“Basel II” has been in the news an awful lot these past 18 month or so. Unlike Basel I the new standard introduces a capital charge based on operational risk. The words Operational risk themselves immediately raise a whole bunch of questions; What is “Basel II”? What is operational risk? How is the charge going to be calculated? What are the operational risk standards that banks will have to comply with?
Basel II or to use is full name “International Convergence of Capital Measurement and Capital Standards” defines operational risk as “the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events”. This definition explicitly includes legal risk but excludes strategic and reputational risk.
In terms of the Basel II Accord there are three methods for calculating the capital charges for operational risk. The methods provide a range of increasing sophistication and risk sensitivity. The three approaches are:
The Basel Committee has encouraged banks to move along the range of available approaches as they develop more sophisticated operational risk measurement systems and practices.
Internationally active banks, as well as banks who have significant operational risk exposures (such as specialized processing banks) are expected to use an approach that is more sophisticated than the Basic Indicator Approach and which fits the risk profile of the institution.
A bank will not be allowed to revert to a simpler approach once it has been approved for a more advanced approach without supervisory approval. However, if a national bank 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 go back 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.
A bank will be permitted to use the Basic Indicator or Standardized Approach for some parts of its operations and an AMA for others provided certain minimum criteria are met. The conditions under which this is permitted are;
The Basel Committee expects that such approvals will only be granted on an exceptional basis and limited to circumstances where a bank is prevented from meeting these conditions because of implementation decisions of supervisors of the bank’s subsidiary operations in other (foreign) jurisdictions.
Despite the relative brevity of the Operational Risk section the Accord, the source material for risk mitigation is wide and deep indeed. The following is a brief list of some of the current Basel guidelines dealing with various aspects of operational risk.
Stanley Epstein is a Principal Associate and Director of Citadel Advantage Ltd. , a consultancy dealing in bank operations and specializing in Operations Risk and Payment Systems. Further information and details can be found at http://www.citadeladvantage.com