Operational Risk

What is operational risk

• The risk of loss resulting from inadequate or
failed internal process, people, and system or
from external events
• Basel committee has identified several loss
categories
1. Internal fraud
Unauthorized activity, theft or fraud, that involves
at least one internal party -
 Loss categories in operational risk
2. External fraud
Refers to theft or fraud carried out by a third party
outside the organization – theft, robbery,
compute hacking, theft of information

3. Employment practices and workplace safety

-employees compensation claims, wrongful
termination, volition of safety and health rules,
discrimination claims, harassment
 Loss categories in operational risk
4. Clients, products, and business practices –
Losses arising from a failure to meet an obligation
to a client, or from nature or design of products
– Misuse of confidential clients’ information
– Money laundering
– Product defects
– Exceeding clients exposure limits

5. Damage to physical assets

Losses arising out of disaster or other events – natural
disasters, terrorism or vandalism
 Loss categories in operational risk
6. Business disruption and system failures
-hardware and software failures
-Telecommunications problems
-Power outages/disruptions

7. Execution, delivery, and process management

-risk associated with transaction processing, trade
counterparties for example, miscommunication,
data entry errors, accounting errors, vendor
disputes, outsourcing
According to Basel II, banks must hold capital for
operational risk that is equal to the average of
the previous three years of a fixed percentage (α)
of positive annual gross income, which means
that negative gross income figures must be
excluded

• where K is the capital charge

• Y positive gross income over the previous three
years
• and n the number of the previous three years for
which gross income is positive
• The fraction α is fixed by the Basel Committee at
15 percent
• For the purpose of estimating K, the Committee
defines gross income as net interest income plus
net non-interest income as defined by the
national supervisors and/or national accounting
standards
• The Committee suggests that the recognition of Y
requires the satisfaction of the following criteria:
(i) being gross of any provisions,
• (ii) being gross of operating expenses,
• (iii) excluding realized profi ts/losses from the sale
of securities, and
• (iv) excluding extraordinary and irregular items
as well as income from insurance claims.
 The Standardized Approach
• Accepting that some financial activities are more
exposed than others to operational risk (at least
in relation to gross income), the BCBS divides
banks’ activities into eight business lines.
• The capital charge for each business line is
calculated by multiplying gross income by a factor
(β) that is assigned to each business line.
• (β) is essentially the loss rate for a particular
business line with an average business and
control environments.
• The total capital charge is calculated as a three-
year average of the simple sum of capital charges
of individual business lines in each year
• Hence

Where j is set by the Basel Committee to relate the

level of required capital to the level of gross
income for business line j.
Examples of activities falling under business lines
Examples of activities falling under business lines
 The advanced measurement approach
• The BCBS (2004a) suggests that if banks move
from the BIA along a continuum toward the AMA,
they will be rewarded with a lower capital charge
• The BCBS makes it clear that the use of the AMA
by a certain bank is subject to the approval of the
supervisors.
• The regulatory capital requirement is calculated
by using the bank’s internal operational risk
measurement system.
• The Committee considers insurance as a mitigator
of operational risk only under the AMA

• Under this approach, banks must quantify

operational risk capital requirements for seven
types of risk and eight business lines, a total of 56
separate estimates
• The Basel II accord allows three alternative
approaches under the AMA:
• (i) the loss distribution approach (LDA);
• (ii) the scenario-based approach (SBA); and
• (iii) the scorecard approach (SCA), which is also
called the risk drivers and controls approach
(RDCA).
• The three approaches differ only in the emphasis
on the information used to calculate regulatory
capital