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Basel Ii's Three Approaches To Operational Risk Management

The operational risk requirements of Basel II proposes three measurement methodologies for calculating the operational risk capital charges. These are the Basic Indicator Approach, the Standardized Approach and the Advanced Measurement Approach.

Under the Basic Indicator Approach banks must hold capital for operational risk equal to the average over the previous three years of a fixed percentage (15% for this approach) of positive annual gross income (figures in respect of any year in which annual gross income was negative or zero are excluded).

Although no specific criteria are set out for use of the Basic Indicator Approach, banks using this method are encouraged to comply with the Committee’s guidance on “Sound Practices for the Management and Supervision of Operational Risk” (BIS; February 2003). These principles require:

•A hands on approach in the creation of an appropriate risk management environment,

•Positive actions in the identification, assessment, monitoring and control of operational risk,

•Adequate public disclosure.

Under the Standardized Approach a bank’s activities are divided into eight business lines. Within each business line, gross income is a broad indicator that serves as a stand-in for the level of business operations and therefore the probable size of operational risk exposure within each of these business lines. The capital charge for each business line is calculated by multiplying gross income by a factor (called the “beta”) assigned to that business line. The beta serves as a substitute for the industry-wide relationship between the operational risk loss experience for a given business line and the aggregate level of gross income for that business line. The business lines and the beta factors range from 12% for “retail banking”, “asset management” and “retail brokerage”; 15% for “commercial banking” and “agency services” to 18% for “corporate finance”, “trading & sales” and “payment & settlement”.

The total capital charge is calculated as the three-year average of the simple summation of the regulatory capital charges across each of the business lines in each year. In any given year, a negative capital charges (as a result of negative gross income) in any business line may offset positive capital charges in other business lines without limit.

At national supervisory level, the supervisor can choose to allow a bank to use the Alternative Standardized Approach (ASA) provided the bank is able to satisfy its supervisor that this alternative approach provides an improved basis for measurement of risks. Under the ASA, the operational risk capital charge/methodology is the same as for the Standardized Approach except that two business lines – “retail banking” and “commercial banking” where a fixed factor ‘m’ – replaces gross income as the exposure indicator and is related to the extent of loans granted in these areas.

Under the Advanced Measurement Approaches (AMA) the regulatory capital requirement equals the risk measure generated by the bank’s internal operational risk measurement system using specific quantitative and qualitative criteria. Use of the AMA is subject to supervisory approval.

Supervisory approval has to be conditional on the bank being able to show to the satisfaction of the supervisory authority that the allocation mechanism for these subsidiaries is appropriate and can be supported empirically. The quantitative standards that apply to internally generated operational risk measures for purposes of calculating the regulatory minimum capital charge are that any internal operational risk measurement system must be consistent with the definition of operational risk and a range of defined loss event types (covering all operational aspects such as fraud, employee practices, workplace safety, business practices, processing practices, business disruption and loss of physical assets).

To qualify for use of the Advanced Measurement Approaches (AMA), a bank must satisfy its supervisor that,

•The banks board of directors and senior management, are actively involved in the oversight of the operational risk management framework;

•The bank has an operational risk management system that is conceptually sound and which includes an independent operational risk management function that is responsible for the design and implementation of the bank’s operational risk management framework;

•The bank has It has sufficient resources to use this approach in the major business lines as well as the control and audit areas.

A bank using the AMA will be subject to a period of initial monitoring by its supervisor before it can be used for regulatory purposes. This period will allow the supervisor to determine if the approach is credible and appropriate. The bank’s internal measurement system must be able to reasonably estimate unexpected losses based on the combined use of internal and relevant external loss data, scenario analysis and bank-specific business environment and internal control factors.

The bank’s measurement system must also be capable of supporting an allocation of economic capital for operational risk across business lines in a manner that creates incentives to improve business line operational risk management.

Additionally,

•The operational risk management function is responsible for documenting policies and procedures concerning operational risk management and controls, designing and implementing the bank’s operational risk measurement methodology, designing and implementing a risk-reporting system for operational risk, and developing strategies to identify, measure, monitor and control/mitigate operational risk,

