LO 44.3: Describe general and specific criteria recommended by the Basel Committee for the identification, collection, and treatment of operational loss data.
Banks that incorporate the loss component into the SMA calculation must follow the following general criteria: Documented processes and procedures must be in place for the identification, collection,
and treatment of internal loss data.
A bank must maintain information on each operational risk event, including gross loss amounts, the date of occurrence (when the event first began or happened), the date of discovery (when the bank became aware of the event), the date of accounting (when the reserve, loss, or loss provision was first recognized in the banks income statement, any gross loss amount recoveries, and what the drivers were of the loss event itself). Specific criteria must exist for loss data assignments stemming from centralized function events and related events over time (considered grouped losses).
For the purposes of calculating minimum regulatory capital per the SMA framework,
operational risk losses tied to credit risk will be excluded from the calculation. Operational risk losses tied to market risk will be included in the SMA calculation.
A bank has to be able to document any criteria used to allocate losses to specific event types. In addition, a bank must be able to categorize historical internal loss data into the appropriate Level 1 supervisory categories per the Basel II Accord (Annex 9) and be prepared to provide this to supervisors when requested.
An observation period of 10 years must be used as a basis for internally generated loss
data calculations. On an exception basis and as long as good-quality data is not available for more than a five-year period, a bank first moving to the SMA can use a five-year observation period. Internal loss data must be comprehensive in nature and capture all material exposures and activities across all geographic locations and subsystems. When a bank first moves to the SMA, a 20,000 de minimis gross loss threshold is acceptable. Afterward, this threshold is lowered to 10,000.
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Topic 44 Cross Reference to GARP Assigned Reading – Basel Committee on Banking Supervision
In addition to the general criteria noted previously, specific criteria must also be followed as described as follows: A policy must exist for each bank that sets the criteria for when an operational risk event or loss (which is recorded in the internal loss event database) is included in the loss data set for calculating the SMA regulatory capital amount (i.e., the SMA loss data set). For all operational loss events, banks must be able to specifically identify gross loss
External expenses (legal fees, advisor fees, vendor costs, etc.) directly tied to the amounts, insurance recoveries, and non-insurance recoveries. A gross loss is a loss before any recoveries, while a net loss takes into account the impact of recoveries. The SMA loss data cannot include losses net of insurance recoveries. In calculating the gross loss for the SMA loss data set, the following components must be included’.
External expenses (legal fees, advisor fees, vendor costs, etc.) directly tied to the
operational risk event itself and any repair/replacement costs needed to restore the bank to the position it was in before the event occurring. Settlements, impairments, write-downs, and any other direct charges to the banks
Settlements, impairments, write-downs, and any other direct charges to the banks
income statement as a result of the operational risk event. .Any reserves or provisions tied to the potential operational loss impact and booked to the income statement. Losses (tied to operational risk events) that are definitive in terms of financial impact
Losses (tied to operational risk events) that are definitive in terms of financial impact
but remain as pending losses because they are in transition or suspense accounts not reflected on the income statement. Materiality will dictate whether the loss is included in the data set. Timing losses booked in the current financial accounting period that are material
Timing losses booked in the current financial accounting period that are material in nature and are due to events that give rise to legal risk and cross more than one financial accounting period. The total cost of improvements, upgrades, and risk assessment enhancements and In calculating the gross loss for the SMA loss data set, the following components must be excluded.
The total cost of improvements, upgrades, and risk assessment enhancements and
initiatives that are incurred after the risk event occurs. Insurance premiums. The costs associated with general maintenance contracts on property, plant, and
The costs associated with general maintenance contracts on property, plant, and
equipment (PP&E).
For every reporting year of the SMA regulatory capital, the gross losses included in the loss data set must incorporate any financial adjustments (additional losses, settlements, provision changes) made within the year for risk events with reference dates up to 10 years before that reporting year. The operational loss amount after adjustments must then be identified and compared to the 10 million and 100 million threshold.
The only two dates a bank can use to build its SMA loss data set are the date of discovery
or the date of accounting. For any legal loss events, the date of accounting (which is when the legal reserve representing the probable estimated loss) is the latest date that can be used for the loss data set.
Any losses that are related to a common operational risk event or are related by
operational risk events over time are considered grouped losses and must be entered as a single loss into the SMA loss data set.
The circumstances, data types, and methodology for grouping data should be defined
with criteria found in the individual banks internal loss data policy. In instances where individual judgment is needed to apply the criteria, this must be clarified and documented.
