Operational risk managers at large banks are generally cool-headed and used to keeping their cool under fire. Since March of this year, however, they have become exceptionally excitable.
The reason for this is the proposal of the Basel Committee on Banking Supervision to introduce a new standardized measurement approach (SMA) for operational risk capital. If introduced, SMA will replace all existing approaches to operational venture capital, including the simpler standardized approaches and the advanced measurement approach (AMA) used by more sophisticated banks. A consultation on the plans ended on June 3, and despite strong industry opposition, the committee is likely to move forward.
Few issues have sparked as much passion in the operational risk community as the proposed AMA removal, which allows banks to use their own internal models to calculate operational risk capital. But it was always clear that sooner or later things would change.
WADA’s inclusion in Basel II came at a time when the discipline of operational risk modeling was in its infancy. Rather than taking a single approach to modeling, it is presented as the Basel Committee’s way of “letting a thousand flowers bloom”, allowing more advanced banks to experiment with different methods.
The floral motif is borrowed from former Chinese leader Mao Zedong, who used it in the 1950s to encourage constructive dissent in Communist China. During its consultation, the Basel Committee said its expectations of WADA “have not materialized”. His experience is reminiscent of that of Mao, who launched a brutal crackdown after receiving more criticism than he likely expected.
The most important debate is not about the replacement of WADA, but about its proposed successor, the ADM. Operational risk practitioners have called the new accusation “madness” and “disaster”, with some writing that it “could very well become a source of operational risk in itself.”
Currently, AMA allows banks to take four categories of input – internal loss data, external loss data, scenario analysis, business environment and internal control factors – and incorporate them into their capital models in proportion. they deem appropriate. The SMA is based on a measure called the “activity indicator” – an indicator of the size of the bank based on gross income – and only one of these four categories, namely internal loss data.
Practitioners say this laser-like focus on historical losses makes SMA overly retrospective and insensitive to current risk levels. This means that some banks would be unfairly penalized for past operational risk mistakes, including those in lines of business they have since closed or sold. Conversely, companies that had suffered lower historical losses would benefit from a lighter capital charge, even if they now expand aggressively into riskier areas.
Some argue that the focus on internal loss data could even lead banks to misreport losses. By characterizing an operational risk loss as a credit risk loss, for example, banks might be able to reduce their historical losses and therefore minimize their capital requirement under the SMA.
In its broader overhaul of bank capital rules, the Basel Committee insisted on the fact that it was pursuing the three objectives of risk sensitivity, simplicity and comparability. But the reality is that they cannot all be achieved at the same time. Increasing risk sensitivity tends to reduce simplicity and comparability. The increase in simplicity and comparability – as the supervisors did in this case – tends to undermine risk sensitivity.
In truth, there is a balance required between the three objectives. Industry critics suggest that when it comes to ADM, the committee has misbalanced that balance.