•The bank’s internal operational risk measurement

Taxpayers may lose £2 billion on Northern Rock rescue, says NAO
(Reuters) - UK taxpayers could lose up to 2 billion pounds from the government's 2008 rescue of mortgage lender Northern Rock by the time all the assets are wound down, according to the country's spending watchdog. The National Audit Office (NAO), an independent body that monitors value for money in government spending, said last year's sale of part of the bank was a good choice and the loss should be seen as part of the overall cost of securing the benefits of financial stability during the financial crisis. UK Financial Investments (UKFI), the body that holds Britain's stakes in banks it rescued, has said the taxpayer will recover all of the cash provided to Northern Rock, but the NAO said that may be optimistic. Britain nationalised Northern Rock in early 2008 after failing to fund a buyer after providing emergency liquidity support to the lender the previous year. After nationalisation the business was split into two companies. A new stand-alone "good" bank, Northern Rock
UK seeks new tools to tackle economic crime wave
LONDON, May 17 (Reuters) - Companies whose staff act unlawfully might be able to avoid prosecution if they come clean under new laws proposed in Britain as part of efforts to cut the costs and length of increasingly complex investigations. The practice is already used in the United States but in Britain, although prosecutors can strike a form of plea bargaining with companies, there is no guarantee that the courts will accept those agreements in any trial. Justice Minister Crispin Blunt and leading lawyer Edward Garnier said on Thursday they planned to introduce so-called Deferred Prosecution Agreements, under which firms would publicly admit wrongdoing, face fines and submit to monitoring. "If we can encourage companies to self-report and come clean, pay penalties and mend their ways, the time and expense of investigations and prosecutions will be better spent elsewhere, enabling us to bring more individuals and companies to justice," Garnier said. The government has
EMIR: ESMA plans final consultation and hearing before summer break
The European Securities and Markets Authority (ESMA) plans to consult on detailed rules, known as draft technical standards, for 'EMIR' in early summer, according to Verena Ross, executive director. She told an Association for Financial Markets in Europe (AFME) conference on post-trade issues that ESMA would publish a consultation paper on EMIR (formally known as the European regulation on OTC derivatives, central counterparties and trade repositories) by the end of June or the beginning of July, and would organise an open hearing at its Paris headquarters "probably in the beginning of July". In March, the authority held an initial hearing to get feedback on its EMIR discussion paper, to which it has since received 135 written responses. The European Commission, Parliament, and Council reached political agreement on the 'level one' EMIR regulation on February 9, and the parliament approved it on March 29. But Ross said that the final consolidated legal text reflecting that agreement
EU Commission to adopt bank resolution scheme on June 6
MILAN, May 17 (Reuters) - The European Commission will adopt on June 6 a proposal for winding up failing banks, the head of the banking unit at the EU executive said on Thursday. "On crisis management, we will adopt a proposal on June 6," Mario Nava told a financial conference in Milan. At the end of April a Commission spokeswoman said the aim was to present the scheme before a June 18-19 summit of the world's 20 biggest economies in Mexico. Nava said the idea behind the scheme was to ask banks to prepare a recovery plan for when they hit trouble. Regulators should also have resolution schemes ready, he said. "We believe there is a need to make the whole bank resolution process more European," he said, adding the proposal would include many references to the role of pan-European authorities during a banking crisis. He said the proposal will also include a "bail-in" mechanism, which makes banks' bondholders take a hit if a lender goes bust. "'Bail-in' will
Lloyds suspends traders in Libor investigation
EDINBURGH, May 17 (Reuters) - Lloyds Banking Group chairman Winfried Bischoff said the bank has suspended two derivatives traders following an investigation into possible interest rate manipulation. "We have suspended two traders. As part of the enquiries they've been asked not to come to work," Bischoff told reporters after the bank's annual shareholder meeting. "A number of banks have been asked to provide information into Libor setting and we've done so. We're not the only ones. It's a precautionary measure at this stage." Lloyds has refused to name the traders. Sources have said banks such as JP Morgan, Deutsche Bank, RBS and inter-dealer broker ICAP have already seen staff either leave or be fired as regulators around the world investigate allegations that banks have colluded on setting Libor rates. (Reporting by Matt Scuffham; Editing by Steve Slater)
Shareholders sue JPMorgan Chase over trading loss
NEW YORK, May 16 (Reuters) - JPMorgan Chase & Co was the target of two separate lawsuits by shareholders on Wednesday, accusing the bank and its management of excessive risk that led to trading losses of at least $2 billion. A spokesman for JPMorgan Chase declined to comment on the lawsuits, which were filed in U.S. District Court in Manhattan, days after Chief Executive Jamie Dimon's May 10 statement that a "failed hedging strategy" caused the massive loss over the last month. "What the Company did not reveal was that those losses were the result of a marked shift in the company's allowable risk model, undisclosed to investors, and the similarly clandestine conversion of a unit within the company that was touted as providing a conservative risk-reduction function into a risky, short-term trading enterprise that exposed the company to large losses instead," said one of the complaints. It was filed derivatively by California shareholder James Baker on behalf of
