Striving for Operational Resilience
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The Basel Committee emphasizes consistency in implementing post-crisis controlling reforms. This consistency improves the flexibility in the banking system, promotes public sureness, and brings a level playing field for international banks. In 2014, a committee addressed flaws in the current standardized approach.
As analyzed by the Committee, the simple standardized approach combined with bank-specific loss data offers a sufficient risk sensitive measure of operational risk. The results made the board develop a single non-model-based system for the approximation of operational risk capital. The proposed SMA outline was to apply to globally active banks. Overseers will to also apply the SMA outline to non-globally active institutes.
The AMA allows for the approximation of controlling assets to be based on a range of inner molding subject to management approval. The AMA’s principle-based framework has some flexibility which is expected to narrow with time. However, the committee’s expectations were not met, as revealed by a recent review.
More so, they decided that it was necessary to remove the internal modeling methods for operational risk regulatory capital from the Basel Framework. The operational risk outline was standardized for capital regulation. In 2016, it was determined when the withdrawal of AMA and the implementation of SMA will happen.
The results of the quantitative impact study will be vital to the operational risk framework. However, the influence of the new outline will vary from bank to bank, leading to an increase in the minimum required capital. Once the committee has reviewed a second consultative document and the quantitative impact study (QIS) results, the publishing of the new framework and its implementation is expected to take place.
A simple financial statement proxy for operational risk exposure that is Business Indicator is combined with bank-specific loss data, by SMA. The structure of BI has been brushed up since October 2014 so as to avoid reprimanding certain business models. For issues related to the treatment of financial and operating leases, there have been some adjustments which have been made.
Business volume is only one factor which influences exposure to operational risk, although BI is stable and comparable to other banks. Therefore, in order to increase risk sensitivity, other sources of information are needed. The historical loss experience is being introduced as a relevance to an indication of future operational risk exposure.
There has been the introduction of the Loss Component into the framework to not only enhance risk sensitivity of SMA but also provide enticements for banks to improve operational risk management.
As in the 2014 consultation, the Bl is made up of almost the same P&L items that are found in the composition of Gross Income (Gl). The main difference relates to how the items are combined. In order to improve the consistency of the BI as a proxy indicator for operational loss exposure, the impact of other operating capital requirements must be changed from negative to positive. There have been adjustments of the BI structure to address the following issues, a response to questions raised during the first consultation of the committee:
The services component is modified \(“Fee\quad Income+Fee\quad Expense+Other\quad Operating\quad Income+Other\quad Operating\quad Expense”\) to \(“max\left( Fee\quad Income;Fee\quad Expense \right) +max\left( Other\quad Operating\quad Income;Operating\quad Expense \right)” \) so as to address \(item \left( 5 \right) \) stated above.
Dividend income is included in the Interest component of the BI so as to address \(item \left( 2 \right) \).
A linear normalization ratio for the high margin banks is adopted so as to address \(item \left( 1 \right) \). In this approach, the interest component of the BI is adjusted by the ratio of Net Interest Margin (NIM) cap to 3.5%; to the actual NIM 4.
The BI structure for the high-fee banks is modified so as to address \(item \left( 3 \right) \), by accounting for only 10% of the fees in excess of 50% of the unadjusted BI.
Below is a representation of the Service Component of the BI:
$$ Services \quad Component=Max\left[ Other\quad operating\quad income,Other\quad operating\quad expenses \right] +Max\left[ |Fee \quad income-Fee \quad Expenses|,Min\left\{ Max\left( Fee\quad income,Fee\quad Expense \right) ,0.5\times unadjusted\quad Bl+0.1\times \left( Max\left( Fee\quad income,Fee\quad Expense \right) -0.5\ast unadjusted\quad BI \right) \right\} \right] $$
In order to address \(item \left( 4 \right) \), all financial of the leased assets and gains/losses from the selling are included and netted in absolute value into the interest component.
One increasing function of the BI is to secure the SMA capital requirements by a bank’s BI component. In the SMA, banks are divided into five lots and according to the size of their BI. In the first one, capital is an increasing linear function of the BI and internal losses are not a must.
In the second one to the last one, capital is calculated in two steps:
There has been a progressive increase in the marginal impact of the BI due to a linear increase of the BI component within the bucket. This showed that operational loss exposure increases more than proportionally with the BI.
The basic assumption is that there exists a relationship between operational loss exposure and the BI. The SMA feels that the relationship is similar and stable for banks with similar BI values. However, the business volume is not the only factor that influences operational loss exposure between banks of similar BI values.
The committee investigated the proportion of the banks using an AMA, TSA, or its variant, the ASA, in the QIS sample across different buckets of the BI, in which they are required to collect operational losses and report these losses to the supervisors. The committee made the proposal that those internal losses should be used by banks.
A reflection of the operational loss exposure, by the Loss Component, can be inferred from its internal loss experience. There is a distinction between loss events above €10 million and €100 million, which is done by the Loss Component. In the transition period, banks without 10 years of good quality loss data may use a minimum of five years data to calculate the loss component.
A bank with exposure at the average of the industry has an Internal Loss Multiplier equal to 1 and its BI Component corresponds to the SMA capital.
$$ Internal\quad Loss\quad Multiplier=Ln\left( exp\left( 1 \right) -1 \right) +\frac { Loss\quad Component }{ BI\quad Component } $$
The \(Internal\quad Loss\quad Multiplier\) is confined by \(Ln\left( exp\left( 1 \right) -1 \right) \approx 0.541\). This means that the Internal Loss Multiplier increases at a decreasing rate with the Loss Component. The outcomes of the QIS conducted by the committee will see to it that a combination of the BI and Loss Component produces stable capital requirements. Alternative approaches that will ensure a stable and risk sensitive framework may be taken by the committee after it has carefully evaluated the efficiency of the logarithmic function.
SMA calculations fully use consolidated BI figures at the consolidated level so as to net all the intragroup expenses and incomes. They are used differently at the subsidiary and sub-consolidated levels.
When BI figures for the two levels mentioned above reach the second bucket, the bank uses only the losses incurred in SMA calculations.
The subsidiary will only calculate the SMA capital by applying 100% of the BI component if bank belonging to bucket 2 or higher does meet the standards and are from the subsidiary level.
The soundness of data collection, integrity, and quality are crucial to generating SMA outcomes that are aligned with the bank’s operational loss exposure.
The committee recommends that banks using the SMA Loss Component must adhere to minimum loss data standards under Pillar1 so as to promote evenness in the implementation of the Loss Component. Banks with heavy losses and unable to meet the standards could seek arbitrage in Pillar 1.
All banks are encouraged to comply with the committee’s principles for the Sound Management of Operational Risk 7 published in 2011 under Pillar 1.
The proper identification, treatment, and collection of internal loss event data are important to capital calculation under the SMA and the following general criteria for the use of the Loss Component in the SMA are as follows.
Operational risk losses related to market risk are treated as the operational risk for the purposes of calculating minimum regulatory capital under this framework and will, therefore, be subject to the SMA regulatory capital.
1) How is the Business Indicator (BI) structure modified to address the overcapitalization of banks with high-fee revenues and costs?
The correct answer is A.
For high fee banks, the BI structure is modified to give an account of only 10% of fees that surpasses 50% of the unadjusted BI (with the absolute value of net fee income as a floor to avoid unintended capital reductions).