Risk–based capital measures for operational risk management
Basel II provides banks with four options that may be used to calculate regulatory capital for operational risk. Each of these options (except the most basic approach) requires an underlying risk measurement and management system, with increasing complexity and more refined capital calculations under the more advanced approaches. Approaches available are BIA, TSA, ASA and AMA. The most advanced and complex option under Basel II is the AMA. This approach allows a bank to calculate its regulatory and economic capital requirements (using internal models) based on internal risk variables and profiles, rather than exposure proxies like gross income. This is the only risk–sensitive approach allowed by and described in Basel II. Accompanying internal models, complex and sophisticated measurement instruments, risk management processes and frameworks, as well as a robust governance structure need to be implemented. This study focuses on the practical design and implementation of an AMA capital model. This includes a beginning–to–end solution for capital modelling and covers all elements of data analysis, capital calculation and capital allocation. The proposed capital model is completely risk–based, leading to risk–sensitive capital calculations and allocations for all business lines in a bank. The model was constructed to comply fully with all Basel II requirements and standards. The proposed model was subsequently applied to one South African bank’s operational risk data, i.e. risk scenario and internal loss data of the bank were used as inputs into the proposed capital model. Regulatory capital requirements were calculated for all business lines in the bank and for the bank as a whole on a group level. Total capital requirements were also allocated to all business lines in the bank. For regulatory capital purposes, this equated to the stand–alone capital requirement of each business line. Calculations excluded the modelling and incorporation of insurance, expected loss offsets and correlation. These capital mitigation techniques were, however, proposed as part of the comprehensive capital model. AMA based capital calculations for the bank’s business lines resulted in significant capital movements compared to TSA capital requirements for the same calculation periods. The retail banking business line was allocated less capital compared to corresponding TSA estimates. This is mainly attributable to lower levels of tail risk exposure given high income levels (which are the bases for TSA capital calculations). AMA–based capital for the investment banking business line was higher than corresponding TSA estimates, due to high levels of extreme risk exposure relative to income generated. Employing capital modelling results in operational risk management and performance measurement was discussed and proposals made. This included the use of capital requirements (modelling results) in day–to–day operational risk management and in strategic decision making processes and strategic risk management. Proposals were also made on how to use modelling results and capital allocations in performance measurement. It was proposed that operational risk capital costs should be included in risk–adjusted performance measures, which can in turn be linked to remuneration principles and processes. Ultimately this would incentivise sound operational risk management practices and also satisfy the Basel II use test requirements with regards to model outputs, i.e. model outputs are actively used in risk management and performance measurement.