Whether a so-called AMA bank, or a bank adhering to the simpler, standardized approaches for calculating operational risk regulatory capital needs – some important changes are waiting to materialize around the corner. All of them are aimed at restoring lost confidence in risk-weighted capital ratios while improving comparability between banks. Here are the 3 most important changes to keep an eye on, and what their likely implications are.
In 2004, the Basel Committee on Banking Supervision first introduced its operational risk framework. Fundamentally, the framework provides banks with two different options for calculating the relative riskiness of their assets and off-balance sheet exposures.
- One option, so far the most popular among banks, is based on prescribed supervisory risk weights – known as Standardized Approaches.
- The other option, based on a bank’s own internal operational risk estimates (subject to supervisory approval) is known as the Advanced Measurement Approach.
Back then, it was made clear that the framework would be reviewed once more operational risk data became available, and implementation experience had grown richer. 10 years later, the time for this seems right as the framework has been getting certain things wrong in its lifetime.
Since 2012, the committee has conducted three studies assessing internationally active banks’ risk-weighting of banking and trading-book assets. These studies unanimously confirm that there are material variances in banks’ regulatory capital ratios that arise from factors other than differences in the riskiness of their respective portfolios.
Hardly surprising, such variance undermines general confidence in published capital ratios. So, what can be done?
Change 1: Sharpening of the Standardized Approaches
Despite an increase in the number and severity of operational risk events during and after the financial crisis, capital requirements for operational risk have remained stable or even fallen for the Standardised Approaches (i e BIA, TSA and ASA). This indicates that the “simple” approaches underestimate the operational risk capital requirements for a wide spectrum of banks – but particularly so for large and complex banks.
The weakness of the simpler approaches comes mainly from their use of gross income (GI) as a proxy indicator for operational risk exposure, based on the assumption that banks’ operational risk exposure increases linearly in proportion to revenue. An assumption that has been proven wrong, again and again.
In particular, where a bank experiences a decline in its GI due to systemic or bank-specific events, its operational risk capital falls when instead it should be increasing. Moreover, the current methodology ignores the fact that the relationship between size and operational risk of a bank does not remain constant as operational risk exposure may well increase with a bank’s size in a non-linear fashion.
The committee’s preferred remedy is to:
- Replace gross income with a superior proxy indicator: A so-called “business indicator” has been identified, comprising three main components of a bank’s income statement – an “interest component”, a “services component” and a “financial component”. These three components are thought to better capture a bank’s exposure to operational risk inherent in its mix of business activities.
- Improve the calibration of the regulatory coefficients: The analytical work conducted since 2012 has shown that the size of a bank is the dominant factor in operational risk exposure – hence regulatory coefficients should be size-based. Preliminary calibrations have identified a five-phased structure with coefficients increasing from about 10% to 30% as the BI rises in value.
- Allow only one non-model-based approach rather than several as this will increase comparability
Change 2: Narrowing of the Advanced Measurement Approach
A weakness of the Advanced Measurement Approaches is that its capital requirements have often been benchmarked against the under-calibrated capital requirements of the simpler approaches – so to say giving the building a weak foundation from the start. Moreover, the framework has allowed for a multitude of individual approaches – from which best practices have yet to emerge and supervisory experience has been mixed.
Overall, consistency and comparability have posed a great challenge, which is why the committee is now mulling a considerable narrowing of the acceptable methodologies.
Change 3: A New Disclosure Regime
The Basel Committee proposed a substantial review of the Pillar III disclosure requirements in June earlier this year, as the current demands have proved inadequate in several ways.
The most concerning shortcoming is the lack of disclosure consistency across banks – both in form and granularity – and how individual banks interpret the existing requirements. Hence, the review will produce a new standard – expected to arrive by the end of 2015 – generating greater comparability between banks in terms of how they disclose information about risks, risk measurement and risk management.
However, the general view is that this is not about disclosing more information, rather about disclosing already existing information in a different, more descriptive, way.
Whether an AMA bank, or a Standardized Approach one, banks will be required to change how they currently calculate their regulatory capital for operational risk.
Most likely, a large number of banks – especially those using Standardized Approaches – will also see their Operational Risk capital requirements go up, meaning that more capital will need to be raised and held. Moreover, more stringent demands on publishing these calculations, their outcomes and consequences will be put in place.
As changes are expected to effect by January 1 2016, it is high time for the banks of Europe to start preparations.