| Ian Linnell | ||||||
One of the biggest talking points in the Basel document is the proposed charge for operational risk. This broad concept is usually defined as the risk of losses stemming from processes, systems, external events and human failure. That seems to cover just about every loss known to humanity, so it is no easy matter to measure – let alone manage – operational risk.
But perhaps surprisingly, a number of banks have already put into place methods for quantifying this risk and set aside capital to cover it. “Some banks are allocating an element of capital for operational risk,” says PricewaterhouseCoopers partner John Tattersall. “But their systems for measuring losses and anticipating amounts at risk tend not to be very robust. Devising a system for monitoring and measuring operational risk that is subject to external review will be quite a challenge.”
The proposals explain how the basic operational risk charge will work. It will take some measure of activity for each type of business – say, gross income for an investment banking business – and apply a so called beta factor to it, to decide how much operation risk that business involves. “The proposals recommend a 20% charge for operational risk,” says Fitch analyst Ian Linnell. “But it is at the regulators’ own discretion. The danger is that one regulator will impose a beta factor of 5% and another will charge 30%.”
In practice, regulators may use operational risk as a catch-all, adding a healthy dollop of operational capital charge if they feel their banking system is a little undercapitalized.
The puzzling thing about the operational risk charge is what the Basel Committee has said about the total level of capital in the banking system. The stated intention of the proposals is that the overall level of capital in the banking system should remain unchanged. How then can an operational risk charge of 20% not be an additional capital requirement?
The answer is that the committee expects other capital charges to fall under the new accord.
For example, it expects the foundation internal ratings based approach to credit risk to reduce banks’ risk weighted assets by an average of between 2% and 3%. By implication, the advanced version of the internal models approach should save banks significantly more.
But some observers can’t see many obvious savings in the internal models approach. “We think that if capital charges are applied as the proposal now stands – with the additional charges for things such as operational risk – it will create an increase in bank capital requirements,” says Emmanuelle Sebton, head of risk management at the International Swaps and Derivatives Association. “The way the charges are calibrated under the internal ratings based approach needs more work.”
As a rough rule of thumb, the internal-ratings based approach would give a 100% risk-weighting to a loan portfolio with an average rating of triple-B. But Standard&Poor’s analyst Tanya Azarchs guesses that most bank portfolios are closer to double-B. A bank with that kind of loan book would have to increase its regulatory capital if it adopted the internal models approach.
Oliver Page, a director at the Financial Services Authority, concedes that the numbers may need some tweaking. “It is possible that at the moment the relative capital requirements between the standard approach, the foundation approach and the advanced approach are not quite calibrated relative to each other,” he says.
But he also believes some observers have missed some of the capital reductions hidden in the fine print of the proposal. “Some people are concerned that the numbers add up to an increase in capital,” says Page. “They have noticed the operational risk charge. But I don’t think they have seen where the savings are. In particular, we have extended recognition of credit risk mitigation; we have provided greater ability to hedge credit-risk through collateral guarantees and credit derivatives.”
In the coming months, especially after the end of the consultation period ending on May 31, the calculations will be repeatedly fine-tuned. The committee is particularly keen to make sure there is a strong incentive for banks to apply for the internal ratings based approach.
Some other parts of the proposal are still only half-written. It is not only the calculations on operational risk that remain vague. The committee has yet to release any detail on the treatment of project finance and equity portfolios. The treatment of interest-rate risk is not yet clear. And retail banking has so far been largely untouched by the proposals.
The regulators who sit on the various sub-committees, working groups and task forces of the Basel Committee have plenty of work left to do.
