Basel IIs 3 Methods to Operational Risk Management

Feb 3rd, 2011 by admin.

The operational threat specifications of Basel II proposes 3 measurement methodologies for calculating the operational threat funds costs. They are the fundamental Indicator Method, the Standardized Method and also the Superior Measurement Method. Beneath the fundamental Indicator Method banking institutions should maintain funds for operational threat equivalent towards the typical more than the prior 3 many years of the fixed proportion (15% for this method) of constructive yearly gross revenue (figures in respect of any yr by which yearly gross revenue was unfavorable or zero are excluded). Even though no particular standards are set out for utilization of the fundamental Indicator Method, banking institutions utilizing this technique are encouraged to comply using the Committees advice on Sound Practices for your Management and Supervision of Operational Risk (BIS; February 2003). These rules need: oA fingers on method within the development of an suitable risk management atmosphere, oPositive steps within the identification, evaluation, monitoring and manage of operational threat, oAdequate public disclosure. Beneath the Standardized Method a banks actions are divided into 8 company lines. Inside every company line, gross revenue is really a broad indicator that serves as being a stand-in for your degree of company operations and thus the probable dimension of operational threat publicity inside every of those company lines. The funds cost for every company line is calculated by multiplying gross revenue by a element (known as the beta) assigned to that company line. The beta serves as being a substitute for your industry-wide romantic relationship in between the operational threat reduction expertise to get a offered company line and also the aggregate degree of gross revenue for that company line. The company lines and also the beta elements assortment from 12% for retail banking, asset management and retail brokerage; 15% for commercial banking and agency services to 18% for corporate finance, trading & sales and payment & settlement. The total funds cost is calculated as the three-year typical from the simple summation from the regulatory funds costs across every from the company lines in every yr. In any offered yr, a unfavorable funds costs (as being a result of unfavorable gross revenue) in any company line may offset constructive funds costs in other company lines without limit. At national supervisory degree, the supervisor can choose to allow a bank to use the Alternative Standardized Method (ASA) provided the bank is able to satisfy its supervisor that this alternative method provides an improved basis for measurement of risks. Beneath the ASA, the operational threat funds charge/methodology is the same as for your Standardized Method except that two company lines retail

banking and commercial banking where a fixed element m replaces gross revenue as the publicity indicator and is related towards the extent of loans granted in these areas. Beneath the Superior Measurement Methods (AMA) the regulatory funds requirement equals the threat measure generated by the banks internal operational threat measurement system utilizing particular quantitative and qualitative standards. Utilization of the AMA is subject to supervisory approval. Supervisory approval has to be conditional on the bank being able to show towards the satisfaction from the supervisory authority that the allocation mechanism for these subsidiaries is suitable and can be supported empirically. The quantitative standards that apply to internally generated operational threat measures for purposes of calculating the regulatory minimum funds cost are that any internal operational threat measurement system should be consistent using the definition of operational threat and a assortment of defined reduction event types (covering all operational aspects such as fraud, employee practices, workplace safety, company practices, processing practices, company disruption and reduction of physical assets). To qualify for utilization of the Superior Measurement Methods (AMA), a bank should satisfy its supervisor that, oThe banking institutions board of directors and senior management, are actively involved within the oversight from the operational risk management framework; oThe bank has an operational risk management system that is conceptually sound and which includes an independent operational risk management function that is responsible for your design and implementation from the banks operational risk management framework; oThe bank has It has sufficient resources to use this method within the major company lines as well as the manage and audit areas. A bank utilizing the AMA will be subject to a period of initial monitoring by its supervisor before it can be used for regulatory purposes. This period will allow the supervisor to determine if the method is credible and suitable. The banks internal measurement system should be able to reasonably estimate unexpected losses based on the combined utilization of internal and relevant external reduction data, scenario analysis and bank-specific company atmosphere and internal manage elements. The banks measurement system should also be capable of supporting an allocation of economic funds for operational threat across company lines in a manner that creates incentives to improve company line operational risk management. Additionally, oThe operational risk management function is responsible for documenting policies and procedures concerning operational risk management and controls, designing and implementing the banks operational threat measurement methodology, designing and implementing a risk-reporting system for operational threat, and developing strategies to identify, measure, monitor and control/mitigate operational threat, oThe banks internal operational threat measurement system should be closely integrated into the day-today risk management processes from the bank and its output should be an integral part from the process of monitoring and controlling the banks operational threat profile. This information should play a major role in threat reporting, management reporting, internal funds allocation, and threat analysis. oOperational threat exposures and reduction expertise should be reported regularly to company unit management, senior management, and towards the board of directors.

