LO 43.1: Compare the basic indicator approach, the standardized approach, and

LO 43.1: Compare the basic indicator approach, the standardized approach, and the alternative standardized approach for calculating the operational risk capital charge, and calculate the Basel operational risk charge using each approach.
Basel II proposed three approaches for determining the operational risk capital requirement (i.e., the amount of capital needed to protect against the possibility of operational risk losses). The basic indicator approach (BIA) and the standardized approach (TSA) determine capital requirements as a multiple of gross income at either the business line or institutional level. The advanced measurement approach (AMA) offers institutions the possibility to lower capital requirements in exchange for investing in risk assessment and management technologies. If a firm chooses to use the AMA, calculations will draw on the underlying elements illustrated in Figure 1.
Figure 1: Role of Capital Modeling in the Operational Risk Framework
Risk Governance
Risk Appetite
Risk Measurement and Modeling / Risk Reporting
V
Internal Loss Data Risk and Control Self-Assessment External Loss Data
Scenario Analysis Key Risk Indicators
(KRIs)
Risk Culture / Risk Policies and Procedures
Topic 43 Cross Reference to GARP Assigned Reading – Girling, Chapter 12
Basel II encourages banks to develop more sophisticated operational risk management tools and expects international banks to use either the standardized approach or advanced measurement approach. In fact, many nations require large financial institutions to calculate operational risk with the AMA in order to be approved for Basel II.
Basic Indicator Approach
With the BIA, operational risk capital is based on 13% of the banks annual gross income (GI) over a three-year period. Gross income in this case includes both net interest income and noninterest income. The capital requirement, KBIA, under this approach is computed as follows:
where: GI = annual (positive) gross income over the previous three years n = number of years in which gross income was positive a =13% (set by Basel Committee)
Firms using this approach are still encouraged to adopt the risk management elements outlined in the Basel Committee on Banking Supervision, Risk Management Group, Sound Practices for the Management and Supervision of Operational Risk. When a firm uses the BIA, it does not need loss data, risk and control self-assessment, scenario analysis, and business environment internal control factors (BEICF) for capital calculations. However, these data elements are needed as part of an operational risk framework to ensure risks are adequately identified, assessed, monitored, and mitigated.
Iixample 1: Calculating BIA capital charge
Assume Omega Bank has the following revenue results from the past three years:
Annual Gross Revenue (in $ 100 millions) Calculate the operational risk capital requirement under the BIA. 25 30 25 Year 1 30 Year 2
Year 3 35
Answer:
_[(25 + 30 + 3 5 )x 0 .1 5 ]_ ., K BIA —————————————– 4 –>
D
Thus, Omega Bank must hold $450 million in operational risk capital under Basel II using the basic indicator approach.
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Topic 43 Cross Reference to GARP Assigned Reading – Girling, Chapter 12
Example 2: Calculating BIA capital charge
Assume Theta Bank has the following revenue results from the past three years:
Annual Gross Revenue (in $100 millions) Calculate the operational risk capital requirement under the BIA. 10 -5 10 Year 1 -5 Year 2
Year 3 15
Answer:
Because Year 2 is negative, it will not count toward the sum of gross income over the past three years. This will also reduce the value of n to two.
[(10 + .5 )X .1 5 L 1J75
Thus, Theta Bank must hold $187.3 million in operational risk capital under Basel II using the basic indicator approach.
The BIA for risk capital is simple to adopt, but it is an unreliable indication of the true capital needs of a firm because it uses only revenue as a driver. For example, if two firms had the same annual revenue over the last three years, but widely different risk controls, their capital requirements would be the same. Note also that operational risk capital requirements can be greatly affected by a single years extraordinary revenue when risk at the firm has not materially changed.
The Standardized Approach
Investment banking (corporate finance): 18%. Investment banking (trading and sales): 18%. For the standardized approach (TSA), the bank uses eight business lines with different beta factors to calculate the capital charge. With this approach, the beta factor of each business line is multiplied by the annual gross income amount over a three-year period. The results are then summed to arrive at the total operational risk capital charge under the standardized approach. The beta factors used in this approach are shown as follows:
Retail banking: 12%. Commercial banking: 13%.
Agency and custody services: 15%. Asset management: 12%. Retail brokerage: 12%. The standardized approach attempts to capture operational risk factors not covered by the BIA by assuming that different business activities carry different levels of operational risk.
