Final Standardised Measurement Approach for Operational Risk May not Increase Capital

The final version of the standardised measurement approach ("SMA") for calculating operational risk capital, expected to be released next month by the Basel Committee on Banking Supervision, may not lead to an increase in capital, a consultant said. This is despite banks' initial concerns that the SMA is a back-door approach that will require banks to hold more capital for operational risk. 

The Basel Committee issued a consultation paper in October 2014, which proposed a revision to the standardised approach for operational risk and simultaneously reviewed the costs and benefits of the framework's advanced measurement approaches ("AMA") for operational risk. The result was the standardised measurement approach, which provides a single non-model-based method for the estimation of operational risk capital outlined in a consultation paper in March 2016.

Basel Aims for a Common Approach

Operational risk is a fairly new discipline introduced by the Basel Committee 10 years ago as part of Basel II. The four approaches introduced as part of Basel II for computing operational risk capital are the basic indicator approach, the standardised approach, alternative standardised approach and advanced standardised approach.

At that time the Basel Committee allowed a wide range of different approaches for calculating capital, but it now wants banks to use only a common approach by introducing SMA, said Simon Topping, head of regulatory practice at KPMG China.

For a smaller number of banks, particularly the global banks and the larger banks from Australia, Japan and China, which have been using the advanced measurement approach, SMA is a step back in sophistication, but for most banks, SMA represents a step forward which implies adding sophistication to the internal approaches they have been using, Topping said.

Small and medium-sized banks, in particular, would face two challenges when using the SMA, Topping said. They need to collect data for the more complex capital calculation, and they will face pressure from regulators to focus more on implementing the Principles for Sound Management of Operational Risk as outlined in a paper in 2011. 

"The smaller banks don’t always have a good understanding of what operational risk is and how they can manage it to limit their losses [from operational risk]. Part of it is to keep the pressure on banks and to keep them on their toes. Operational risk is an important risk they have to consider. Certainly for the big banks, it is a big focus," he said.

SMA may not Lead to Higher Capital

There were concerns that the SMA was a back-door way to increase the capital banks have to hold but that may not be the case now. The likely change in calibration in the final version of the SMA may imply that banks, in general, will not need to hold a higher level of capital for operational risk, Topping said. 

"When SMA was first proposed, banks were suggesting it may lead to a significant increase in capital. The feeling now is it will not result in a big change in capital. It seems that this approach is more neutral," he said.

Criticism of SMA

Even so the proposed SMA has had its fair share of criticism. Rajit Punshi, founder of ORP2b, a marketplace for risk, compliance and transformation in Singapore, said the SMA proposal represents a step backwards because the Basel Committee failed to link the measurement methodology to specific risk measurement criteria. It also fails to clearly articulate the incentive mechanism for banks to make the necessary investments in risk management to manage operational risk. 

"The progressive reduction in capital in the three-stage continuum measurement approaches, each of which was linked to specific risk management criteria, was the chief incentive for banks to invest in people, technology and processes to manage operational risks. The industry is at a crucial crossroad with very strong push back on the proposal and the direction of the SMA," he said. 

A lower capital charge is considered an incentive for banks to put in investment to manage operational risk given that banks do not earn revenue by taking operational risk. Punshi said the increasing risk in the operating environment now calls for the right incentive structure, without which banks may adopt a reactive approach which will do more harm than good.

"That is certainly not the culture regulators and banks want to see," he said.

Punshi said the SMA proposal seems to assume that banks will do what it takes to ensure risks are identified, taken and managed in a manner that is commensurate with their size, complexity of business and risk profile. But past experience has proved this assumption wrong. He said there were concerns that the industry would risk reverting to a more reactive approach driven by regulatory pressure rather than by an incentive to bring about the right behavioural changes and to embed a sound risk culture at banks. 

Double Jeopardy

Another concern about the SMA is what Topping termed "double jeopardy". When fines were imposed on banks for breaches, they had to factor the fines into the capital calculation as part of internal loss data, in addition to paying the fines, he said.

Banks have been keeping records of money loss due to operational risk and the major source of operational risk is largely the regulatory fines. Other types of operational risk include compensations banks have to pay as result of regulatory breaches, mis-selling or system breakdown. 

Will holding capital reduce operational risk?

Banks have also questioned whether holding capital will necessarily reduce operational risk. Topping said the operational risk regime was ultimately about two things: both meeting the requirement to hold capital and following the Principles for Sound Management of Operational Risk.

Patricia Lee is a South-East Asia editor at Thomson Reuters Regulatory Intelligence in Singapore. She also has responsibility for covering wider G20 regulatory policy initiatives as they affect Asia.