Overcoming challenges with the new standard approach
On 7 December 2017, the Basel Committee on Banking Supervision (Paper BCBS 424) published the new standardized approach for operational risk, which will replace all three existing approaches—the Basic Indicator Approach (BIA), the Standardized Approach (STA) and the Advanced Measurement Approach (AMA)—in Pillar I.
The aim of this simplification is to achieve a more homogeneous comparison of the capital adequacy of their institutions they supervise. At the same time, however, the institutions are still required to continue using internal models for Pillar II. The new approach is to be applied as of 01.01.2022.
The SMA comprises 2 components that are multiplied:
- Business Indicator Component (BIC)
- Internal Loss Multiplier (ILM)
While the business indicator component BIC is derived from components of the P&L, the internal loss multiplier depends on the institution’s operational losses.
Business Indicator Component (BIC)
The BIC is calculated by multiplying the business indicator (BI) by the factor alpha, whereby the BI is calculated as the sum of the 3 following components: the interest component, the service component and the financial component.
The BI is then multiplied by the alpha factor according to the following table. The rationale behind this is the assumption that the capital requirements of large, complex banks are greater than those of smaller banks and that the business indicator is therefore more heavily weighted.
The Internal Loss Multiplier (ILM) – new requirements for financial institutions
For banks in buckets 2 and 3, internal loss data must be included in the calculation logic. For these banks, this includes the new requirement to document / link the loss events with the corresponding postings in the P&L. Whether institutions in bucket 1 are allowed to implement this requirement on a voluntary basis has yet to be clarified by the German banking supervisory authorities.
The ILM is caculated as follows:
where the loss component is 15 times the average loss of all claims per year (for the last 10 years!). For banks from bucket 1 (alpha factor 12%), the ILM is weighted with 1. Thus, these (smaller) institutions must meet the higher requirements for which no loss data collection is mandatory. However, the decision is still open as to whether smaller institutions should be given the option of also allowing historical loss data to be taken into account in the calculation of equity capital.
Have a sample calculation done with our S(M)A calculator!
Establishing an operational risk framework
Irrespective of the new standardised approach, the proven methods of OpRisk management should continue to be applied within financial institutions in accordance with best practice, taking the proportionality principle into account.
This means that the following instruments, in particular, should be used:
- Implementing an efficient three-lines-of-defence organizational structure with a living operational risk culture including extensive internal training
- Implementing a comprehensive and consistent loss data collection framework based on that structure
- Regular risk assessments
- Introducing functional early warning indicators
- Analyzing scenarios and considering external loss events
This ensures audit-compliant implementation for banks and helps to avoid losses in the medium term through efficient OpRisk management, which in turn reduces costs.
Fine-tuning your OpRisk management for the new S(M)A
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Working closely with our subsidiary Interexa AG, the SKS Group has both the technical expertise and the appropriate solution for all major OpRisk methods thanks to our Operational Risk Center (ORC) software.
The requirements for setting up a loss data collection system are set to increase, especially for small to medium-sized banks. It's crucial that institutions start compiling thorough data histories at an early stage, even though a shorter period than 10 years may be considered in the first few years if data availability is low. It should be noted that certain qualitative requirements (e.g. posting logic) have been formulated by the BCBS for loss data, and these are already being met by institutions in Bucket 2.
SKS has extensive experience successfully supporting (especially for AMA institutes, but also in cooperation with Interexa AG) banks with the implementation of an OpRisk framework and/or has continued further refining existing frameworks in line with the current status of the regulatory framework as well as the business model of the respective bank.
Best practice methods in OpRisk Management – product ORC from interexa and competency of SKS Advisory
We support you to successfully integrate OpRisk methods, ICS and MaRisk compliance.