Basic indicator approach

Abstract: One defines operational risk as the loss resulting from inadequate or failed internal processes, people and systems or from external events (see Basel Committee on Banking Supervision (2004)). Operational risk quantification has become increasingly important for financial institutions since the New Basel Capital Accord first consultative paper. According to the New Basel Capital Accord (see Basel Committee on Banking Supervision (2004)), the capital charge for operational risk can be calculated using three alternative methods: the basic indicator approach (BIA), the standardized approach (TSA) and the advanced measurement approach (AMA). The first two methods are a function of gross income, while the advanced method is based on internal loss data, external loss data (see Baud et al (2002a,b) and Frachot and Roncalli (2002)), scenario analysis, business environment and internal control factors.1 A specific feature of AMA models, compared to BIA and TSA, is the potential recognition of insurance as a percentage of the operational risk

Abstract: Its main objective is to succinctly present a description of the models considered the most relevant in the wide range of possibilities for the quantification of operational risk. The article is structured in the following form: first it briefly contextualizes operational risk in the frame of financial risks in general, and in the frame of the current regulations world-wide. In the following section the basic models (Basic Indicator Approach, Indicator Standard Approach and Alternative Standard Approach) proposed for the quantification of the operational risk are described. Then it describes the minimum general, qualitative and quantitative requirements, in the light of the New Basilea Agreement, that should be met by the advanced measurement approach that financial organizations try to submit to approval of the regulating institutions. Later, it shows some recent specific local and world-wide studies and finally some conclusions are obtained.

Abstract: Pillar I of the Basel II framework developed by the Basel Committee on Banking Supervision (BCBS) deals with the calculation of minimum capital requirements for operational, credit and market risk exposures in banks. The BCBS proposes three increasingly sophisticated approaches to calculating operational risk capital. In order of increasing sophistication, these are the Basic Indicator Approach (BIA), the Standardised Approach (TSA) and the Advanced Measurement Approach (AMA). The operational risk capital charge under the BIA and the TSA is dependent on a bank's GI level and distribution. Banks that wish to use the TSA or the AMA are required to fulfil a set of qualifying criteria, resulting in compliance costs for the bank. The benefit would be a lower capital charge. Our paper focuses on two distinct themes. In the first theme, we show that, based on a hypothetical example, banks with a particular GI distribution will not benefit from gradating from the BIA to the TSA. In the second theme, we examine if the BIA and the TSA would have captured the operational risk build-up in the National Australia Bank's between 2001 and 2004. These years relate to the period in which a cohort of traders engaged in fraudulent activities that resulted in foreign exchange trading losses of $360m. We find that while the TSA would have indicated such a build-up, the BIA would have pointed towards a decline in the bank's operational risk exposure and thus capital. We are facing mixed results. While, dependent on a bank's distribution of GI, the incentive for banks to gradate from the BIA to the TSA might be marginal or non-existent, the approach would have performed better as a predictor for the build up of operational risk in the National Australia Bank.