How operational risk is measured?

Basel Committee on banking supervision has adopted a common industry definition of operational risk. Operational risk is defined as the risk of direct or indirect loss resulting from breakdowns in internal procedures, people, system and external events. Examples of operational risk are frauds, system failure, error in financial transactions, failure to discharge demand of contractual obligations due to insufficient funds etc. The revised BASEL II framework offers the following three approaches for estimating capital charges for operational risk:

1) The Basic Indicator Approach (BIA): The Basic Indicator Approach is an approach to calculate operational risk capital under the Basel II Accord. Based on the original Basel Accord, banks using the basic indicator approach must hold capital for operational risk equal to the average over the previous three years of a fixed percentage of positive annual gross income.  In case of annual gross income is negative or zero for any year that should be excluded from both the numerator and denominator while calculating the average. This approach sets a charge for operational risk as a fixed percentage (“alpha factor”) of a single indicator and uses the bank’s total gross income as a risk indicator for the bank’s operational risk exposure. The fixed percentage ‘alpha’ is typically 15 percent of annual gross income.

2) The Standardised Approach (SA): The standardised approach is a set of operational risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions. Basel II requires all banking institutions to set aside capital for operational risk into eight standard business lines. The capital charge for each business line is calculated by multiplying gross income of that business line by a factor (denoted beta) assigned to that business line.  Corporate finance (18%), trading & sales (18%), retail banking (12%), commercial banking (15%), payment & settlement (18%), agency services (15%), asset management (12%), and retail brokerage (12%) are eight statndard business lines. The beta assigned to each business line shown  in the bracket.

3) Advanced Measurement Approach (AMA): The Advanced Measurement Approach is a sophisticated approach used under Basel II by banks and financial institution to use internally generated models to calculate operational risk capital requirement. The AMA leads to the suitable incentives to reduce exposure to operational risk. This approach allows the bank to use internally generated models to calculate their operational risk capital requirements. In India, at present the banks have been advised to adopt the BIA to estimate the capital charge for operational risk.

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