Risk Monitoring Department

Financial Risk Division

Various approaches to calculate risk provisioning for operational risk

1. Basic Indicator Approach

This is the simplest approach and is used by banks with less sophisticated risk management
functions. The required capital for operational risk is equal to the bank's average annual gross
income (i.e., net interest income plus non-interest income) over the last three years multiplied
by 0.15.

2. Standardized Approach

This method is similar to the basic indicator approach. The primary difference between the
two approaches is that a different multiplier is applied to the bank's gross income for different
lines of business. The capital charge for each business line is calculated by multiplying gross
income by a factor (denoted beta) assigned to that business line. Beta serves as a proxy for
the industry-wide relationship between the operational risk loss experience for a given
business line and the aggregate level of gross income for that business line.

Business Line Beta Factor

Corporate finance 18%
Trading and sales 18%
Retail banking 12%
Commercial banking 15%
Payment and settlement 18%
Agency services 15%
Asset Management 12%
Retail Brokerage 12%

The total capital charge is calculated as the three-year average of the simple summation of the
regulatory capital charges across each of the business lines in each year.
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Financial Risk Division

3. Advanced Measurement Approach

The capital requirement for operational risk under the advanced measurement approach is
based on an operational risk loss (i.e., VaR) calculated over a one-year time horizon with a
99.9% confidence level. The approach has an advantage in that it allows banks to consider
risk mitigating factors such as insurance contracts (e.g., fire insurance).

The AMA allows banks to develop empirical models to quantify the capital required for
operational risks. The AMA is flexible and modelling reflects individual bank risk profiles.
The Basel Committee requires four data elements that a bank must use to calculate the
operational risk capital charge based on the AMA framework. The elements must be used in
different "combinations" and the bank must prove that the combinations are sufficient for
successful model estimations. The four data elements are:

1) Internal loss data: Loss data used in the AMA model should reflect both the bank's
risk profile and risk management systems. Data is used in the operational risk
measurement system ( 0 RMS) to estimate the frequency of losses and severity
distributions and as an input in scenario analysis.
2) External loss data: External data contains valuable information regarding the tail of
the loss distribution(s). External data helps the bank estimate the severity of losses.
Public databases can provide external data where members submit loss information or
they can collect pertinent external data themselves.
3) Scenario analysis: Reliable scenario outputs form part of the input into the AMA
model. Scenario analysis is an important tool in the operational risk management
framework (ORMF). Scenario analysis is, however, qualitative and likely contains
considerable uncertainties. The uncertainty (along with other non-scenario analysis
related uncertainties) should be reflected in the output of the model estimating the
operational risk capital charge although quantifying these uncertainties is a major
challenge. The committee indicates that this is an area requiring further research.
4) Business environment and internal control factors (BEICFs): BEICFs are
subjective and are often used as indirect inputs in models or are used ex post to adjust
a model's output.
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Financial Risk Division

One of the approved alternatives under the Basel II AMA framework to quantifying
operational risk is called the loss distribution approach (LDA). Under the LDA, capital
requirements are determined based on the historical losses suffered by the institution. The
Basel Committee defines LDA as an estimate of the loss distribution resulting from each
business line and event type of operational risk. The distribution is constructed based on
assumptions of loss frequency and loss severity, which primarily come from the historical
loss experience of the institution.

The loss distribution approach has several steps as follows:

• Step 1: Organize and group loss data into a business line/event type matrix that
corresponds to the LDA model. The evaluation of loss data allows a bank to
understand its exposure to operational risk. Note that loss data is "backward looking."
• Step 2: Assign every data point in the matrix an equal weight (except for split losses,
old losses, and external losses and scenarios).
• Step 3: Model an operational risk loss distribution in each cell of the business
line/event type matrix using an actuarial approach. This involves deriving one
distribution for event frequency and one distribution for severity from loss data and
then combining them using Monte Carlo simulation.
• Step 4: Determine the operating risk capital requirements for each business line by
combining empirical distributions and parametric tail distributions.

4. The new Approach – Standardised Measurement Approach

Under the Basel II framework, banks were “encouraged to move along the spectrum of
available approaches as they develop more sophisticated operational risk measurement
systems and practices” (BCBS, 2006). However, the BCBS’s latest proposals on operational
risk, which were first put forward in October 2014, then subsequently updated in March
2016, envisage discontinuing all three current approaches, including the AMA, moving all
banks to an updated standardized approach, the SMA, that incorporates both backward-
looking and scale-based elements. The BCBS cited non-convergence of risk measurement
methodologies as a key reason for withdrawing the option of internal modelling of
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Financial Risk Division

operational risk under the AMA (BCBS, 2016). With a logic analogous to recent proposals
for credit risk RWA, the BCBS is looking to achieve greater comparability of operational risk
RWA across banks and regulatory jurisdictions by implementing a single standardized
approach that is more risk-sensitive than current standardized approaches. As the BCBS
states, “the combination of a simple standardized measure of operational risk and bank-
specific loss data provides a sufficiently risk sensitive measure of operational risk…[and]
meets its objectives of promoting comparability of risk-based capital measures and reducing
model complexity.”

