FINANCIAL RISK MANAGEMENT ASSIGNMENT

Submitted by: Richa Sharma Roll no-177 Batch Finance 2

INSTITUTE FOR TECHNOLOGY & MANAGEMENT BUSINESSSCHOOL Kharghar, Navi Mumbai

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Theory An operational risk is, as the name suggests, a risk arising from execution of a company's business functions. It is a very broad concept which focuses on the risks arising from the people, systems and processes through which a company operates. It also includes other categories such as fraud risks, legal risks, physical or environmental risks. A widely used definition of operational risk is the one contained in the Basel II regulations. This definition states that operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. The approach to managing operational risk differs from that applied to other types of risk, because it is not used to generate profit. In contrast, credit risk is exploited by lending institutions to create profit, market risk is exploited by traders and fund managers, and insurance risk is exploited by insurers. They all however manage operational risk to keep losses within their risk appetite - the amount of risk they are prepared to accept in pursuit of their objectives. What this means in practical terms is that organizations accept that their people, processes and systems are imperfect, and that losses will arise from errors and ineffective operations. The size of the loss they are prepared to accept, because the cost of correcting the errors or improving the systems is disproportionate to the benefit they will receive, determines their appetite for operational risk. The Basel Committee defines operational risk as: "The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events." However, the Basel Committee recognizes that operational risk is a term that has a variety of meanings and therefore, for internal purposes, banks are permitted to adopt their own definitions of operational risk, provided that the minimum elements in the Committee's definition are included. In the context of operational risk, the standardized approach or standardized approach is a set of operational risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions. Basel II requires all banking institutions to set aside capital for operational risk. Standardized approach falls between basic indicator approach and advanced measurement approach in terms of degree of complexity. Based on the original Basel Accord, under the Standardized Approach, banks activities are divided into eight business lines: corporate finance, trading & sales, retail banking, commercial banking, payment & settlement, agency services, asset management, and retail brokerage. Within each business line, gross income is a broad indicator that 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 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.

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Business Line Corporate finance Trading and sales Retail banking Commercial banking Payment and settlement Agency services Asset Management Retail Brokerage

Beta Factor 18% 18% 12% 15% 18% 15% 12% 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. In any given year, negative capital charges (resulting from negative gross income) in any business line may offset positive capital charges in other business lines without limit. In order to qualify for use of the standardized approach, a bank must satisfy its regulator that, at a minimum:

Its board of directors and senior management, as appropriate, are actively involved in the oversight of the operational risk management framework; It has an operational risk management system that is conceptually sound and is implemented with integrity; and It has sufficient resources in the use of the approach in the major business lines as well as the control and audit areas.

Basic Indicator Approach (BIA) and Standardized Approach (SA)

Banks using the BIA method have a minimum operational risk capital requirement equal to a fixed percentage of the average annual gross income over the past three years. Hence, the risk capital under the BIA approach for operational risk is given by:

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Where,

Stands for gross income in year i, and = 15% is set by the Basel Committee. The results of the first two Quantitative Impact Studies (QIS) conducted during the creation of the Basel Accord showed that on average 15% of the annual gross income was an appropriate fraction to hold as the regulatory capital. Gross income is defined as the net interest income added to the net non-interest income. This figure should be gross of any provisions (unpaid interest), should exclude realized profits and losses from the sale of securities in the banking book, which is an accounting book that includes all securities that are not actively traded by the institution, and exclude extraordinary or irregular items. No specific criteria for the use of the Basic Indicator Approach are set out in the Accord. In the Standardized Approach, banks' activities are divided into 8 business lines corporate finance, trading & sales, retail banking, commercial banking, payment & settlements, agency services, asset management, and retail banking. Within each business line, there is a specified general indicator that reflects the size of the banks' activities in that area. The capital charge for each business line is calculated by multiplying gross income by a factor assigned to a particular business line. As in the Basic Indicator Approach, the total capital charge is calculated as a three year average over al positive gross income (GI) as follows:

The second QIS issued by the Basel Committee, covering the same institutions surveyed in the first study, resulted in 12%, 15% and 18% as appropriate rates in calculating regulatory capital as a percentage of gross income.

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Example of Basic Indicator Approach (BIA) and Standardized Approach (SA) calculation

In table 2, we see the basic and standardized approach for the 8 business lines. The main difference between the BIA and the SA is that the former does not distinguish its income by business lines. As shown in the tables, we have the annual gross incomes related to year 3, year 2 and year 1. With the Basic Approach, we do not segregate the income by business lines, and therefore, we have a summation at the bottom. We see that three years ago, the bank had a gross income of around 132 million which then decreased to -2 million the following year, and finally rose to 71 million. Moreover, the Basic Indicator Approach doesn't take into consideration negative gross incomes. So, in treating the negatives, the -2 million was removed. To get our operational risk charge, we calculate the average gross income excluding negatives and we multiply it by an alpha factor of 15% set by the Basel Committee. We obtain a result of 15.23 million . Similarly to the BI Approach, the Standardized Approach has a Beta factor for each of the business lines as some are considered riskier in terms of operational risk than others. Hence, we have eight different factors ranging between 12 and 18 percent as determined by the Basel Committee. For this approach, we calculate a weighted average of the gross income using the business line betas. Any negative number over the past years is converted to zero before an average is taken over the three years. In this case, we end up with a capital charge of around 10.36 million .
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