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The Bank of International Settlements (BIS) has created the Basel norms so that the operational risk measurement and mitigation are standardized across all financial institutions.
However, the approach suggested by BIS has not been constant. Over the years, it has been evolving to become more complex and sophisticated.
Over the course of time, three approaches have been suggested by the BIS:
At the present moment, most of the companies in the world follow the Advanced Measurement Approach. This is the reason why in this article, we will understand the introduction to all three approaches.
However, in the next few articles, we will go in-depth into the Advanced Measurement Approach since that is the one being currently followed worldwide.
The basic indicator approach is one of the earliest approaches which was recommended by the Bank of International Settlements in its Basel norms.
Compared to the current method, it seems like a crude back-of-the-envelope calculation today.
However, it is still widely useful for banks that do not have a significant international presence.
The purpose of the basic indicator approach is to help the banks calculate the amount of capital that they need to set aside to meet operational risk requirements. This is done in three steps.
Step 1: Calculate a fixed percentage known as alpha. In most parts of the world, this number is 15%.
Step 2: Calculate the positive gross income over the past three-year period. It is important to note the emphasis on the word positive. If the income is less than zero, then it should be excluded both from the numerator and denominator.
Also, extraordinary one-time incomes, as well as expenses, should be excluded from the calculation. The positive gross income for the past three years needs to be averaged in order to arrive at a number.
Step 3: Multiple the alpha with the average gross income over the past three years to derive the amount of capital that needs to be set aside for risk management purposes.
The standardized approach is the next approach which is suggested by the Bank of International Settlements (BIS). It is more sophisticated as compared to the basic indicator approach.
As a part of this approach, the operations of a financial institution are divided into eight separate lines of business viz. retail banking, corporate finance, commercial banking, settlements and payments, trading, retail brokerage, asset management, and agency services.
The revenue earned by the organization is split into these eight lines of business. The revenue of each line of business is considered to be a proxy for the scale of operations and hence the scale of operational risk which may arise.
The next step is to calculate beta. Beta is an industry-wide number that symbolized the percentage of capital which needs to be set aside for that line of business based on historical losses generated by that line of business.
In the end, the beta for a line of business is multiplied by the revenue for that line of business to obtain the capital charge for that line of business.
The Bank of International Settlement recommends that the average revenue for three years be considered instead of single-year revenue. This is because the average of three years is more reliable and may represent the business conditions more accurately.
The capital charge for all eight lines of business is added together in order to obtain the capital that the organization needs to set aside in order to meet operational risk requirements.
The Standardized approach is considered to be more advanced because it takes into account the fact that all lines of business do not have the same risk. There are some businesses that are inherently riskier and hence organizations that indulge in these businesses should set aside more capital.
Secondly, the beta factor which is the main determinant of the amount of risk capital to be set aside is not calculated internally. Instead, the same beta figures are used by the entire industry. This is why the approach is called a standardized approach.
The advanced measurement approach is the most current approach. This is the one which is currently being recommended by Basel.
However, there are certain pre-requisites for implementing this approach. Firstly, the senior management of the organization has to be actively involved in the management of risk in the company.
Secondly, the company must have enough resources to create a risk and audit department which can oversee the operations. There are certain standards that need to be met before Basel allows banks to use the AMA approach.
The advanced measurement approach is a time and resource-consuming iterative approach consisting of four steps.
In the next few articles, we will detail the four steps viz. loss data collection, risk identification, and self-assessment, scenario planning, and business environment and control factors. All this data needs to be collected and then put into a framework to derive the amount of money that needs to be set aside in order to meet operational risk.
The bottom line is that the Bank of International Settlements has provided three broad approaches to risk management. Based on the scale of their business as well as whether the business is spread out in different geographies, a suitable approach can be selected.
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