Operational Risk Chapter XX What Is Operational Risk

Operational Risk Chapter XX

What Is Operational Risk? • Operational risk is the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events. • This definition includes legal risk but does not include business risk such as reputation risk and strategic risk.

Determination of Regulatory Capital • Banks have three approaches in determining operational risk regulatory capital. • The simplest approach is the basic indicator approach where operational risk is set equal to 15% of annual gross income (net interest income plus noninterest income) over the previous three years.

Determination of Regulatory Capital • Another approach is the standardized approach that divides bank’s activities into eight business lines. • The average gross income over the last three years for each business line is multiplied by a “beta factor” for that business line and the result summed to determine the total capital.

Determination of Regulatory Capital Business line Beta factor 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%

Determination of Regulatory Capital • The last approach is the advanced measurement approach (AMA) in which operational risk regulatory capital requirement is calculated by the bank internally using qualitative and quantitative criteria.