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Operational Risk & the Regulatory Environment. Simon Hills Director - Prudential Capital team. Operational Risk & the Regulatory Environment. What is Prudential Capital regulation for? enhancing stability of the financial system protecting depositors

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operational risk the regulatory environment

Operational Risk & the Regulatory Environment

Simon Hills

Director - Prudential Capital team

operational risk the regulatory environment2
Operational Risk & the Regulatory Environment

What is Prudential Capital regulation for?

  • enhancing stability of the financial system
  • protecting depositors
  • advancing financial institutions‘ risk management
  • ensuring level-playing field by further aligning regulatory practices

But:

  • capital is expensive
  • trade-off between stability and efficiencyof banking system
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Operational Risk & the Regulatory Environment

Basel I

  • Relatively crude risk weighting system
  • Inadequate incentives for risk mitigation (and some perverse incentives)
  • Some categories of risk not covered at all
  • Market developments not properly reflected –
    • new products
    • avoidance/mitigation techniques
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Operational Risk & the Regulatory Environment

Basel 2

  • More flexible, risk sensitive system
  • Overall capital broadly unchanged under standard approach, but with incentives for better risk management
  • Competitive equality
  • Emphasis on banks’ own internal control, management and risk assessment, with supervisory evaluation
  • Market discipline
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Operational Risk & the Regulatory Environment

Structure of new Accord: the three pillars

  • Pillar I – minimum capital requirement
  • Pillar II – supervisory review
  • Pillar III – market discipline
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Operational Risk & the Regulatory Environment
  • Replaces Basel 1 which requires banks to hold 8% of funds lent in capital
  • Capital required to cover credit, market and operational risk
  • Operational risk charge covers expected and unexpected losses – but not catastrophic loss
  • Must quantity operational risk – and assess the quality of Operational Risk management in order to ensure that banks that manage risk well see a reduction in regulatory capital
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Operational Risk & the Regulatory Environment

Operational risk

Risk of loss from inadequacy/failure of internal

processes/systems people or external events: includes legal risk but not strategic and reputation risk

  • “Basic indicator” and “standardised” approaches based on income (differentiated by business line in standardised approach)
  • “Advanced measurement approach” uses risk measure generated by bank’s internal operational risk measurement system
  • AMA permitted only where specified standards satisfied
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Operational Risk & the Regulatory Environment

Problems with Quantification

  • Inadequate or insufficient data to build a well populated database
  • Need to apply imprecise measures for frequency and impact
  • No quantifiable size of exposure amount due to impossibility of forecasting how different risk issues will combine to produce a major operational loss event
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Operational Risk & the Regulatory Environment

Problems with Quantification

  • Can’t know when portfolio of risks is complete
  • Context dependent – reduction in relevance of historic loss data
  • Not an exact science!
  • Main benefit – to prioritise management actions and assess Cost benefit of mitigation measures
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Operational Risk & the Regulatory Environment

The Basic Indicator Approach

  • Hold capital for operational risk equal to 15% of average annual gross income over the previous three years
  • Gross income is net interest income + net non-interest income + gross of provisions and before profits/losses from sale of securities in the banking book, extraordinary items and insurance income.
  • No specific qualitative requirements but banks using the approach are encouraged to comply with the requirements of the Sound Practices paper
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Operational Risk & the Regulatory Environment

The Standardised Approach

  • Under the Standardised approach the institution divides its activities into 8 business lines.
  • Each business line has a beta factor based on the perceived “riskiness” of each activity.
  • The capital charge for each business line will be found by multiplying the gross income by the beta factor.
  • The resulting figures will be added together to find the overall capital charge.
  • A qualitative assessment of the OR management framework will be carried out by Regulators before this approach can be used and certain governance standards must be met.
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Operational Risk & the Regulatory Environment

Business Lines and Beta Factors

  • Corporate Finance 18%
  • Trading and Sales 18%
  • Retail Banking 12%
  • Commercial Banking 15%
  • Payment and Settlement 18%
  • Agency Services 15%
  • Asset Management 12%
  • Retail Brokerage 12%
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Operational Risk & the Regulatory Environment

The Advanced Measurement Approaches

  • Under the AMA, the regulatory capital requirement will equal the risk measure generated by the bank’s internal operational risk management system using the quantitative and qualitative criteria for the AMA.
  • The methodology developed by the bank will need to be approached by the regulator before use.
  • Under the AMA the capital charge may be reduced by up to 20% to reorganise the mitigating effect of insurance.
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Operational Risk & the Regulatory Environment

Firms must track internal loss data and meet the following standards:

  • 5 year observation period (3 years initially).
  • Reviewed regularly to ensure consistency with current activities.
  • Mapped to the Basel loss categorisation.
  • Comprehensive above a threshold.
  • Appropriately and consistently assigned.
  • Consistent, defined boundaries with other risk types
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Operational Risk & the Regulatory Environment
  • What are the characteristics of the loss events?
  • What are the key factors in determining size and frequency of loss?
  • Why was the tail event more significant?
  • Can we think of other scenarios that could give rise to similarly significant losses?
  • Is there anything we can do to stop these events?
  • Is it our belief that the dataset represents a “typical” year?
  • Are we capturing the full range of potential loss events in the histogram? Does this reflect our full risk profile?
  • Do the losses that have occurred fully illustrate our risk exposures?
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Operational Risk & the Regulatory Environment

Conclusions

  • Management not Measurement
  • Imprecise science
  • Integrate measurement into Operational Risk Management framework
  • Use data to inform decisions
    • Control framework
    • Evaluate mitigation
    • Prioritise corrective action
  • Low frequency/High impact events drive operational risk capital!
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