Transcript www.bankofengland.co.uk

BRITISH BANKERS' ASSOCIATION
Operational Risk & the Regulatory
Environment
Simon Hills
Director - Prudential Capital team
Operational Risk & the Regulatory
Environment
What is Prudential Capital regulation for?

enhancing stability of the financial system
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protecting depositors
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advancing financial institutions‘ risk management
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ensuring level-playing field by further aligning regulatory practices
But:
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capital is expensive
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trade-off between stability and efficiency of banking system
Operational Risk & the Regulatory
Environment
Basel I
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Relatively crude risk weighting system
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Inadequate incentives for risk mitigation (and some
perverse incentives)
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Some categories of risk not covered at all
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Market developments not properly reflected –
•
new products
•
avoidance/mitigation techniques
Operational Risk & the Regulatory
Environment
Basel 2
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More flexible, risk sensitive system
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Overall capital broadly unchanged under standard approach, but with
incentives for better risk management
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Competitive equality
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Emphasis on banks’ own internal control, management and risk
assessment, with supervisory evaluation
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Market discipline
Operational Risk & the Regulatory
Environment
Structure of new Accord: the three pillars
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Pillar I – minimum capital requirement
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Pillar II – supervisory review
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Pillar III – market discipline
Operational Risk & the Regulatory
Environment
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Replaces Basel 1 which requires banks to hold 8% of funds lent in
capital
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Capital required to cover credit, market and operational risk
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Operational risk charge covers expected and unexpected losses –
but not catastrophic loss
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Must quantity operational risk – and assess the quality of Operational
Risk management in order to ensure that banks that manage risk well
see a reduction in regulatory capital
Operational Risk & the Regulatory
Environment
Operational risk
Risk of loss from inadequacy/failure of internal
processes/systems people or external events: includes legal risk but not
strategic and reputation risk

“Basic indicator” and “standardised” approaches based on income
(differentiated by business line in standardised approach)
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“Advanced measurement approach” uses risk measure generated by bank’s
internal operational risk measurement system
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AMA permitted only where specified standards satisfied
Operational Risk & the Regulatory
Environment
Problems with Quantification
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Inadequate or insufficient data to build a well populated
database
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Need to apply imprecise measures for frequency and impact
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No quantifiable size of exposure amount due to impossibility
of forecasting how different risk issues will combine to
produce a major operational loss event
Operational Risk & the Regulatory
Environment
Problems with Quantification

Can’t know when portfolio of risks is complete
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Context dependent – reduction in relevance of historic loss data
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Not an exact science!
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Main benefit – to prioritise management actions and assess Cost
benefit of mitigation measures
Operational Risk & the Regulatory
Environment
The Basic Indicator Approach
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Hold capital for operational risk equal to 15% of average annual gross income
over the previous three years
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Gross income is net interest income + net non-interest income + gross of
provisions and before profits/losses from sale of securities in the banking
book, extraordinary items and insurance income.
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No specific qualitative requirements but banks using the approach are
encouraged to comply with the requirements of the Sound Practices paper
Operational Risk & the Regulatory
Environment
The Standardised Approach

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Under the Standardised approach the institution divides its activities into 8
business lines.
Each business line has a beta factor based on the perceived “riskiness” of each
activity.
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The capital charge for each business line will be found by multiplying the gross
income by the beta factor.
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The resulting figures will be added together to find the overall capital charge.
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A qualitative assessment of the OR management framework will be carried out
by Regulators before this approach can be used and certain governance
standards must be met.
Operational Risk & the Regulatory
Environment
Business Lines and Beta Factors
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Corporate Finance
18%
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Trading and Sales
18%
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Retail Banking
12%
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Commercial Banking
15%
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Payment and Settlement
18%
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Agency Services
15%
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Asset Management
12%
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Retail Brokerage
12%
Operational Risk & the Regulatory
Environment
The Advanced Measurement Approaches
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Under the AMA, the regulatory capital requirement will equal the risk
measure generated by the bank’s internal operational risk management
system using the quantitative and qualitative criteria for the AMA.
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The methodology developed by the bank will need to be approached by the
regulator before use.
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Under the AMA the capital charge may be reduced by up to 20% to
reorganise the mitigating effect of insurance.
Operational Risk & the Regulatory
Environment
Firms must track internal loss data and meet the following standards:
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5 year observation period (3 years initially).
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Reviewed regularly to ensure consistency with current activities.
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Mapped to the Basel loss categorisation.
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Comprehensive above a threshold.
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Appropriately and consistently assigned.
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Consistent, defined boundaries with other risk types
Operational Risk & the Regulatory
Environment
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What are the characteristics of the loss events?
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What are the key factors in determining size and frequency of loss?
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Why was the tail event more significant?
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Can we think of other scenarios that could give rise to similarly significant
losses?
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Is there anything we can do to stop these events?
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Is it our belief that the dataset represents a “typical” year?
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Are we capturing the full range of potential loss events in the histogram?
Does this reflect our full risk profile?
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Do the losses that have occurred fully illustrate our risk exposures?
Operational Risk & the
Regulatory Environment
Conclusions
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Management not Measurement
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Imprecise science
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Integrate measurement into Operational Risk Management framework
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Use data to inform decisions
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•
Control framework
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Evaluate mitigation
•
Prioritise corrective action
Low frequency/High impact events drive operational risk capital!