Regulatory Treatment of Operational Risk (Basel).

There are three methods for calculating operational risk capital charges:
1. The Basic Indicator Approach;
2. The Standardised Approach;
3. Advanced Measurement Approaches.

The Basic Indicator Approach

        Banks using the Basic Indicator Approach have to hold capital for operational risk equal to a fixed percentage (denoted alpha) of a single indicator. The current proposal for this indicator is gross income. The charge may be expressed as follows:

KBIA = EI*α

Where:

KBIA = the capital charge under the Basic Indicator Approach

EI = the level of an exposure indicator for the whole institution, provisionally gross income

α = a fixed percentage, set by the Committee, relating the industry-wide level of required capital to the industry-wide level of the indicator.

For the Basic Indicator Approach, alphas are calculated as 12 percent of minimum regulatory

capital divided by gross income.

        In the Standardised Approach, banks’ activities are divided into 8 business lines. Within each business line, there is a broad indicator specified that reflects the size or volume of banks’ activities in that area. The indicator serves as a proxy for the scale of business operations and thus the likely scale of operational risk exposure within each of these business lines. The table below shows the proposed business lines and indicator.

Business lines of bank:

Corporate finance,

Trading and sales, 

Retail banking, 

Commercial banking, 

Payment and settlement, 

Agency services and custody, 

Asset management, 

Retail brokerage.

The total capital charge is calculated as the simple summation of the regulatory capital charges across each of the business lines. The total capital charge may be expressed as follows:

KTSA = Σ (EI1-8*β1-8)

Where:

KTSA = the capital charge under the Standardised Approach

EI1-8 = the level of an exposure indicator for each of the 8 business lines

β1-8 = a fixed percentage, set by the Basel Committee, relating the level of required capital to the level of the gross income for each of the 8 business lines.

Advanced Measurement Approaches

The regulatory capital requirement for operational risk under the AMA would be based on an estimate of operational risk derived from a bank’s internal risk measurement system. This risk estimate would be subject to a floor based on the Standardised Approach capital charge for operational risk. The floor be set at 75% of the Standardised Approach capital charge.

Reference: Basel Commitee