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Basel II's Three Approaches to Operational Risk Management

The operational risk requirements of Basel IIof the process of monitoring and controlling
proposes three measurement methodologies forthe bank's operational risk profile. This
calculating the operational risk capitalinformation must play a major role in risk
charges. These are the Basic Indicatorreporting, management reporting, internal
Approach, the Standardized Approach and thecapital allocation, and risk
Advanced Measurement Approach.Under the Basicanalysis.-Operational risk exposures and loss
Indicator Approach banks must hold capitalexperience must be reported regularly to
for operational risk equal to the averagebusiness unit management, senior management,
over the previous three years of a fixedand to the board of directors.-The bank's
percentage (15% for this approach) ofoperational risk management system must be
positive annual gross income (figures inwell documented and the bank must have a
respect of any year in which annual grossroutine in place for ensuring compliance with
income was negative or zero area documented set of internal policies,
excluded).Although no specific criteria arecontrols and procedures concerning the
set out for use of the Basic Indicatoroperational risk management system, which
Approach, banks using this method aremust include policies for the treatment of
encouraged to comply with the Committee'snoncompliance issues.-Internal and/or
guidance on "Sound Practices for theexternal auditors must perform regular
Management and Supervision of Operationalreviews of the operational risk management
Risk" (BIS; February 2003). These principlesprocesses and measurement systems. This
require:-A hands on approach in the creationreview must include both the activities of
of an appropriate risk managementthe business units and of the independent
environment,-Positive actions in theoperational risk management function.-The
identification, assessment, monitoring andvalidation of the operational risk
control of operational risk,-Adequate publicmeasurement system by external auditors and
disclosure.Under the Standardized Approach aor supervisory authorities must include the
bank's activities are divided into eightverification that the internal validation
business lines. Within each business line,processes are operating in a satisfactory
gross income is a broad indicator that servesmanner; and making sure that data flows and
as a stand-in for the level of businessprocesses associated with the risk
operations and therefore the probable size ofmeasurement system are transparent and
operational risk exposure within each ofaccessible. In particular, it is necessary
these business lines. The capital charge forthat auditors and supervisory authorities are
each business line is calculated byin a position to have easy access, whenever
multiplying gross income by a factor (calledthey judge it necessary and under appropriate
the "beta") assigned to that business line.procedures, to the system's specifications
The beta serves as a substitute for theand parameters.Because the analytical
industry-wide relationship between theapproaches for operational risk continue to
operational risk loss experience for a givenevolve the approach or distributional
business line and the aggregate level ofassumptions used to generate the operational
gross income for that business line. Therisk measure for regulatory capital purposes
business lines and the beta factors rangeis not being specified by the Basel
from 12% for "retail banking", "assetCommittee. A bank must however be able to
management" and "retail brokerage"; 15% forshow that its approach captures potentially
"commercial banking" and "agency services" tosevere 'tail' loss events. Irrespective of
18% for "corporate finance", "trading &the approach is used, a bank must demonstrate
sales" and "payment & settlement".The totalthat its operational risk measure meets a
capital charge is calculated as thesoundness standard comparable to that of the
three-year average of the simple summation ofinternal ratings-based approach for credit
the regulatory capital charges across each ofrisk.Based on this, bank supervisors will
the business lines in each year. In any givenrequire the bank to calculate its regulatory
year, a negative capital charges (as a resultcapital requirement as the sum of expected
of negative gross income) in any businessloss (EL) and unexpected loss (UL), unless
line may offset positive capital charges inthe bank can demonstrate that it is
other business lines without limit.Atadequately capturing EL in its internal
national supervisory level, the supervisorbusiness practices (to base the minimum
can choose to allow a bank to use theregulatory capital requirement on UL alone,
Alternative Standardized Approach (ASA)the bank must be able to demonstrate to the
provided the bank is able to satisfy itssatisfaction of its national supervisor that
supervisor that this alternative approachit has measured and accounted for its EL
provides an improved basis for measurement ofexposure).A bank needs to have a credible,
risks. Under the ASA, the operational risktransparent, well-documented and verifiable
capital charge/methodology is the same as forapproach for weighting these basic elements
the Standardized Approach except that twoin its overall operational risk measurement
business lines - "retail banking" andsystem.Internal loss data is critical to
"commercial banking" where a fixed factor 'm'linking a bank's risk estimates to its actual
- replaces gross income as the exposureloss experience. Such data is most relevant
indicator and is related to the extent ofwhen it is clearly linked to a bank's current
loans granted in these areas.Under thebusiness activities, technological processes
