LO 41.2: Summarize the process of collecting and reporting internal operational

LO 41.2: Summarize the process of collecting and reporting internal operational loss data, including the selection of thresholds, the timeframe for recoveries, and reporting expected operational losses.
The foundation of an OpRisk framework is the internally created loss database. Any event that meets a firms definition of an operational risk event should be recorded in the loss event database and classified based on guidelines in the operational risk event policy. Many firms adopt Basel II categories at the highest level and then customize lower level entries to match their firms specific needs. A minimum of five years of historical data is required to satisfy Basel II regulatory guidelines. Collecting and analyzing operational risk events provides valuable insights into a firms operational risk exposures. When loss data is not collected, it could be perceived by regulators that operational risk management issues are not a concern. Usually once a firm begins to collect loss data, the organization gains a new appreciation of its operational risks.
The collection of data is challenging because large amounts of data must be gathered over diverse geographical areas. The process of gathering data must ensure that it accurately reflects all loss information from all locations. The process should have checks and balances to ensure human errors are not present in gathering data and sending it to the central data collection point. Basel II regulations require a high degree of reliability in the loss data flow from all areas of the financial institution.
Page 46
2018 Kaplan, Inc.
Topic 41 Cross Reference to GARP Assigned Reading – Cruz, Chapter 2
Financial institutions often create OpRisk filters to identify potential operational events used in the calculation of operational losses. These OpRisk filters are typically the most expensive cost in the process. Flowever, filters provide important added assurance for regulators regarding the accuracy of the data collection process.
Basel II requirements allow financial institutions to select a loss threshold for loss data collection. This threshold amount will have significant implications for the risk profile of business units within the firm. OpRisk managers should not set the threshold for collecting loss data too low (e.g., $0) if there are business units that have a very large number of smaller losses, because it would require a very high amount of reporting. OpRisk managers should also not just think in terms of large OpRisk threshold amounts. The following example illustrates how setting a threshold too high will bias the total losses and therefore the risk profile for a financial institution.
Suppose the OpRisk manager for Bank XYZ sets the threshold at $50,000. Bank XYZ categorized all losses by the amount of the loss into loss brackets or buckets illustrated in Figure 4. The first row of Figure 4 states that there were two losses greater than $4,000,000 in the past year and the total amount of loss from these two events was $18,242,000. These two losses accounted for 25.3% of the total losses for the year. If a loss threshold was set at $50,000, then the last two rows or 28.3% of the total losses for the year would not be reported. Therefore, if the firm did not set a loss threshold for collecting data they would show that they actually had $72,136,148 of total losses instead of $51,724,314 (computed as $72,136,148 – $4,480,627 – $15,931,207).
Figure 4: Bank XYZ Total Annual Losses
Loss Bracket
Over $4,000,000 $1,000,000 to $4,000,000 $500,000 to $1,000,000 $250,000 to $500,000 $100,000 to $250,000 $75,000 to $100,000 $50,000 to $75,000 $25,000 to $50,000 Less than $25,000 Total
Events 2 8 9 7 10 15 18 50 1230
Loss Amount $18,242,000 $17,524,400 $7,850,425 $1,825,763 $1,784,632 $1,948,971 $2,548,123 $4,480,627 $15,931,207 $72,136,148
Percentage 25.3% 24.3% 10.9% 2.5% 2.5% 2.7% 3.5% 6.2% 22.1% 100.0%
When quantifying capital requirements, Basel II does not allow recoveries of losses to be included in the calculation. Regulators require this rule because gross losses are always considered for capital calculations to provide a more realistic view of the potential of large losses that occur once every 1,000 years.
Another important issue to consider in the process of collecting loss data is the timeframe for recoveries. The financial crisis of 20072009 illustrated that the complexity of some loss events can lead to very long time horizons from the start of the loss event to the final closure. Complex litigation cases from this financial crisis took five to six years for resolutions. Sometimes loss events will take lawyers and OpRisk managers several years to estimate the loss amount.
2018 Kaplan, Inc.
Page 47
Topic 41 Cross Reference to GARP Assigned Reading – Cruz, Chapter 2
While firms could create reserves for these losses, they seldom do to avoid giving the impression that they may owe a certain amount prior to reaching a judgment. The fact that many firms do not have legal expertise within the firm to handle these complex cases adds to the cost, because outsourcing of lawyers is often required. It is important for firms to have a policy in place for the processing of large long timeframe losses.
To help firms know what to report, the International Accounting Standards Board (IASB) prepared IAS37, which establishes guidelines on loss provisions or the reporting of expected operational losses after the financial crisis in 20072009. Three important requirements for the reporting of expected operational losses are as follows: 1. Loss provisions are not recognized for future operating losses.
2. Loss provisions are recognized for onerous contracts where the costs of fulfilling
obligations exceed expected economic benefits.
3. Loss provisions are only recognized for restructuring costs when a firm has a detailed
restructuring plan in place.
The IAS37 report states that loss provisions of restructuring costs should not include provisions related to relocation of staff, marketing, equipment investments, or distribution investments. Loss provisions must be recognized on the balance sheet when the firm has a current obligation regarding a past loss event. Balance sheet reporting of loss events is required when the firm is likely to be obligated for a loss and it is possible to establish a reliable estimate of the amount of loss. Gains from the disposal of assets or expected reimbursements linked to the loss should not be used to reduce the total expected loss amount. Reimbursements can only be recognized as a separate asset.
I d e n t i f y i n g , C o n t r o l
i n g , a n d A s s e s s i n g O p e r a t i o n a l R i s k