SOUTH CAMPUS,

UNIVERSITY OF KASHMIR
Prepared By: Dilawar Kamran
Roll NO.: 17
MBA 4th SEMESTER
Subject: Financial Risk Management
Submitted to: DR.Altaf Ahmad
RISK BASED CAPITAL REQUIREMENT
&
APPROCHES TO MEASURE
OPERTAIONAL RISK
What Is a Risk Based Capital
Requirement?
• Risk-based capital requirement refers to a rule
that establishes minimum regulatory capital for
financial institutions. Risk-based capital
requirements exist to protect financial firms,
their investors, their clients, and the economy as
a whole. These requirements ensure that each
financial institution has enough capital on hand
to sustain operating losses while maintaining a
safe and efficient market.
Understanding Risk Based Capital
Requirement
• Risk-Based Capital (RBC) is a method of measuring the minimum
amount of capital appropriate for a reporting entity to support its
overall business operations in consideration of its size and risk
profile. RBC limits the amount of risk a company can take. It requires
a company with a higher amount of risk to hold a higher amount of
capital. Capital provides a cushion to a company against insolvency.
RBC is intended to be a minimum regulatory capital standard and
not necessarily the full amount of capital that an insurer would want
to hold to meet its safety and competitive objectives. In addition,
RBC is not designed to be used as a stand-alone tool in determining
financial solvency of an insurance company; rather it is one of the
tools that give regulators legal authority to take control of an
insurance company.
• Before RBC was created, regulators used fixed capital standards as a
primary tool for monitoring the financial solvency of insurance
companies. Under fixed capital standards, owners are required to
supply the same minimum amount of capital, regardless of the
financial condition of the company. The requirements required by
the states ranged from $500,000 to $6 million and was dependent
upon the state and the line of business that an insurance carrier
wrote. Companies had to meet these minimum capital and surplus
requirements in order to be licensed and write business in the state.
As insurance companies changed and grew, it became clear that the
fixed capital standards were no longer effective in providing a
sufficient cushion for many insurers.
• The NAIC’s RBC regime began in the early 1990s as an early warning
system for U.S. insurance regulators. The adoption of the U.S. RBC
regime was driven by a string of large-company insolvencies that
occurred in late 1980s and early 1990s. The NAIC established a
working group to look at the feasibility of developing a statutory
risk-based capital requirement for insurers. The RBC regime was
created to provide a capital adequacy standard that is related to risk,
raises a safety net for insurers, is uniform among the states, and
provides regulatory authority for timely action.
• Risk-based capital requirements are now subject to a permanent
floor, as per a rule adopted in June 2011 by the Office of the
Comptroller of the Currency (OCC), the Board of Governors of the
Federal Reserve System, and the Federal Deposit Insurance
Corporation (FDIC). In addition to requiring a permanent floor, the
rule also provides some flexibility in risk calculation for certain low-
risk assets.
• The Collins Amendment of the Dodd-Frank Wall Street Reform and
Consumer Protection Act imposes minimum risk-based capital
requirements for insured depository institutions, depository
institutions, holding firms, and non-bank financial companies that
are supervised by the Federal Reserve.
• Under the Dodd-Frank rules, each bank is required to have a total
risk-based capital ratio of 8% and a tier 1 risk-based capital ratio of
4.5%. A bank is considered “well-capitalized” if it has a tier 1 ratio of
8% or greater and a total risk-based capital ratio of at least 10%, and
a tier 1 leverage ratio of at least 5%.
• U.S. banks and banking organizations are subject to a dual
framework of capital Regulation. A set of leverage requirements
specifies the minimum amount of tier 1 capital that banks and
banking organizations must hold as a percentage of balance sheet
Assets. For insured banks, the leverage requirements are an integral
component of the statutory framework of Prompt Corrective Action
(PCA) mandated in the Federal Deposit Insurance Corporation
Improvement Act of 1991 (FDICIA). The leverage and PCA
requirements are unaffected by this final rule.
• Risk-based capital requirements complement the leverage
requirements by requiring capital for risks that are either not
reflected on the balance sheet, or that pose materially more risk
than the leverage requirements were designed to address. Current
Risk-based capital rules involve converting the notional amounts of
off-balance sheet risks to on-balance sheet equivalents using
defined conversion factors, and then requiring capital for the
resulting on-balance sheet equivalents, and for all other balance-
sheet items, using predefined risk buckets. Current rules also
prescribe separate capital requirements for market risk, which
apply to a small number of U.S. banks
3 Approaches To Measure
Operational Risk.
Here we’ll explain the different approaches to measuring operational risk in an
organization. According to the Basel Committee, there are three ways to
measure operational risk: the basic indicator approach (BIA), the standard
approach (SA) and the advanced measurement approach (AMA).
1. Basic Indicator Approach for Measuring Operational Risk:
•The basic indicator approach is much simpler than the other techniques for
measuring operational risk and is therefore recommended for small financial
entities whose operations are not very complex.
•This method calculates the operational risk for the entire organization and
then assigns the result to the operational lines. The basic indicator is
measured as a percentage of gross income over that of the preceding three
years.
•There are several reasons why this indicator is calculated through gross
income. First of all, it is verifiable. Secondly, because it is immediately
available and also because it is a counter-cyclical measure that helps to
reliably measure the size of activities.
• 
2. Standard approach to measuring operational risk (SA):
•According to this method for measuring operating risk, banks’ activities
are divided into eight lines of business: corporate finance, sales and
trading, retail banking, commercial banking, payments and settlements,
agency services, asset management and retail brokerage.
•Within each line of business, gross revenue serves as an indicator to
measure the scale of commercial operations and, therefore, to calculate
the possible exposure to operational risk in each line.
•It is calculated by taking the three-year average of the sum of the
regulatory capital charges for each operating line in each year.
•To use the standard approach, a bank must meet certain requirements:
•Both the board of directors and senior management must be involved in
overseeing the operational risk management framework.
•It must have a solid operational risk management system that is
implemented throughout the company.
•It must have sufficient resources to use this approach in the main lines of
business, as well as in the areas of control and auditing.
3. Advanced measurement approach (AMA):
• Out of the three approaches to measuring operational risk, this is
the most sophisticated method. With the AMA model, banks can
create their own empirical model to quantify the capital required for
operational risk.
• An AMA framework should include the use of four quantitative
elements for its development: internal loss data, external data,
scenario and business environment analysis, or internal control
factors.
• Among the AMA models, there are three different types of
methodologies: internal measurement approach (IMA), loss
distribution approach (LDA) and scorecards.
• At CERO, the advanced measurement approach (AMA) is the one we
use to estimate operational risk capital based on the loss
distribution approach (LDA). This approach allows us to establish
continuous improvement systems, predict expected losses for the
organization over a period of time, define loss indicators and
thresholds, and create scenarios to simulate catastrophic events.