Under the BCBS proposals, the SMA will be determined by two components: first, a business
indicator (“BI”) component with coefficients increasing with scale (to reflect the BCBS’s
view that operational risks increase more than linearly with the size of banks); and second, an
Internal Loss Multiplier (“ILM”) based on a Loss Component (“LC”) that factors in a bank’s
own loss history.

4.1. Calculation of the BI Component

The BI component includes income statement items related to activities producing

operational risk that are omitted or netted in the gross income. BI comprises interest, lease,
and dividend component (ILDC); services component (SC); and financial component (FC).

BI Buckets in the BI Component

Under the SMA, banks are divided into five buckets according to the size of their BI (as
mentioned above). For banks in bucket 1, capital is an increasing linear function of the BI and
does not depend on internal losses. For banks in buckets 2 through 5, capital is calculated in
two steps:
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Financial Risk Division

1) Calculate a baseline level of capital using the BI component

2) The portion of the BI component above the threshold separating buckets 1 and 2 is
multiplied up or down by a function that depends on the banks’ internal losses, to
differentiate between banks with different risk profiles

The BI Component increases linearly within buckets, but marginal effect of BI on the BI
component is greater for the higher buckets than for the lower ones. The marginal increase of
BI component resulting from one unit increase in the BI is 0.11 in bucket 1, 0.15 in bucket 2,
0.19 in bucket 3, 0.23 in bucket 4, and 0.29 in bucket 5. The constants added to the BI
component in buckets 2 to 5 are necessary to ensure that the BI component is continuous.
They reflect the value of BI component at the top of the range of the bucket directly below.

To calculate BI for year t, a bank must determine the three-year average of the BI, as the sum
of the three-year average of its components. The formula for BI follows:

4.2. Calculation of Loss Component

The loss component reflects the operational loss exposure of a bank that can be inferred from
its internal loss experience. The addition of loss component to BI improves the risk-
sensitivity of SMA. Internal loss experience is introduced to the SMA through the internal
loss multiplier (ILM). A bank with the loss component equal to the BI component is a bank
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Financial Risk Division

with exposure at the average of the industry. Therefore, under the proposed formula, its ILM
is 1 and its SMA capital corresponds to the BI Component. Banks with loss experience above
the industry average will have a loss component above the BI component and their SMA
capital will be above the BI component. Similarly, banks with loss experience below the
industry average will have a loss component below the BI component. Their SMA capital
will be below the BI component.

The formula of the ILM is presented below:

The ILM is bounded below by L (e (1)−1) ≈ 0.541. The logarithmic function used to calculate
the ILM means that it increases at a decreasing rate with the loss component. The BCBS is
open to considering alternative adjustments to the methodology that appropriately incorporate
the impact of extreme loss events.

4.3. Calculation of Capital Requirement

The BI and loss components calculated earlier are used to calculate the capital requirement
for operational risk. Capital for banks in bucket 1 corresponds solely to the BI component.
For banks in buckets 2 through 5, capital results from multiplying the BI component by the
ILM. However, for continuity of the capital requirement, as banks move from bucket 1 to
bucket 2, the portion of the BI component relative to the first €1 billion of the BI (that is,
€110 million) is not multiplied by the ILM.
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Financial Risk Division

5. The Role of Loss Data

Ideally, banks should use 10 years of good-quality loss data to calculate the averages used in
the loss component. In the transition period, banks that do not have 10 years of data can use a
minimum of five years of data to calculate the loss component. As banks accumulate more
years of good-quality loss data, the number of years for the averages used in the loss
component should increase until it reaches 10 years. Banks that do not have five years of
good data (or in general fail to meet the qualitative requirements) must calculate the capital
requirement based solely on the BI component.

Overall, data quality and integrity are crucial under the SMA, as medium to large banks are
required to use loss data as a direct input to capital calculations. The BCBS proposed
minimum loss data standards under Pillar 1 for banks using the SMA’s loss component and
these banks must:

• Document policies, procedures, and processes for identification, collection, and

treatment of internal loss data (ILD).
• Have an internal loss data policy that establishes criteria for deciding the
circumstances, types of data, and methodology for grouping data as appropriate for its
business, risk management, and SMA regulatory capital calculation needs.
• Be able to map its historical ILD into the relevant Level 1 supervisory categories and
to provide this data to supervisors on request.
• Have minimum threshold of EUR 10,000 for capturing ILD, with a EUR 20,000
threshold being acceptable when a bank moves to the SMA.
• Collect loss data information such as gross loss, recoveries, reference dates (date of
occurrence, discovery, and accounting), drivers, and causes of the loss event.
• Operational risk losses related to credit risk that have historically been included in
banks’ credit risk databases (e.g. collateral management failures) will continue to be
treated as credit risk and therefore such losses will not be subject to the SMA
regulatory capital. Operational risk losses related to market risk are treated as
operational risk for the purposes of calculating minimum regulatory capital under this
framework and will therefore be subject to the SMA regulatory capital.
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Financial Risk Division

• Group losses due to a common operational risk event or related operational risk
events over time and enter them into the SMA loss dataset as a single loss.