Course: Risk Management (Module III: Management of Risk in Bank Portfolios) NIBM, Pune
Module III: Management of Risk in Bank Portfolios
Section C: Operational Risk
Chapter 5: Operational Risk under Basel III
Dr. Richa Verma Bajaj
Objective
The objective of this chapter is to introduce the new approach “Standardised Approach” to
readers issued recently under Basel III.
Structure
1. Introduction
2. Introduction of Standardised Measurement Approach (SMA) of Operational Risk
3. Standardized Approach of Operational Risk Capital Charge: Computation under
Basel III
1. Introduction
The Operational Risk Analytical Framework, as discussed in previous chapters, provides an
estimate of bank’s operational risk exposure in various business lines from various event
types, which is an aggregate of operational losses that it faces over a one year period at a
soundness standard consistent with a 99.9 percent confidence [Link], various
processes in Operational Risk Management (ORM) framework are:
- Risk mapping of Business lines and Event Types (using internally developed
flowcharts, and control/quality diagrams);
- Risk Identification and assessment through Risk and control self-assessment (use of
audit information)
- Monitoring of data through Key-risk-indicator definition (capture of KRIs)
- Loss data collection (use of operational, exception reports to generate loss or near
miss data), and
- Use of measurement analytics (Building of Scenarios)
All above processes are heavily data driven in producing the needed operational risk
outputs (i.e. loss distributions, operational risk capital charge calculations, ORM reporting
through dashboard etc.), however, banks consider that the capital saving provided by
advanced approach i.e. AMA, relative to TSA, is insufficient, given the cost of implementing
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Course: Risk Management (Module III: Management of Risk in Bank Portfolios) NIBM, Pune
Loss Data Collection System in a bank. Still, some internationally active banks have taken
advantage of strong risk management systems in reducing their capital charge under
advanced approaches in line with regulatory guidelines. Following table shows a quick look
at the major qualitative and quantitative requirements under Basel II of three approaches
detailed in earlier chapters:
Approaches under Basel II for the calculation of the Regulatory Capital for
Operational Risk
Basic Indicator The Standardized Approach Advanced Measurement
Approach Approach
Implementation of -Board of directors and senior -Board of directors and senior
Sound Practice Paper management must be management must be involved
involved - Independent OR function for
- Clear responsibilities for OR OR methods and policies
management function (OR - Regular, systematic OR
policies) reporting integrated into day-
- OR assessment and to-day management
collection of OR losses - Collection of OR losses
- Regular and systematic OR (History≥5 years, initially 3
reporting years)
- Regular independent - Scenario assessment
monitoring of OR - Economic capital (1 year,
- Business Line Mapping 99.9%) and OR expected loss
- Regular independent review
by internal and external
auditors
- Recognition of Insurance (20
percent of Operational Risk
Capital Charge)
2. Introduction of Standardised Measurement Approach (SMA) of Operational
Risk (consultative document issued in March 2016)
The experience of International active banks suggests that AMA involves diverse range of
internal modelling, subject to supervisory approval and provides significant degree of
flexibility to banks. In reality, Basel Committee’s expectations failed to materialize as far as
implementation of advanced approach is concerned. As, AMA is complex and banks have
varied internal modelling practices to compute the capital charges. That is why; committee
determined the withdrawal of internal modelling approaches and introduced SMA
(consultative document, March 2016).
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Course: Risk Management (Module III: Management of Risk in Bank Portfolios) NIBM, Pune
The SMA addresses a number of weaknesses in the current framework:
• The SMA will replace the three existing top-down approaches for calculating
operational risk capital as well as the Advanced Measurement Approach (AMA),
thus significantly simplifying the regulatory framework;
• The revised methodology combines a financial statement-based measure of
operational risk - the "Business Indicator" (BI) - with an individual firm's past
operational losses collected internally. This results in a risk-sensitive framework,
while also promoting consistency in the calculation of operational risk capital
requirements across banks and jurisdictions; and
• The option to use an internal model-based approach for measuring operational risk
- the "Advanced Measurement Approaches" (AMA) - has been removed from the
operational risk framework. As, the Committee believes that existing approach of
modelling of operational risk for regulatory capital purposes is unduly complex and
that the AMA has resulted in excessive variability in risk-weighted assets and
insufficient levels of capital for some internationally active banks.
3. Standardized Approach (SA) of Operational Risk Capital Charge Computation
under Basel III
BCBS published “Basel III: Finalising post-crisis reforms” on December 7. The revised
approach for Operational risk under Basel III is called as Standardised Appraoch. The SA
for measuring minimum operational risk capital requirements replaces all existing top-
down (BIA, TSA, ASA) and Bottom-up (AMA) methods. This approach is applicable to
internationally active banks at a consolidated level, but supervisors retain discretion to
apply SA framework to non-internationally active banks. RBI has not issued any guidelines
on operational risk Standardised approach as yet. Though, Implementation date for SA is
1.1.2022 as mentioned in Basel document.
