What are the Basel II Operational Risk Requirements?

"Basel II" has been in the news an awful lot theseadvanced approach no longer meets the qualifying
past 18 month or so. Unlike Basel I the new standardcriteria for this approach, it may require the bank to
introduces a capital charge based on operational risk.go back to a simpler approach for some or all of its
The words Operational risk themselves immediatelyoperations, until it meets the conditions specified by
raise a whole bunch of questions; What is "Basel II"?the supervisor for returning to a more advanced
What is operational risk? How is the charge going toapproach.A bank will be permitted to use the Basic
be calculated? What are the operational riskIndicator or Standardized Approach for some parts
standards that banks will have to comply with?Baselof its operations and an AMA for others provided
II or to use is full name "International Convergencecertain minimum criteria are met. The conditions under
of Capital Measurement and Capital Standards"which this is permitted are;-All operational risks of the
defines operational risk as "the risk of loss resultingbank's global, consolidated operations must be
from inadequate or failed internal processes, peoplecaptured- All of the bank's operations that are
and systems or from external events". This definitioncovered by the Advanced Measurement Approaches
explicitly includes legal risk but excludes strategic andmust meet the qualitative criteria for using an AMA,
reputational risk.In terms of the Basel II Accord therewhile those parts of its operations that are using one
are three methods for calculating the capital chargesof the simpler approaches meet the qualifying criteria
for operational risk. The methods provide a range offor that approach-At implementation of an AMA, a
increasing sophistication and risk sensitivity. The threemajor part of the bank's operational risks must be
approaches are:-Basic Indicator Approach (BIA) -captured by the AMA-The bank must provide its
which requires banks to hold capital for operationalsupervisor with a plan specifying its intended
risk equal to the average over the previous threetimetable for implementing the AMA across all its
years of a fixed percentage of positive annual grossoperationsThe Basel Committee expects that such
income.-Standardized Approach - which uses grossapprovals will only be granted on an exceptional basis
income across eight business lines as a stand-in forand limited to circumstances where a bank is
the level of business operations and therefore theprevented from meeting these conditions because of
probable size of operational risk exposure within eachimplementation decisions of supervisors of the bank's
business line.-Advanced Measurement Approachessubsidiary operations in other (foreign)
(AMA) - this requires a bank to calculate itsjurisdictions.Despite the relative brevity of the
regulatory capital requirement as the sum ofOperational Risk section the Accord, the source
expected loss and unexpected loss. This is a highlymaterial for risk mitigation is wide and deep indeed.
complicated process and still remains the subject ofThe following is a brief list of some of the current
much controversy.The Basel Committee hasBasel guidelines dealing with various aspects of
encouraged banks to move along the range ofoperational risk.-"Sound Practices for the Management
available approaches as they develop moreand Supervision of Operational Risk"-"A framework
sophisticated operational risk measurement systemsfor Internal Control Systems in Banking
and practices.Internationally active banks, as well asOrganizations"-"Internal Audits in Banks and the
banks who have significant operational risk exposuresSupervisors Relationship with Auditors"-"The
(such as specialized processing banks) are expectedcompliance function in banks"-"Consolidated KYC Risk
to use an approach that is more sophisticated thanManagement"-"Risk management principles for
the Basic Indicator Approach and which fits the riskelectronic banking"-"Management and Supervision of
profile of the institution.A bank will not be allowed toCross-Border Electronic Banking Activities".Stanley
revert to a simpler approach once it has beenEpstein is a Principal Associate and Director of Citadel
approved for a more advanced approach withoutAdvantage Ltd., a consultancy dealing in bank
supervisory approval. However, if a national bankoperations and specializing in Operations Risk and
supervisor determines that a bank using a morePayment Systems.