FIN 6002 – Session 15

Pradeepta Sethi
TAPMI
 Operational Risk

¢ Risk of loss resulting from

inadequate or failed internal
process, people and systems or
B from external events.

A ¢ Internal fraud – intentional

S Pillar I: Minimum misreporting of positions, employee
capital requirements theft, and insider trading on an
E employee’s own account.
L ¢ External fraud – robbery, forgery,
Operational Risk cheque kiting, and damage from
computer hacking.
I
I ¢ Employment practices and
workplace safety – workers
compensation claims, violation of
employee health and safety rules,
organized labour activities,
discrimination claims, and general
liability.
 ¢ Clients, products and business
practices – fiduciary breaches,
misuse of confidential customer
information, improper trading
activities on the bank’s account,
money laundering, and sale of
B unauthorised products.
A ¢ Damage to physical assets – For
S Pillar I: Minimum example, terrorism, vandalism,
capital requirements earthquakes, fires and floods.
E
¢ Business disruption and system
L failures – hardware and software
Operational Risk failures, telecommunication
problems, and utility outages.
I
¢ Execution, delivery and process
I management – data entry errors,
collateral management failures,
incomplete legal documentation,
and unauthorized access given to
client accounts, non-client
counterparty mis performance, and
vendor disputes.
B
A ¢
S Pillar I: Minimum
capital requirements
E
L ¢
Operational Risk
I profit, a gain event.
I
Unlike some other risk types,
not all operational risk events
lead to banks incurring losses.
Operational failures can result in
no loss to a bank, a near miss,
or even lead to a bank making a
Source: Richard Apostolik, Christopher Donohue (2015) Foundations of Financial Risk
B ¢ 3 methods for measurement of
A operational risk–

S Pillar I: Minimum
¢ Basic Indicator Approach (BIA)
capital requirements
E
¢ The Standardized Approach
L (TSA) / The Alternative
Operational Risk Standardized Approach (ASA)
I
¢ Advanced Measurement
I Approach (AMA)
 Basic Indicator Approach (BIA)
¢ Under BIA, banks have to maintain
capital to a fixed percentage (alpha)
of a single indicator.

B ¢ This indicator is ’gross income’.

A ¢ 𝐾!"# = ∑(𝐺𝐼×𝛼) /𝑛, 𝐾!"# = capital

charge under BIA, 𝐺𝐼 = Gross
S Pillar I: Minimum
income, 𝛼 = fixed percentage, n=
capital requirements number of previous 3 years where
E
GI is positive.
L
Operational Risk - BIA ¢ Gross Income = Net profit +
Provisions & contingencies +
Operating expenses – Profit on sale
I of HTM investments – Income of
I insurance – Extraordinary/irregular
item of income + loss on sale of
HTM investments.
¢ Banks to maintain capital at 15% of
their average annual gross income
(over the past three years).
 The Standardized Approach (TSA)
¢ Bank’s activities are divided into
eight business lines.

B ¢ Against each business line a broad

indicator is specified (GI) to reflect
A the size or volume of banks’
S Pillar I: Minimum activities in that area.
capital requirements Within each business line, the
E ¢
capital charge is calculated by a
L factor (beta) assigned to that
Operational Risk - TSA business line.
¢ The idea is that business lines with
I lower operational risk (e.g., asset
I management) would translate into
lower reserve requirements.
¢ 𝐾$%# =
{∑ 1 − 3 𝑦𝑒𝑎𝑟𝑠 max(∑ (𝐺𝐼&'( ×
𝛽&'( ), 0}1/3
 Business Line Indicator Beta
Factor(%)
Corporate finance Gross Income 18
Trading and sales Gross Income 18

The Retail banking Gross Income 12

Commercial banking Gross Income 15
Standardized Payment and 18
Gross Income
Approach settlement
Agency services Gross Income 15
Asset management Gross Income 12
Retail brokerage Gross Income 12
 Alternative Standardized Approach
(ASA)

¢ Under the ASA, the operational risk

capital charge/methodology is the
same as for the Standardised
B Approach except for two business
lines – retail banking and commercial
A banking.
S Pillar I: Minimum
capital requirements ¢ For these business lines, loans and
E advances – multiplied by a fixed factor
‘m’ – replaces gross income as the
L exposure indicator.
Operational Risk - ASA
¢ The betas for retail and commercial
banking are unchanged from the
I Standardised Approach
I ¢ 𝐾𝑅𝐵 = 𝛽𝑅𝐵×𝑚×LARB
¢ KRB – Capital required for retail
banking unit, βRB is the beta for the
retail banking business line, m is
0.035, LARB is total outstanding retail
loans and advances.
 Advance Measurement
Approach (AMA)

¢ Based on an estimation of
operational risk derived from bank’s
internal Operational Risk
B Measurement System (ORMS).
A ¢ Use of both quantitative and
S Pillar I: Minimum qualitative criteria for calculation of
capital requirements capital charge.
E
¢ Qualitative Criteria
L
Operational Risk - AMA ¢ The bank must have an
independent Operational Risk
I Management Framework (ORMF).

I ¢ Rigorous procedures for the

development, implementation and
review of the ORMF.
¢ Use of the output from the AMA
model in its day-to-day operational
risk management and integrated
with credit and market risk.
 ¢ Quantitative Criteria

B ¢ Mapping the Operational Risk

Categories (ORCs) i.e., various
A combinations of loss event types
S Pillar I: Minimum and business lines.
capital requirements
E ¢ Preparing the loss distribution -
L distribution of losses is generated
Operational Risk - AMA for each recognized combination of
business line and loss event type.
I
¢ This is aggregated to compute the
I enterprise level operational risk VaR
for the purpose of obtaining the
operational risk capital charge.