U.S. man ran cross-border swindle targeting U.K. pensioners, SEC says
A Hawaiian man created a fraudulent scheme that included recruiting Spain-based boiler room telemarketers to pressure elderly investors in the U.K. into buying worthless stock, the U.S. Securities and Exchange Commission charged on Wednesday. The case represents a challenge for a national regulator trying to protect its investors from being bilked by offshore telemarketers into buying worthless stock in bogus U.S.-based companies. But the case is also an opportunity for a financial services firm to ensure that its staff will protect its customers by asking about unusual transactions such as withdrawing large sums or wiring or sending the funds to offshore recipients and accounts. An SEC complaint filed in Los Angeles federal court named the man, Nicholas Louis Geranio, an associate, Keith Michael Field, and The Good One Inc. and Kaleidoscope Real Estate Inc., two companies Geranio created and used to orchestrate the suspected scheme. The complaint also named a related entity, BWRE
EU lawmaker backs faster stock settlement time
LONDON, May 16 (Reuters) - The prospect of a common transatlantic approach to curbing settlement risk in securities trading was boosted on Wednesday after a senior European Union lawmaker signalled backing for a core element of draft EU law. The bloc's executive European Commission has proposed that the time taken to settle trades should be no more than two days -- known in the industry as T+2 -- compared with three days in nearly all EU countries at present. Settlement refers to the exchange of cash for legal ownership and custody of a stock, and regulators are pushing to shorten the time this takes to minimise risky exposures. The law will need approval from member countries and the European Parliament. In a first indication of the assembly's position, UK centre-right EU lawmaker Kay Swinburne said she would back T+2. Some in the industry feared Swinburne, who is responsible for the measure in parliament, would push for next-day settlement, a far more burdensome prospect
FSA bases prohibition of senior executive on High Court findings
The Financial Services Authority (FSA) has based a decision to prohibit Anthony Verrier, a senior executive at BGC Brokers LP, on findings by the High Court in a civil case between BGC and a rival inter-dealer broker. Verrier has referred the matter to the Upper Tribunal. The FSA said it had based its decision on the High Court's findings in Tullett Prebon plc (and two others) v BGC Brokers LP (and 13 others, including Verrier), [2010] EWHC 484 (QB). The regulator said: "As the Court of Appeal summarized in Tullett Prebon plc & Ord v BGC Brokers LP & Ors, [2011] EWCA Civ 131: 'Mr Verrier was found [by the High Court] to have participated in an unlawful means conspiracy, the unlawful means including the inducement of the broker defendants to breach their contracts of employment with Tullett by leaving early without lawful justification.'" It highlighted part of the court's finding that Verrier "stuck to the truth where he was able to, but departed from it with equanimity and adroitness
EBA issues guidelines on trading book reforms
National regulators have six months to implement guidelines that the European Banking Authority (EBA) has published on Stressed Value-at-Risk (Stressed VaR) in the trading book, and on Incremental Risk Charge (IRC) modelling. The requirement for stressed VaR modelling when calculating regulatory capital for market risk in the trading book, supplemented by an incremental risk capital charge for unsecuritized credit products, are intended to address weaknesses in the regulatory capital framework revealed during the financial crisis. The latest pointer to the shortcomings of VaR, at least of unstressed VaR, has been the approximately $2 billion loss that JPMorgan Chase announced earlier this month. The IRC includes both default risk and "migration risk" (the risk that a portfolio's credit quality will deteriorate over time). In six months' time national regulators will be expected to have incorporated both sets of guidelines into their supervisory procedures, and begin ensuring the
JPMorgan investment unit played by different high-risk rules
LONDON/FRANKFURT - The JPMorgan Chase & Co. unit that lost more than $2 billion through a failed hedging strategy had looser risk controls than the rest of the bank, according to people familiar with the situation. The risk of losses is tallied by the bank using a so-called value at risk (VaR) calculation. However, the Chief Investment Office, the unit responsible for the high-profile loss that JPMorgan disclosed last Thursday, had a separate VaR system. It used a less stringent calculation that gave a lower risk assessment of its trades, according to people who previously worked at the bank. The unit also reported directly to CEO Jamie Dimon, a factor which allowed it to maintain a separate risk monitoring set-up to other parts of the investment bank, these people said. Despite repeated warnings from executives inside the firm as long ago as 2005, the CIO unit remained notably free from oversight. A source with knowledge of the situation said that
JPMorgan was warned risk management not up to task
