The Institute of Operational Risk’s response to Basel III: Finalising post-crisis reforms

The Basel Committee published on Thursday 7th December the final version of its Standardised Approach (SA) methodology which will replace the approaches set out in Basel II (i.e. the simpler approaches and AMA) from 1st January 2022.

Basel III has discretionary transitional arrangements until 2027 if there is a major impact on the firm’s Risk Weighted Assets (RWA), set at 25% of the firm’s RWAs before the application of the floor.  In most cases, this should not impact the implementation date of 2022 for the revised operational risk framework as it is a standardised approach.

The Institute is pleased that some of its recommendations have been reflected in this final version, e.g.:

  1. Insurance recoveries are now reflected in net losses;
  2. The impacts of losses that are paid out over many years, such as PPI, are now to be included within the calculation in the year when posted to the accounts, removing a significant “cliff effect”; and
  3. Dropping the differentiation of capital required for different sizes of losses, again removes another potential “cliff effect”.

The Institute of Operational Risk also welcomes:

  • The requirement for firms to provide greater disclosure of their losses putting Operational Risk on an equal footing with Credit Risk. (This was also a recent recommendation of the Institute’s in its response to a PRA consultation paper.);
  • Firms with low levels of loss data being rewarded with a reduction in their Operational Risk capital requirements as a result of the Internal Loss Multiplier (ILM) being less than “1”; and
  • What appears to be the sensible symmetrical treatment of losses attributable to acquisitions and disposals i.e. losses should be reflected within the SA calculation of just the acquirer.

The Institute notes, however, that:

  • The incorporation of local regulatory discretion to set the ILM to “1” would have the effect of turning Basel III’s operational risk framework into a tax, which gets progressively larger with the size of the organisation.  As a result, the Institute will concentrate its energies to get feedback from members on how their respective risk departments are approaching the operational risk element, and ensure that any potential negative incentives to improve the management of operational risk, by using this discretion, are clearly understood by national supervisors. 
  • The lengthy implementation period to 2022, coupled with the discretion of national supervisors to set coefficients to 6%, 9% and 12%, and ILM to 1 during that interim period, also concerns the Institute, and see it as a recipe to widen the disparity of approaches across jurisdictions, rather than the stated aims of the SA of achieving greater international comparability.
  • Using the date of accounting “…for the probable estimated loss in the P&L” to determine the period a loss is included within the ILM calculation may be vulnerable to “gaming”.  The Institute commits to working with its members to ensure sound practices guides within our toolkit, help our operational risk practitioners put in the necessary systems and controls required for the accurate capture of loss data around the accounting date, and support them as they develop their processes to demonstrate the accuracy of their loss data to their Supervisors.

Finally, the Institute also notes that the SMA is essentially backward looking i.e. the Business Indicator is based on the last three years of financial performance, and the ILM utilises the last ten years of loss data.

This is not necessarily a bad thing.  Operational risk management is more than just operational risk capital.  By closing the chapter on how Pillar 1 capital is calculated allows practitioners to now focus on the real benefits of forward-looking risk management.

Hence we shall be encouraging our members to think, discuss and collaborate on what their firms will need from the discipline of operational risk to produce a realistic, forward-looking view that supports their strategic objectives and minimises their future losses.  It is logical that over time, this will re-focus operational risk practitioners as strategic operators within their firms, supporting the business in achieving its objectives by taking measured risks, safely.

It remains true that to manage and mitigate your risks, you first still need to be able to quantify and measure them.  Getting the fundamentals of this right will be far more useful to the management of operational risk than AMA ever was, because measurement of this risk type will no longer be equated with capital set at the very unrealistic 99.9% confidence interval, based on a paucity of data within AMA LDA models, and the sheer guess-work required around assumptions of frequency and severity within AMA scenario models.

One of the key benefits of the SMA will be the ability of operational risk practitioners to stop being handcuffed by the artificial segregation of risk types for capital purposes and embrace a truly enterprise view of risk modelling, such as the impact of sudden changes to business plans on costs, the potential cost of failure of change and infrastructure project implementations, and additions of new strategic ventures, and the impact of operational risks in terms of being drivers of other risk types such as liquidity and the creditworthiness of counterparties.

However, we also feel there still is a place for operational risk loss data models for stress testing purposes (required for Pillar 2b capital calculations), where studies have shown that there is a great comparability of output across different firm’s LDA models at the more sensible quantiles of a 1 in 20 year confidence interval

The Institute will work to support its members in developing different types of internal models that are better suited to explain the factors showing why large losses can only be a certain size (as required by scenario analysis for Pillar 2a Internal Capital Adequacy Assessment Process), and models that focus on informing management decisions. 

In conclusion, we are looking forward to the next chapter of the operational risk management story…and over time we also expect this will also have the added bonus of reducing Pillar 1 operational risk capital element in both through lower operating costs via the Business Indicator and fewer (but better mitigated) losses that will inform the Loss Components

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