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Topic 44 Cross Reference to GARP Assigned Reading – Basel Committee on Banking Supervision
K e y C o n c e p t s
LO 44.1 The standardized measurement approach (SMA) includes both a business indicator (BI) component accounting for operational risk exposure and an internal loss multiplier and loss component accounting for operational losses unique to an individual bank. While the BI component is factored into the SMA for banks of all sizes, the impact it has on the SMA calculation will vary depending on where the bank is classified from buckets 15. The loss component is factored in for all banks classified in buckets 25.
LO 44.2 The older advanced measurement approach (AMA) allowed banks to use a vast range of models that were inherently more flexible for individual banks but prevented valuable comparisons among banks. From this, the SMA was created as a non-model-based approach used to assess operational risk using both financial statement measures and loss data unique to individual banks.
LO 44.3 For identifying, collecting, and accounting for operational loss data, the Basel Committee has outlined several general and specific criteria that should be used. Key general criteria include processes and procedures, documentation needed, thresholds for capturing losses, and appropriate periods. Specific criteria include how to calculate gross losses (what is included versus what is excluded), key dates used to capture the losses, how to quantify grouped losses, and policies needed.
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Topic 44 Cross Reference to GARP Assigned Reading – Basel Committee on Banking Supervision
C o n c e p t C h e c k e r s
1.
2.
3.
4.
3.
The business indicator (BI) component in the standardized measurement approach (SMA) calculation for a bank with a BI of 13 billion will be closest to: A. 1.43 billion. B. 1.91 billion. C. 2.43 billion. D. 13.00 billion.
Which of the following items from the profit & loss (P&L) statement should be included in the BI component calculation? A. Administrative expenses. B. Insurance premiums paid. C. Depreciation related to capitalized equipment. D. Provision reversals related to operational loss events.
Which of the following components within the BI calculation takes into account a banks trading and banking book P&L results? A. Loss component. B. Services component. C. Financial component. D. Interest, lease, dividend component.
Which of the following statements best describes a difference between the SMA and the older operational risk capital approaches? A. The standardized approach (TSA) and the alternative standardized approach
(ASA) were variations of the SMA.
B. The advanced measurement approach (AMA) was more flexible in its
C. The SMA accounts for internal loss experiences that were not factored into the
D. The SMA uses a model-based methodology, while the AMA was more flexible
application than the SMA.
AMA.
and principles-based.
In deriving the SMA loss data set for an individual bank, each of the following items will most likely be included in the gross loss calculation except: A. legal fees of 900,000 associated with an unusual risk event. B. a 2 million settlement tied to a recent operational risk event. C. a 1.4 million reserve booked to the income statement to cover a potential
D. 1.73 million spent on maintenance contracts tied to the banks property, plant,
operational loss.
and equipment (PP&E).
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C o n c e pt C h e c k e r An s w e r s
1. C A bank with a BI of 13 million will fall into bucket 4, which covers a BI range of 10
billion to 30 billion. With the BI component formula of 1.74 billion + 0.23(BI – 10 billion) for bucket 4 banks, the BI component for this bank will be equal to 1.74 billion + 0.23(13 billion – 1 0 billion) = 2.43 billion.
2. D A provision reversal would normally be excluded except when it relates to operational loss
events. Each of the other three choices represents a P&L item that should be excluded from the BI component calculation.
3. C The formula for the financial component of the BI calculation is equal to:
abs(net P<B
) + abs(net P&LBB
vo
) vo
with TB representing the trading book and BB representing the banking book.
4. B Because banks were able to use a wide range of models for calculating the AMA, there was more flexibility to these approaches than under the new SMA. TSA and ASA were older approaches rather than variations of the SMA. AMA did account for internal losses. The SMA is non-model-based, whereas the AMA did incorporate bank-specific models.
5. D The costs associated with maintenance contracts for PP&E are outlined in the specific
criteria for collecting operational loss data as excluded for the purposes of calculating the gross loss for the SMA loss data set.
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The following is a review of the Operational and Integrated Risk Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
Pa r a m e t r i c A ppr o a c h e s (II): Ex t r e me Va l u e
Topic 45
E x a m F o c u s
Extreme values are important for risk management because they are associated with catastrophic events such as the failure of large institutions and market crashes. Since they are rare, modeling such events is a challenging task. In this topic, we will address the generalized extreme value (GEV) distribution, and the peaks-over-threshold approach, as well as discuss how peaks-over-threshold converges to the generalized Pareto distribution.
M a n a g i n g E x t r e m e V a l u e s