How does Basel II define "operational risk"

The Measurement of Operational Risks According to Basel II - A Critical Analysis

TABLE OF CONTENTS

List of abbreviations

Symbol directory

1 Introduction

2 Definition of operational risks

3 Measurement of operational risks according to Basel II
3.1 Preliminary remarks
3.2 Basic indicator approach
3.3 Standardized Approach
3.4 Advanced approaches
3.4.1 Internal design approach
3.4.2 Loss Distribution Approach
3.4.3 Scorecard approaches
3.5 Critical assessment of the approaches

4 Possibility of further development
4.1 Requirements for an optimal measurement process
4.2 Comparison with the approaches according to Basel II

5 Conclusion

bibliography

LIST OF ABBREVIATIONS

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1 Introduction

By some more or less sensational claims, such as at the Barings-Bank or the trading house Sumitomo[1], operational risk has come into focus in the banking world. The current equity capital agreement of 1988 does not yet contain a separate capital adequacy requirement for operational risks. Rather, it is assumed that these risks are implicitly backed with sufficient equity through the obligation to back credit risks[2]. Operational risks were first explicitly mentioned by the Basel Committee in a publication in September 1998[3]. The first consultation paper followed in June 1999, which now also called for operational risks to be backed with equity capital[4]. These proposals were then put into concrete terms in the second consultation paper in January 2001.

An important question arising from the recommendations of the Basel Committee is to what extent the proposed approaches for measuring operational risks are suitable for determining the risk potential and the resulting capital adequacy requirement. I will pursue this question in my work by first addressing the definition of the term operational risk, and then in the following chapter I will describe in more detail the measurement methods proposed by the Basel Committee to quantify these risks. I would like to close the chapter with a critical analysis of the individual measurement methods.

With reference to the criticism of the individual measurement approaches, in the following chapter I will pursue the question of what requirements must be placed on an optimal method for measuring operational risks. I will then compare these results with the approaches presented by the Basel Committee. I would like to conclude my work with a brief summary.

2 Definition of operational risks

Operational risks are not new to banking practice. In the past, however, they were not seen as a separate discipline of risk management[5]but were integrated into the existing risk management systems if necessary[6]. The operational risks came into the focus of the credit institutions and supervisory authorities only after a few spectacular banking crises in the 1990s[7]. Not least because of these incidents, it has been recognized that they must be seen as a separate risk category and must be treated as such[8].

A generally recognized definition has not yet come about in the short period of the discussion, so that in the following a meaningful definition for this work will be developed from the current state of discussion.

One way of defining the term operational risk is to distinguish it from market and credit risks. In this definition approach, operational risk is defined as the residual value of these risks. The advantage of this approach is that it covers all risk categories[9]. However, this negative definition has the disadvantage that the operational risks are directly dependent on the credit and market risks and their interpretation. In addition, the multitude of individual risks within operational risks and their significance for the individual credit institution are not clear.

These disadvantages can be eliminated by an exact positive definition of the term. With this approach, dependencies on other risks are excluded. An attempt is made to describe the operational risks in an abstract way on the basis of properties[10]. The path to a current (positive) definition began with the first consultation paper. For the first time, the BCBS spoke of risks other than market and credit risks[11] ". In the following publications and the subsequent discussions, this negative definition developed into the current definition of the Basel Committee. Operational risk is defined here as the risk of losses resulting from the inappropriateness or failure of internal processes, people and systems or from external events[12], Are defined. This also includes legal risks, but excludes strategy and reputational risks[13]. The discussion in the literature shows that this is not yet a final definition. Some problems and loopholes still need to be fixed beforehand[14]. Nevertheless, I would like to refer to the definition of the Basel Committee in the following chapters, as this seems to me to be the most suitable for my work.

3 Measurement of operational risks according to Basel II

3.1 Preliminary remarks

In today's equity capital agreement, equity requirements were only set with regard to credit risks. It was assumed that the specified equity ratio of 8% also covered the other risks. In 1996, market risks were removed and given their own equity ratio. Thanks to the improved measurement methods for market and credit risks, these risks can be analyzed and assessed more precisely. The Basel Committee therefore proposes that operational risks should also be backed with a separate equity ratio[15]. Various approaches to quantifying operational risks are proposed to determine the capital requirement. I would like to present these in the following.

3.2 Basic indicator approach

The basic indicator approach provides that the minimum capital requirement (KB) consists of a percentage alpha (α) multiplied by a specific indicator (EI) according to the following formula[16] is calculated:

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In the opinion of the Basel Committee, the indicator used temporarily - until a generally recognized indicator has been found - is the gross income of the respective credit institution[17]. The percentage α, on the other hand, is currently set at 17 to 20 percent by the Basel Committee. This value is based on the endeavor to set the proportion of operational risks in the minimum capital requirement at twelve percent[18].

The application of the basic indicator approach should be made possible for all banks, so that no special admission criteria are required here. However, it is expected that credit institutions using this approach will proceed in accordance with the Basel recommendations for the proper management of operational risks[19].

3.3 Standardized Approach

The standardized approach determines the capital requirements in a more differentiated manner. Here, the entire business activities of the bank are currently divided into eight business areas[20]. In each of the business areas (i) - analogous to the basic indicator approach - an indicator (EIi) is multiplied by a certain percentage beta (βi). The sum of the capital requirements determined in this way per business area then results in the total capital requirement (KSt) for operational risks of the bank[21]:

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The beta factors for each business area are in turn determined by the Basel Committee. Here, too, they should be determined in such a way that operational risks account for twelve percent of the total capital backing. The determination of the betas is based on the results of the QIS. However, this approach still leads to considerable problems, as only 30 banks were able to provide information on the level of the individual beta factors within the business areas. In this approach, the gross income of the respective business area is assumed as an indicator[22].

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[1] See KING (2001), pp. 24-34

[2] See BASEL COMMITEE (2001a), p. 1

[3] See BASEL COMMITEE (1998), p. 1

[4] See BASEL COMMITTEE (1999), p. 6

[5] See FISCHER (2001), p. 662

[6] See RÖCKLE (2002), p. 16

[7] See WAGNER (2002), p. 74

[8] See JOVIC / PIAZ (2001), p. 923

[9] See PETER / VOGT / KRAß (2002), p. 657

[10] See BEECK / KAISER (2000), p. 637

[11] See BASEL COMMITTEE (1999), p. 6

[12] See BASEL COMMITTEE (2002), p. 2

[13] See BASLER AUSSCHUSS (2001), p. 103

[14] See HOSSFELD / KRÄMER (2001), p. 13

[15] See BOOS / SCHULTE-MATTLER (2001), p. 549

and BASEL COMMITEE (2001), p. 1

[16] modified from KAISER (2001), p. 142

[17] Gross income = interest result + non-interest income see also BASLER AUSSCHUSS (2001), p. 104

[18] See BASEL COMMITEE (2001b), p. 26

[19] See BASEL COMMITEE (2001b), p. 11

[20] See BASEL COMMITEE (2001b), pp. 6 - 7

[21] modified from KAISER (2001), p. 142

[22] See BASEL COMMITEE (2001b), pp. 28-29

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