3.1 Components of Standardized Approach
The standardised approach methodology is based on the following components:
(i) the Business Indicator (BI) which is a financial-statement-based proxy for
operational risk;
(ii) the Business Indicator Component (BIC), which is calculated by multiplying
the BI by a set of regulatory determined marginal coefficients (αi); and
(iii) the Internal Loss Multiplier (ILM), which is a scaling factor that is based on a
bank’s average historical losses and the BIC.
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Course: Risk Management (Module III: Management of Risk in Bank Portfolios) NIBM, Pune
3.1.1. Business Indicator
The Income from banking operations are grouped into three categories for computation of
BI(Business Indicator). It is computed as:
[the ILDC (Interest, Leases and Dividend) component] + [the SC (Services Component)]
+ [the FI (Financial Component)]
- Under Interest, Lease and Dividend Income (ILDC) component (interest income
restricted to 2.25% of Interest Earning Assets)
- Under Services Component (Maximum of other operating income/expense, Max of
fee income/expense
- Financial Component (Absolute net P&L trading book, Absolute net P&L banking
book
In the formula below, a bar above a term indicates that it is calculated as the average over
three years: t, t-1 and t-2,
BI Components: definition
BI P & Lor balance Description
Component sheet items
Interest, Interest income Interest income from all financial assets and other interest
Lease and income
Dividend (includes interest income from financial and operating leases
and profits from leased assets)
Interest expenses Interest expenses from all financial liabilities and other interest
expenses
(includes interest expense from financial and operating leases,
losses, depreciation and impairment of operating leased assets)
Interest earning Total gross outstanding loans, advances, interest bearing
assets (balance securities (including government bonds), and lease assets
sheet item) measured at the end of each financial year
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Course: Risk Management (Module III: Management of Risk in Bank Portfolios) NIBM, Pune
Dividend income Dividend income from investments in stocks and funds not
consolidated in the bank’s financial statements, including
dividend income from non-consolidated subsidiaries,
associates and joint ventures.
Services Fee and Income received from providing advice and services. Includes
commission income received by the bank as an outsourcer of financial
income services.
Fee and Expenses paid for receiving advice and services. Includes
commission outsourcing fees paid by bank for supply of financial services,
expenses but not outsourcing fees paid for supply of non-financial
services
Other Operating Income from ordinary banking operations not included in other
Income BI items but of similar nature
(income from operating leases should be excluded
Other operating Expenses and losses from ordinary banking operations not
expenses included in other BI items but of similar nature and from
operational loss events (expenses from operating leases should
be excluded)
Financial Net profit (loss) • Net profit/loss on trading assets and trading liabilities
on the trading (derivatives, debt securities, equity securities, loans and
book advances, short positions, other assets and liabilities)
• Net profit/loss from hedge accounting
• Net profit/loss from exchange differences
Net profit (loss) Net profit/loss on financial assets and liabilities measured at
on the banking fair value through profit and loss
book • Realized gains/losses on financial assets and liabilities not
measured at fair value through profit and loss (loans and
advances, assets available for sale, assets held to maturity,
financial liabilities measured at amortized cost)
• Net profit/loss from hedge accounting
• Net profit/loss from exchange differences
Source: Basel III guidelines on Operational Risk
3.1.2. The Business Indicator Component
Business Indicator is grouped under three different buckets on the basis of size in euros. At
each bucket a differential coefficient is applied to arrive at the BI component. To calculate
the BIC, the BI is multiplied by the marginal coefficients (αi). The marginal coefficients
increase with the size of the BI as shown in Table 1.
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Course: Risk Management (Module III: Management of Risk in Bank Portfolios) NIBM, Pune
The Sum of the BI components at different buckets will be adjusted with loss data multiplier
3.1.3. Computation of Internal Loss Multiplier
A bank’s internal operational risk loss experience affects the calculation of operational risk
capital through the Internal Loss Multiplier (ILM). ILM is a function of the BIC and the Loss
Component (LC), where the latter is equal to 15 times a bank’s average historical
operational risk losses over preceding 10 years. The ILM is defined as:
The ILM is equal to one where the loss and business indicator components are equal.
Where the LC is greater than the BIC, the ILM is greater than one. That is, a bank with losses
that are high relative to its BIC is required to hold higher capital due to the incorporation of
internal losses into the calculation methodology. Conversely, where the LC is lower than
the BIC, the ILM is less than one. That is, a bank with losses that are low relative to its BIC is
required to hold lower capital due to the incorporation of internal losses into the
calculation methodology. At national discretion, supervisors may set the value of ILM equal to
one for all banks in their jurisdiction. Under Basel III, the Minimum standards for use of loss
data have been prescribed.
3.1.4 Formula for Calculation of SA Capital
Minimum “Operational Risk Capital” = (BIC) * (ILM)
Where:
BIC= Business Indicator Component
ILM= Internal Loss Multiplier
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