Advanced Measurement Approaches (AMA) theand risk management procedures. To do this a
regulatory capital requirement equals thebank must have documented procedures for
risk measure generated by the bank's internalassessing the on-going relevance of
operational risk measurement system usinghistorical loss data, including those
specific quantitative and qualitativesituations in which judgment overrides or
criteria. Use of the AMA is subject toother adjustments may be used, to what extent
supervisory approval.Supervisory approval hasthey may be used and who is authorized to
to be conditional on the bank being able tomake such decisions. Internally generated
show to the satisfaction of the supervisoryoperational risk measures used for regulatory
authority that the allocation mechanism forcapital purposes must be based on a minimum
these subsidiaries is appropriate and can befive-year observation period of internal loss
supported empirically. The quantitativedata. However, when the bank first moves to
standards that apply to internally generatedthe AMA, a three-year historical data window
operational risk measures for purposes ofis acceptable.To qualify for regulatory
calculating the regulatory minimum capitalcapital purposes, a bank's internal loss
charge are that any internal operational riskcollection processes must be able to map its
measurement system must be consistent withhistorical internal loss data into the
the definition of operational risk and arelevant supervisory categories as are
range of defined loss event types (coveringdefined in detail in the Basel II Annexes.
all operational aspects such as fraud,The bank must have documented objective
employee practices, workplace safety,criteria for allocating losses to the
business practices, processing practices,specified business lines and event types. A
business disruption and loss of physicalbank's internal loss data must be
assets).To qualify for use of the Advancedcomprehensive. It must capture all material
Measurement Approaches (AMA), a bank mustactivities and exposures from all appropriate
satisfy its supervisor that,-The banks boardsub-systems and geographic locations. The
of directors and senior management, arebank must be able to justify that any
actively involved in the oversight of theexcluded activities or exposures, both
operational risk management framework;-Theindividually and in combination would not
bank has an operational risk managementsignificantly impact the overall risk
system that is conceptually sound and whichestimates. This should be based on an
includes an independent operational riskappropriate minimum gross loss threshold for
management function that is responsible forinternal loss data collection. Additionally,
the design and implementation of the bank'sa bank should collect information relating
operational risk management framework;-Thethe date of the event, any recoveries of loss
bank has It has sufficient resources to useamounts, as well as descriptive information
this approach in the major business lines asabout the drivers or causes of the loss
well as the control and audit areas.A bankevent. The level of detail in any descriptive
using the AMA will be subject to a period ofinformation should be appropriate to the size
initial monitoring by its supervisor beforeof the gross loss amount.Operational risk
it can be used for regulatory purposes. Thislosses that are related to credit risk and
period will allow the supervisor to determinehave traditionally been included in banks'
if the approach is credible and appropriate.credit risk databases (e.g. collateral
The bank's internal measurement system mustmanagement failures) must continue to be
be able to reasonably estimate unexpectedtreated as credit risk for the purposes of
losses based on the combined use of internalcalculating minimum regulatory capital. It
and relevant external loss data, scenariofollows that such losses will not be subject
analysis and bank-specific businessto the operational risk capital charge.
environment and internal control factors.TheNevertheless, for the purposes of internal
bank's measurement system must also beoperational risk management, banks must
capable of supporting an allocation ofidentify all material operational risk losses
economic capital for operational risk acrossconsistent with the scope of the definition
business lines in a manner that createsof operational risk and the defined event
incentives to improve business linetypes, including those related to credit
operational risk management.Additionally,-Therisk.A bank's operational risk measurement
operational risk management function issystem must use pertinent external data
responsible for documenting policies and(either public data and/or pooled industry
procedures concerning operational riskdata), especially when there is any
management and controls, designing andpossibility to believe that the bank is
implementing the bank's operational riskpotentially exposed to severe losses, however
measurement methodology, designing andinfrequent. Additionally a bank must use
implementing a risk-reporting system forscenario analysis of expert opinion in
operational risk, and developing strategiesconjunction with external data to evaluate
to identify, measure, monitor and controlits exposure to high-severity events.Stanley
mitigate operational risk,-The bank'sEpstein is a Principal Associate and Director
internal operational risk measurement systemof Citadel Advantage Ltd., a consultancy
must be closely integrated into thedealing in bank operations and specializing
day-to-day risk management processes of thein Operations Risk and Payment Systems.
bank and its output must be an integral part



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