Basel III gives operational risk management a new lease of life

Basel III gives operational risk management a new lease of life

Influencer, opinion leader, team leader, CEO, market leader, and another business leading concepts.

By Mark Russell, OpRisk Expert, PRA supervisory/BoE Policy, (Interim Consultant), Pragmatic Assignments.

The new Basel III mandate on Operational Risk (OpRisk) Pillar 1 capital was met by howls of shock and horror.

This missed the point. In fact, the Basel changes are likely to give OpRisk management a new lease of life.

If we seize the opportunity:
  • The industry and its regulators can stop pretending that OpRisk capital modelling works. They can strip away smoke and mirrors and establish a more open, informed, dialogue about OpRisk exposures.
  • Banks will save the cost of OpRisk models. Bank boards, and PRA supervisors, will be spared the anguish of trying to understand senseless statistics.
  • The other OpRisk framework tools will sharpen their focus on managing exposures, no longer distracted by the need to avoid bumping up the capital burden.
  • OpRisk capital requirements themselves will be more stable. They might even drop, over time.

But this won’t happen unless the industry, legislators, and the regulators, work together to take the new Basel mandate to its logical conclusion.

There are three barriers for us all to overcome:
  • In the UK, the PRA requires first and second tier banks to use OpRisk models to calculate a Pillar 2A capital number. This is inconsistent with Basel’s scrapping of OpRisk modelling for Pillar 1. So, it should be dropped.
  • Basel’s new Standardised Measurement Approach (SMA) for OpRisk has a loss-based component which can be switched on or off at national discretion. If this isn’t switched off, OpRisk capital can be extremely volatile. And if a bank has a major OpRisk loss, its capital requirement will be inflated for 10 years. This is loss-sensitive, but not risk-sensitive.
  • The last step will be for the Bank of England to update its overall approach to setting OpRisk capital add-ons. It now uses a simplistic form of OpRisk modelling to give it an independent view of how much capital a bank should hold for OpRisk. The approach is no longer credible. Perhaps the idea of Pillar 2 for OpRisk should be scrapped.

I understand the shock and horror. The SMA is flawed… it is not risk-sensitive. But no-one has a credible alternative.

I have worked on this on and off for 13 years. I have tackled it, first-hand, from inside the industry and from inside both the PRA and the Bank of England, engaging directly in the last round of Basel negotiation. I am 100% certain that it is not just very difficult, but impossible, to devise a risk-sensitive method for calculating a bank’s OpRisk capital requirement. And I guess nobody really thought that OpRisk capital modelling could work. As a statistical methodology it was no more than emperor’s new clothes.

It’s time to move on. We must grab the opportunity to re-focus on tackling the huge OpRisk exposures we all face. But now with greater clarity and candour.