Current practices and guidelines for classifying credit risk boundary events : a South African approach
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The financial crisis turmoil has exposed notable weakness in the risk management processes of the financial services industry. It has also led to a critical look at the scope of the various risk types as well as the classification of loss events. More importantly, the effects that incorrect risk classification might have on capital requirements are now also examined and taken into account. Boundary events between credit risk and operational risk continue to be a significant source of concern for regulators and the industry in general. The Basel Committee on Banking Supervision (BCBS) requires that boundary events should be treated as credit risk for the purposes of calculating minimum regulatory capital under the Basel II Framework. Such losses will, therefore, not be subject to any operational risk capital charges. However, for the purposes of internal operational risk management, banks are required to identify all material operational risk losses. Boundary events should be flagged separately within a bank’s internal operational risk database. The Basel II Framework does not provide any further guidelines as to what constitutes boundary events and, therefore, consistent guiding principles that banks can follow for accurately classifying and subsequently flagging such events do not exist. The potential exists that actual boundary events might be classified as purely credit risk, and correctly be included in the credit risk capital charge, but not be flagged separately within the bank’s internal operational risk database. Alternatively, boundary events might be classified as operational risk and, therefore, be subject to the operational risk capital charge, instead of the credit risk capital charge. The former instance might give rise to an operational risk manager not being completely informed of the operational risks that the business is facing. The emphasis should always be on the management of risks and for this reason it is important that a financial institution indicates and flags all boundary events in their operational risk systems. To remedy this lack of guidance on the boundary event issue, guidelines are provided that banks can utilise within their risk classification processes. The approach utilised is to consider mechanisms and tools for classification, guidance from the Operational Risk Data Exchange (ORX) and the BCBS, as well as the International Accounting Standards Board (IASB). By compiling and submitting questionnaires to five South African banks, an investigation is conducted in order to obtain a view of the current mechanisms, tools and approaches that South African Advanced Measurement Approach (AMA) banks currently utilise within their classification processes. The effectiveness of boundary event classification is assessed by analysing the percentage of losses classified as boundary. In addition, the degree of uniformity or disparity in the classification of typical boundary event scenarios is considered. This analysis is performed by providing respondents with a total of 16 typical boundary event risk descriptions, and requesting the respondents to classify each of the losses in the scenarios as credit risk, operational risk or boundary event type.