Introduction

Ascertaining the gravity of operational risk as opposed to other types is handicapped by the relative difficulty of defining and quantifying it. Fortunately, enshrined within Basel II is an attempt to provide guidance in this direction. The Advanced Measurement Approach to gauge losses arising from operational risk and allocating sufficient capital is the most analytical and flexible method. With standards of measurement still in their infancy, a wide range of practices may prevail among banks using the AMA approach owing to the latitude it accords.

Key findings

• Treatment of Internal Loss Data – Regulators are yet to converge upon consistent standards of loss measurement and reporting, which can have a significant impact on the capital buffers reserved for operational risk. Under this situation, one may not necessarily expect consistent practices across different banks.

• Treatment of External Loss Data – As severe operational risk losses tend to be quite infrequent, paucity of internal loss data can inhibit accurate modelling of correlations and distributions among risk categories. In this situation, banks can take recourse in loss data from third parties to fill the gaps in the database.

• Scenario Analysis – The exact manner in which banks implement scenario analysis is relieved of excessive regulatory supervision, which admits a diversity of practices. However, allowing such decisions to rest on ‘expert judgement’ without explicating further credentials can lead to wide differences in opinion.

• Insurance as a Risk Mitigant – Neither the European, nor US banks interviewed for this study are yet to benefit from this clause. They are yet to seek regulatory approval for mitigation through insurance, and the respondents did not express any plans of doing so in the near future.

Conclusion

With the banking sector seeking to reverse its highly tarnished reputation in the wake of fraudulent activity and questionable accounting practices, It has become clear of late that operational risk is receiving greater attention from regulators and industry practitioners alike. Though initial efforts to quantify operational risk through the AMA approach are converging practices, there is still some way to go.

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Tagged with: 2010, operational risk, risk management, Risk Research Report