Settlement and payment services: 18%.
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Topic 43 Cross Reference to GARP Assigned Reading – Girling, Chapter 12
Any negative capital charges from business lines can be offset up to a maximum of zero capital. The capital requirement, KTSA, under this approach is computed as follows:
3 Years
3
where: GIt 8 = annual gross income in a given year for each of the eight business lines (3j_8 = beta factors (fixed percentages for each business line)
In the following examples, Gamma Bank has only three lines of business and uses the standardized approach for its operational risk capital calculation.
Example 1: Calculating TSA capital charge
Assume Gamma Bank has the following revenue (in $100 millions) for the past three years for its three lines of business: trading and sales, commercial banking, and asset management.
Business Line
Year 1
Year 2
Trading and Sales Commercial Banking A set Management Calculate the operational risk capital requirement under TSA.
10 5 10
15 10 10 20 15 10 20 15 10 Year 3
Answer:
To calculate TSA capital charge, we first incorporate the relevant beta factors as follows:
Business Line
Year 1
Year 2
Year 3
Ok OJ II 0s Vp
0 X 0
boo
15 x 15% = 2.25 10 x 12% = 1.2
7.05
k-n
IIo
0s Vp -n
X k
kJ\
5.4
bo II 0s Vp
0 X 0
10 x 18% = 1.8 Trading and Sales Commercial Banking A set Management Total Next, enter these totals into the capital charge calculation as follows:
10 X 15% = 1.5 10 x 12% = 1.2
10 x 12% = 1.2
3.75
c/ k t s a —————-: —————- N4
_ (3.73 + 3.4 + 7.03)
Thus, Gamma Bank must hold $540 million in operational risk capital under Basel II using the standardized approach.
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Topic 43 Cross Reference to GARP Assigned Reading – Girling, Chapter 12
Example 2: Calculating TSA capital charge
If Delta Bank has negative revenue in any business line, it can offset capital charges that year up to a maximum benefit of zero capital. Beta Bank has had the following revenue (in $100 millions) for the past three years for its two lines of business: corporate finance and retail banking.
Business Line
Year 1
Corporate Finance Retail Banking Calculate the operational risk capital requirement under TSA.
5 5 10 -25 10 -25 Year 2
Year 3 15 5
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Year 1
Year 2
Year 3
IIbo
Vp
0 X 0
v-n
10 x 18%= 1.80
‘Oo IIo
0s
0 X 0
b\o IIo vP0s
o Xb
1
o

II 0s nP
o Xb
bo
1
N OO
O
II NP 0s
o Xb
1.5
-1.2
3.3
Answer:
Business Line Corporate Finance Retail Banking Total
Because a negative number cannot be used in the numerator, we replace 1.2 in Year 2 with zero. However, unlike the BIA, the number of years remains at three. Entering these totals into the capital charge calculation yields:
is” r t s a ———– ;——– — ho
(1.5+ 0 + 3.3)
Thus, Delta Bank would hold $160 million operational risk capital under Basel II using the standardized approach.
Alternative Standardized Approach
Under Basel II, a bank can be permitted to use the alternative standardized approach (ASA) provided it can demonstrate an ability to minimize double counting of certain risks. The ASA is identical to the standardized approach except for the calculation methodologies in the retail and commercial banking business lines. For these business lines, gross income is replaced with loans and advances times a multiplier, which is set equal to 0.035. Under the ASA, the beta factor for both retail and commercial banking is set to 15%. The capital requirement for the retail banking business line, K ^, (which is the same for commercial banking) is computed as follows:
K r b = P r b x L A r b x m
where: (3r b = beta factor for retail banking business line (15%) LAr b = average total outstanding retail loans and advances over the past three years m multiplier (0.035) = multiplier (0.035)
Under this scenario, the standardized approach will compute a capital charge of $50 million as follows:
(1.5+ 0 + 0)
3
However, recall that the BIA applies a fixed 15% of gross income and reduces the value of n when negative gross income is present. Thus, under the same scenario, the BIA will compute a capital charge of $150 million as follows:
[(5 + 5) x 0.15] 1
Therefore, this bank would hold only $50 million in operational risk capital using TSA but $150 million under the BIA. The Basel Committee has recognized that capital under Pillar 1 (minimum capital requirements) may be distorted and, therefore, recommends that additional capital should be added under Pillar 2 (supervisory review) if negative gross income leads to unanticipated results.
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