Operational risk framework hints at Basel IV

Author: Edward Price | Published: 21 Mar 2016
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The Basel Committee on Banking Supervision (BCBS) has issued proposed revisions to the operational risk capital framework. The result, the new Standardised Measurement Approach (SMA) for operational risk, will replace existing methods. Some view it as a further sign of Basel IV.

According to the BCBS website, the SMA will replace the three existing standardised approaches for calculating operational risk capital. It will also replace the Advanced Measurement Approach (AMA). The Committee states its aim is promoting simplicity, comparability and risk sensitivity as well as addressing weaknesses in the existing framework.

Gregory Lyons
Gregory Lyons, Debevoise & Plimpton
The proposed SMA framework builds on a previous BCBS consultation paper published in 2014. It would also be applied to banks which are internationally active and on a consolidated basis.

"The proposals are an important step towards completing the post-crisis reforms during the current year," said BCBS chairman Stefan Ingves in a press release.

Ingves said the Committee expects the proposals will have a relatively neutral impact on capital for most banks. But he added: “While the objective of these proposals is not to significantly increase overall capital requirements, it is inevitable that minimum capital requirements will increase for some banks."

“That suggests that the Basel Committee is very concerned that the banks believe that the standardised approach, on both the operational and the capital side, is effectively creating Basel IV,” said Gregory Lyons, partner at Debevoise & Plimpton.

As such, while the Basel Committee states the SMA would address a number of weaknesses in the current framework, including inconsistency and complexity in the existing framework, there are plentiful concerns.

Concerns

According to BCBS, the option to use an internal model-based approach for measuring operational risk, or the Advanced Measurement Approaches (AMA), has been removed from the operational risk framework. The Committee says it believes the modelling of operational risk for regulatory capital purposes is unduly complex. It also claims the AMA has resulted in excessive variability in risk-weighted assets and insufficient levels of capital for some banks.

The proposal to abandon the AMA for risk calculation, in favour of a standardised-measurement approach, has however met with criticism.

"My biggest fear of what will happen with SMA is that the knowledge and the work that we've done will not be allowed to transfer risk," said Robert Stewart, an economist at the Federal Reserve Bank of Chicago at a recent operational risk conference in New York.

Removing the AMA is also concerning banks.

KEY TAKEAWAYS

  • The Basel Committee has issued proposed revisions to the operational risk capital framework
  • The Standardised Measurement Approach (SMA) for operational risk, will replace existing methods, including the AMA
  • US counsel suspect banks may be concerned about Basel IV
  • The Committee says while the proposals don’t aim at significantly increasing capital requirements, it’s inevitable that minimum requirements will increase for some banks

“The banks’ basic point is that they’ve spent all this time and money building these systems and showing the benefits of enhanced risk measurement, but won’t be given appropriate credit for that with the SMA,” said Lyons.

The broader industry is also concerned that tailored risk management systems will not be pursued as aggressively. However, that’s not to say that banks will abandon the way they measure risk.

“Senior OCC staff said recently that, regardless of whether the Basel proposal ultimately is implemented, it expects banks to retain something like the AMA,” says Lyons.

According to Lyons, that’s not necessarily because it will reduce capital charges, but because the OCC want banks to retain tailored risk management structures. Regulators are generally concerned about too much variability in AMA as between banks, as it results in opacity.

“Regulators don’t always know why certain adjustments are being made by banks or whether they are appropriate. So Basel is moving to a more standardised approach that would make it easier for regulators to validate what they think to be the case,” said Lyons.

And in that, Lyons sees links between the current proposal and the Basel capital rules more generally. “It’s the same theme as capital rules: moving towards less discretion and more defined regulatory guidelines,” Lyons said.

Capital benefits 

The SMA proposal consists of two components, a Business Indicator, which is standardised and is based on defined factors, and another component based on bank-specific operational loss data, which focuses more on the bank’s specific loss experience. 

“The inclusion of the second component may help with capital charges, but it likely won’t be as advantageous for the banks as the AMA,” said Lyons.


"It’s the same theme as capital rules: moving towards less discretion"


Banks are already focused on proactive risk management: cyber controls, strong exam reviews, a strong approach to litigation. But the bank-specific operational loss data will make proactive approaches even more important, as under the proposals banks would see capital benefits attached to precautionary measures.   

“The proposal would change proactive risk management from a prudentially good thing to a capital benefit. This is a sign of the increasing intertwining of capital benefits and prudential best practice,” said Lyons.

And as a result of the actual loss-indicator component, proactive risk management would become all the more important if the proposal is finalised globally. Regardless, banks believe their advanced approaches should be used to set appropriate capital. Instead, the Committee’s standardised proposal would likely see higher capital charges than banks’ operational risks warrant. 

“Overall, the proposal is something that’s likely not viewed favourably by the industry,” said Lyons.

The proposal  will have to become final at the Basel Committee and then adopted by the US The Committee’s consultation period is open until 3 June 2016. 

See also:

How Fed's SCCL proposals diverge from Basel 

Basel leverage ratio impacts derivatives

Turkey: Implementing Basel III