LO 58.6: Describe and contrast the major elements of the three options

LO 58.6: Describe and contrast the major elements of the three options available for the calculation of operational risk capital: basic indicator approach, standardized approach, and the Advanced Measurement Approach.
Basel II requires banks to maintain capital for operational risks. Operational risks include failures of the banks procedures that result in loss (e.g., fraud, losses due to improper trading activities). External events that result in loss, such as a fire, are also considered operational risks.
Under Basel II, there are three approaches banks may use to calculate capital for operational risk: 1. Basic indicator approach.
2. Standardized approach.
3. Advanced measurement approach. Basic Indicator Approach (BIA). This is the simplest approach and is used by banks with less sophisticated risk management functions. The required capital for operational risk is equal to the banks average annual gross income (i.e., net interest income plus non-interest income) over the last three years multiplied by 0.15.
The Standardized Approach (TSA). This method is similar to the basic indicator approach. The primary difference between the two approaches is that a different multiplier is applied to the banks gross income for different lines of business.
Advanced Measurement Approach (AMA). Like the IRB approach discussed for credit risk, the capital requirement for operational risk under the advanced measurement approach is based on an operational risk loss (i.e., VaR) calculated over a one-year time horizon with a 99.9% confidence level. The approach has an advantage in that it allows banks to consider risk mitigating factors such as insurance contracts (e.g., fire insurance).
Professors Note: While Basel IIgenerally lowered credit risk capital requirements fo r most banks, requiring banks to hold capital fo r operational risks had the effect o f raising overall capital requirements back to (approximately) Basel I levels.
B a s e l II P i l
l a r s o f S o u n d B a n k M a n a g e m e n t