income over the previous three years.
     =  fixed percentage
B – The Standardised Approach

Bank’s activities are divided into 8 business lines: corporate finance, trading and sales, retail banking, commercial banking, payment and settlement, agency services, asset management and retail brokerage. Within each business line, there is a specified broad indicator that reflects the amount of operational risk. The capital charge for each business line is calculated by multiplying gross income by a factor (denoted beta) assigned to that business line. In case, however, any significant revenue earning activity of a bank cannot be approximately categorised under any of the above lines, then that emerging / new activity may be classified under the one to which the highest beta factor is attached, indicating high risk.

C – The Advanced Measurement Approach

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 subject to supervisory approval.

MARKET RISK (Trading Book Issues)

A trading book consists of positions in financial instruments and commodities held either with trading intent or in order to hedge other elements of the trading book.  Valuation of positions in the trading book include systems and control, valuation methodologies and valuation adjustments.

The Second Pillar – Supervisory Revision Process

It includes principles of supervisory review, supervisory transparency and accountability and risk management guidance with respect to banking risks, including guidance pertaining to the treatment of interest rate risk in the banking book.

The supervision review process is intended not only to ensure that banks have adequate capital to support all the risks in their business, but also to encourage banks to develop and use better risk management techniques in monitoring and managing their risks.
There are three main areas that might be particularly suited to treatment under Pillar 2.

i)    Risks considered under Pillar 1 that are not fully captured by the Pillar 1 process (e.g. the proposed Operational risk in Pillar 1 may not adequately cover all the specific risks of any given institution).

ii)    Those factors not taken into account by the Pillar 1 process e.g. interest rate risk

iii)    Factor external to the bank e.g. business cycle effects.

The Committee has identified four key principles of supervisory review: -

I)    Bank should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.

II)    Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process.

III)    Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum.

IV)    Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.

The Third Pillar – Market Discipline

It contains disclosure recommendations and requirements for banks. Core disclosures are those which convey vital information for all institutions and are important to the basic operation of market discipline.  Supplementary disclosures are important for some, but not all, institutions depending on the nature of their risk exposures, capital adequacy and methods adopted to calculate the capital requirement.

3.    COMMENTS OF RBI

RBI appreciates the Basel Committee’s efforts in evolving the New Accord containing proposals that are comprehensive in coverage.When implemented, they would go a long way in making the capital allocation more risk-sensitive and use of supervisory oversight with market discipline would reinforce the supervisory framework and ensure financial stability.  However, the complexity and sophistication of the proposals restricts its universal application in emerging markets, where the banks continue to be the major segment in financial intermediation and would be facing considerable challenges in adopting all the proposals.

The New Accord would involve shift in direct supervisory focus away to the implementation issues.  Further, banks and the supervisors would be required to invest large resources in upgrading their technology and human resources to meet the minimum standards.  The increasing reliance on external rating agencies in the regulatory process would undermine the initiatives of banks in enhancing their risk management policies and practices and internal control systems.  The minimum standards set are complex and beyond the reach of many banks.

It is therefore essential that the Basel Committee should evolve a simplified standardised approach, which could be adopted uniformly by all banks that are not internationally active.  Further, the transitional arrangement proposed in the New Accord may not be sufficient for their banks.  National supervisors may, therefore, be given discretion to decide on the time frame for implementing the Accord and applying it to various banks in their jurisdiction depending upon the scale and complexity of their operations.

Some of the key responses of the RBI are as under :-

    External rating agencies should not be assigned the direct responsibility for risk rating of banking assets primarily in view of enormous subjective element involved in the rating process and lack of transparency and uniformity in risk assessment.

    As an alternative to external rating, supervisor-validated internal rating systems, developed by credit institutions themselves could be accepted as a standard tool for risk assessment.

    Risk weighting of the banks should be delinked from that of the sovereign in which they are incorporated.

    A range of risk weight baskets could be devised to better reflect the default probabilities of corporates at different rating levels.

    Regarding credit risk models, major hurdles principally concern data availability and model validation. Model based approach could be adopted only when the banks develop sufficient expertise and database to estimate the capital.  (Words used : 1067)