The Reserve Bank of India has today (June 26, 2023) issued the Master Direction on Minimum Capital Requirements for Operational Risk. The Central Bank said that the circular is issued after appropriately considering the feedback received from stakeholders.
According to the Directions require all specified Commercial Banks (excluding Local Area Banks, Payments Banks, Regional Rural Banks, and Small Finance Banks) to hold sufficient regulatory capital against their operational risk exposures.
“Operational risk means the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk,” as per RBI master directions.
The circular said that all existing approaches viz. The basic Indicator Approach (BIA), The Standardised Approach (TSA)/ Alternative Standardised Approach (ASA), and Advanced Measurement Approach (AMA) for measuring minimum operational risk capital (ORC) requirements shall be replaced by the new Standardised Approach
(hereafter referred to as the ‘Basel III Standardised Approach’) with coming into effect of these Directions.
Basel III Standardised Approach (Basel III SA) calculation methodology is based on the (i) Business Indicator (BI), (ii) the Business Indicator Component (BIC), and (iii) the Internal Loss Multiplier (ILM).
The BI is a financial-statement-based proxy for operational risk while the BIC is calculated by multiplying the BI by a set of marginal coefficients (αi). The ILM is a scaling factor that is based on a bank’s average historical losses and the BIC.
Business Indicator (BI):
The BI shall be the summation of the following three constituents, i.e. BI = ILDC+SC+FC + Dividend Income
Where,
ILDC is the Interest, Lease, and Dividend component, SC is the Services Component, and FC is the Financial Component.
Computation of ILDC, SC, and FC:
The ILDC, SC, and FC shall be computed as per the formula below, where a ( – )bar below a term indicates that it is calculated as the average over three years (t, t-1, and t-2),
ILDC= Min [(Abs (interest income-Interest expense); 2.25% × (Interest Earning Assets)]
Business Indicator (BI):
SC= Max [(other operating income-other operating expenses)+ Max (fee income; fee expenses)]
FC= {(Abs Net P&L trading book) + (Abs Net P&L Banking book)}
Where,
Max=Maximum,
Min=Minimum, and
Abs= Absolute value of sub-components irrespective of their signs (+ or -)
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