oThe banks operational risk management system should be well documented and also the bank should have a routine in place for ensuring compliance with a documented set of internal policies, controls and procedures concerning the operational risk management system, which should include policies for your treatment of noncompliance issues. oInternal and/or external auditors should perform regular reviews from the operational risk management processes and measurement systems. This review should include both the actions from the company units and from the independent operational risk management function. oThe validation from the operational threat measurement system by external auditors and/or supervisory authorities should include the verification that the internal validation processes are operating in a satisfactory manner; and making sure that data flows and processes associated using the threat measurement system are transparent and accessible. In particular, it is necessary that auditors and supervisory authorities are in a position to have easy access, whenever they judge it necessary and beneath suitable procedures, towards the systems specifications and parameters. Because the analytical methods for operational threat continue to evolve the method or distributional assumptions used to generate the operational threat measure for regulatory funds purposes is not being specified by the Basel Committee. A bank should however be able to show that its method captures potentially severe tail reduction events. Irrespective from the method is used, a bank should demonstrate that its operational threat measure meets a soundness standard comparable to that from the internal ratings-based method for credit threat. Based on this, bank supervisors will need the bank to calculate its regulatory funds requirement as the sum of expected reduction (EL) and unexpected reduction (UL), unless the bank can demonstrate that it is adequately capturing EL in its internal company practices (to base the minimum regulatory funds requirement on UL alone, the bank should be able to demonstrate towards the satisfaction of its national supervisor that it has measured and accounted for its EL publicity). A bank needs to have a credible, transparent, well-documented and verifiable method for weighting these fundamental elements in its overall operational threat measurement system. Internal reduction data is critical to linking a banks threat estimates to its actual reduction expertise. Such data is most relevant when it is clearly linked to a banks current company actions, technological processes and risk management procedures. To do this a bank should have documented procedures for assessing the on-going relevance of historical reduction data, including those situations by which judgment overrides or other adjustments may be used, to what extent they may be used and who is authorized to make such decisions. Internally generated operational threat measures used for regulatory funds purposes should be based on a minimum five-year observation period of internal reduction data. However, when the bank first moves towards the AMA, a three-year historical data window is acceptable. To qualify for regulatory funds purposes, a banks internal reduction collection processes should be able to map its historical internal reduction data into the relevant supervisory categories as are defined in detail within the Basel II Annexes. The bank should have documented objective standards for allocating losses towards the specified company lines and event types. A banks internal reduction data should be comprehensive. It should capture all material actions and exposures from all suitable sub-systems and geographic locations. The bank should be able to justify that any excluded actions or exposures, both individually and in combination would not significantly impact the overall threat estimates. This should be based on an suitable minimum gross reduction threshold for internal reduction data collection. Additionally, a bank should collect information relating the date from the event, any recoveries of reduction amounts, as well as descriptive information about the drivers or causes from the reduction event. The degree of detail in any descriptive information should be suitable towards the dimension from the gross reduction amount. Operational threat losses that are related to credit threat and have traditionally been included in banks credit threat databases (e.g. collateral management failures) should continue to be treated as credit threat for your purposes of calculating minimum regulatory funds. It follows that such losses will not be subject

towards the operational threat funds cost. Nevertheless, for your purposes of internal operational risk management, banking institutions should identify all material operational threat losses consistent using the scope from the definition of operational threat and also the defined event types, including those related to credit threat. A banks operational threat measurement system should use pertinent external data (either public data and/or pooled business data), especially when there is any possibility to believe that the bank is potentially exposed to severe losses, however infrequent. Additionally a bank should use scenario analysis of expert opinion in conjunction with external data to evaluate its publicity to high-severity events.