Banks have invested heavily in their Operational Risk capability in recent years with many continuing to do so. The papers released at the start of the month by the Basel Committee on Banking Supervision (BCBS) indicate that the job is not yet done for such enhancement programmes and these latest proposals are likely to prompt organisations to reconsider the nature of their operational risk framework as well as their approach for operational risk regulatory capital calculation and the associated business case.

Earlier this month, the BCBS released two papers of interest and importance to operational risk. The first reflects the BCBS' findings following banks' self-assessment of their implementation of the Principles for Sound Management of Operational Risk; the second, their consultation on proposed changes to the Basic Indicator Approach (BIA) and the Standardised Approach (TSA) for operational risk capital calculation under Pillar 1.

Principles for Sound Management of Operational Risk

Unsurprisingly, banks' self-assessment indicated that they continue to implement the Principles with none of the Principles being 'fully complied with' across the 60 banks included in the exercise.

Key areas of focus for improvement include:

  • improving the implementation of each of the operational risk identification and assessment tools, including risk and control self-assessments, key risk indicators, external loss data, business process mapping, comparative analysis, and the monitoring of action plans generated from various operational risk management tools;
  • enhancing the implementation of change management programmes and processes and ensure their effective monitoring;
  • strengthening the implementation of the three-lines of defence, especially by refining the assignment of roles and responsibilities; and
  • improving board and senior management oversight; articulation of operational risk appetite and tolerance statements; and risk disclosures.

Pillar 1 Operational Risk Capital Requirements

The proposals being consulted on involve replacing the current BIA and TSA approaches with a revised Standardised Approach (SA). Gross income is replaced with a new Business Indicator (BI) and the alphas and betas would be replaced a newly calibrated regulatory coefficient ranging from 10-30% on a tiered basis depending on level of the BI.

The BI comprises the three components of a bank's income statement: the "interest component", the "services component", and the "financial component". The BI includes items that are an indicator of operational risk that are omitted or netted from the gross income definition, e.g. operating expense. In addition, the BI uses the absolute values of its components, e.g. for interest income in the "interest component".

The BCBS has not identified a timeframe for the implementation of the revised SA and provides that it "...intends to publish the final standard within an appropriate timeframe and provide sufficient time for implementation"

Impact

Banks have invested heavily in their Operational Risk capability in recent years with many continuing to do so. The papers released last week indicate that the job is not yet done for such enhancement programmes. The proposals for the revised SA and recommendations for continued efforts on implementing the Principles of Sound Management of Operational Risk are likely to prompt organisations to reconsider the nature of their operational risk framework as well as their approach for operational risk regulatory capital calculation and the associated business case.

We welcome the BCBS' steps to develop a revised formulaic approach to quantify pillar 1 operational risk minimum BIA/TSA capital requirements which seeks to address cyclic and sensitivity limitations of the current formulae. We also agree with the use of internal operational risk banking losses as the basis on which the new formula has been developed. It must be noted that amendments will need to be made to the CRR for these proposals to take effect in the EU.

Pillar 1 operational risk capital requirements are expected to increase for many firms under these proposals. This will have a greater impact on firms whose total Pillar 1 capital requirements are currently dominated by operational risk (e.g. some categories of investment firms).

This has a number of implications:

  • The differential between regulatory and internal assessments of operational risk capital for BIA/TSA firms is likely to reduce resulting in lower Pillar 2A capital add-ons. 
  • Firms need to undertake a review of their solvency ratios and associated capital ratio targets and limits given that a greater proportion of total capital requirements will be comprised of Pillar 1 which are 'binding' constraints as opposed to 'guidance'. Also, Pillar 1 capital requirements are disclosed to the market as part of Pillar 3 disclosures. 
  • Firms may also experience an uplift in their CRD-IV buffer requirements since these are calibrated to total Pillar 1 RWAs.
  • In the UK, there would be no impact from a quality of capital perspective since both Pillar 1 and Pillar 2A capital requirements are expected to be satisfied through provision of Tier 1 and Tier 2 capital in the same proportion (i.e. minimum 56% in Common Equity Tier 1, maximum 44% in Additional Tier 1 and maximum 25% in Tier 2) 
  • However, firms operating in jurisdictions where the quality of capital for Pillar 2A capital requirements is not specified will be impacted by the potential increase in Pillar 1 capital requirements. 
  • Finally, firms may need to review and recalibrate their risk appetite frameworks to reflect the above changes

However, as with all formulaic approaches, the true reflection of an institution's OR profile is limited. We would expect the BCBS and adopting UK regulators to develop mechanisms whereby institutions are encouraged to develop and / or maintain risk sensitive models (either under Pillar 2 for those adopting the revised Standardised approach or under Pillar 1 for AMA firms).

Read the BCBS papers here:
Review of the Principles for the Sound Management of Operational Risk
Operational risk - Revisions to the simpler approaches - consultative document

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