The Basel Committee on Banking Supervision (BCBS) are proposing to scrap internal modelling of operational risk capital in an attempt to introduce simplicity and comparability across banks.
Banks will welcome this clarity in an area that has been under review for many years but concerns will remain around increased capital costs, additional data and disclosure burdens, good risk management incentivisation, national application and global consistency.
The BCBS has published a further consultation on operational risk capital measurement. This confirms the withdrawal of the internal modelling-based Advanced Measurement Approach (AMA), and proposes to replace all of the Basel II approaches to operational risk with a single revised Business Indicator (BI) approach – the Standardised Measurement Approach (SMA). Responses should be submitted by 3 June 2016.
The BCBS has also published a consultation paper on revised Pillar 3 disclosure requirements, including amendments relating to operational risk. These include revising disclosures to meet the newly proposed SMA, additional disclosures of internal losses, and more detailed information relating to a bank’s operational risk management framework. Responses should be submitted by 10 June 2016.
These are both part of a wider picture covering all the components of the denominator of the capital ratio – the BCBS has already published its revised market risk framework, while revisions to the capital treatment of credit risk and the introduction of a capital floor are both due to be finalised by the end of 2016. It is clear that apparently technical papers will continue to shape business model and strategy.
The proposed SMA combines a revised version of the BI approach (which the BCBS first consulted on in 2014) with some recognition of bank-specific loss data. The BCBS sees this as a way of introducing a degree of risk-sensitivity, which provides some incentive for banks to improve their operational risk management, while simplifying the approach. Banks with low operational risk losses will benefit from a lower operational risk regulatory capital charge – although this will not apply to small banks.
The removal of the internal modelling approach for operational risk regulatory capital reflects the view of the BCBS that the inherent complexity of the AMA and the lack of comparability arising from a wide range of internal modelling practices has exacerbated the variability in risk-weighted asset calculations across banks using the AMA and eroded confidence in risk-weighted capital ratios.
The BCBS states that the objective of these proposals is not to increase significantly overall capital requirements. However, this is not a ‘one size fits all’ proposal, and the impact will vary from bank to bank and will lead to an increase in minimum capital requirements for some institutions.
Banks will welcome greater certainty in an area that has been under review for many years, notably the revisions to the BI approach in response to comments on the 2014 proposals, and the recognition of bank-specific loss data. However, some concerns are likely to remain:
Capital – Analysis of the 2014 proposals showed that some global banks could face increases of up to 70 percent of their Pillar 1 operational risk capital charges. The latest proposals should have a smaller impact, but this could still be significant for some banks. The overall impact will also depend on how the proposed new Pillar 1 approach interfaces with Pillar 2 capital requirements – banks that can demonstrate good internal modelling and strong operational risk systems and controls could potentially gain a partial offset to higher Pillar 1 requirements.
Data and systems – The data requirements for calculating internal loss experience and the proposed disclosure requirements will impose an additional burden on some banks. Banks not currently using the AMA will have to put the necessary systems and processes in place to collect, analyse, and report the required data; while even banks currently adopting AMA may have to revise their systems and processes to deliver the required calculations and disclosures.
Incentives for good operational risk management – The introduction of an internal loss component will provide some regulatory incentive for firms to reduce their operational risk losses. However, this element of risk-sensitivity is limited to past losses, and does not include the three other key elements of the AMA, namely external data, forward-looking scenario analysis information, and the business environment and internal control factors (BEICF) data (even if these elements were difficult to apply consistently across banks under the AMA). The Pillar 2 capital framework is used as a tool by some regulators to encourage enhanced risk management across banks. As an example in the UK, the PRA has issued standard methodologies for assessing Pillar 2 operational risk capital, taking into account internal data, forecast losses and scenario analysis. However, it remains to be seen how this will be applied by supervisors and how consistently this will be used globally.
Disclosure – The enhanced Pillar 3 disclosure requirements will require banks to detail how they manage their operational risks as well as their loss history.