NEW YORK - CtW Investment Group, a labor-backed shareholder group, last year warned JPMorgan Chase & Co that its risk management committee was not up to the task and sought to remove one of its members, Ellen Futter, who had been a director at American International Group Inc (AIG) before its near-collapse in 2008. "We are deeply concerned that the current three-person risk policy committee, without a single expert in banking or financial regulation, is simply not up to the task of overseeing risk management at one of the world's largest and most complex financial institutions," an April 1, 2011, letter from CtW said. A failed hedging strategy by the bank's Chief Investment Office in London could cost the firm more than $3 billion. CtW urged replacing Futter, one of the three members of the risk committee on JPMorgan's board, and increasing the committee's authority and oversight responsibilities. "Without an overhaul of the committee's mandate and membership,
IOSCO set to get tough with national regulators not yet signed up to enforcement cooperation, annual meeting hears
The International Organization of Securities Commissions (IOSCO) will take tougher measures to encourage members who have not yet signed its Multilateral Memorandum of Understanding (MMoU) to do so. The global body is also streamlining its organization and seeking ways to beef up its finances. IOSCO's annual conference in Beijing approved a resolution allowing it to take tougher measures to encourage compliance by members who have not yet signed the MMoU, a tool to help ensure effective global securities regulation and preserve and strengthen securities markets around the globe. IOSCO said the new powers were designed to assist non-signatories in overcoming the obstacles they often encountered in securing support from their own governments or legislatures for implementing the legal and regulatory changes required for compliance with the MMoU. Mark Steward, executive director of enforcement at the Hong Kong Securities and Futures Commission said the MMoU had created "a groundswell
Firms need more "certainty" about sanctions targets, conference hears
Firms need more certainty about the ultimate targets of economic sanctions, delegates at an anti-money laundering conference have heard. Neil Munro, senior vice president, AML risk manager at Bank of America Merrill Lynch, said that the raft of sanctions introduced following the Arab Spring had been "challenging" for financial services firms. Munro, who was speaking at the annual conference of the Institute of Money Laundering Prevention Officers in Manchester this week, said that firms needed more help if they were to comply with the sanctions regime. "One thing we do need is certainty. Who are the targets? Who are we interested in?" Munro used the example of the sanctions imposed on Libya in the lead up to the fall of the Colonel Gadaffi regime. He said that the names of state-owned Libyan companies should have been disclosed. "Sanctions are not used at the drop of a hat ? we need to understand what the answers and the objectives are," he said. He said that the sanctions imposed
European Union breaks deadlock on bank rules
BRUSSELS, May 15 (Reuters) - EU finance ministers agreed on tougher capital rules for banks on Tuesday, resolving years of sparring between Britain and the rest of the European Union over how best to craft measures to prevent another financial crisis. Acknowledging the depth of the recent euro zone difficulties that have driven Spain to take over lender Bankia and prompted a sweeping credit downgrade of Italy's banks, British finance minister George Osborne dropped earlier objections and threw his weight behind the draft law. He had previously accused his EU peers of trying to dilute globally agreed capital rules to the point where they would make him "look like an idiot". The deal paves the way for regulations effective from next year aiming to make the 27-member bloc's 8,300 banks safer. It makes it more expensive for banks to lend, by demanding they hold more capital to cover potential losses on loans. "We are reaching a point where we have got to make a decision to
EU's Barnier pushes for binding pay votes, says FT
LONDON, May 16 (Reuters) - The EU's Internal Market Commissioner Michel Barnier outlined on Wednesday new plans empowering shareholders in Europe's listed companies and investors in the continent's banks, according to the Financial Times. Plans being drawn up by senior EU officials intend to give shareholders a binding vote and give those who invest in banks powers to set a cap on bonus levels. The French commissioner discussed his final governance reform plans, which will be unveiled this autumn once approved by fellow EU Commissioners, in an interview with the Financial Times. Barnier also gave his response to pay rebellions that have rattled executives at Barclays and Citigroup. "I like that expression - the shareholder spring - or even a regulation spring, a rule-making spring," he is quoted as saying. "I'm very attentive to this movement which I see as very positive. It corresponds with what I've been doing for the last two years. We need to put responsibility
EU banks to discuss rating agencies dominance, says report
LONDON, May 15 (Reuters) - Around 20 of Europe's biggest banks are to discuss plans to challenge the dominance of the top three credit ratings agencies, the Financial Times reported. The plans will be discussed in Frankfurt on Wednesday at a meeting of the CFO Network, a loose federation of finance directors from Europe's top banks, according to the article published on the FT's website on Tuesday. Some of the banks want to change the culture of information disclosure of the "Big Three" credit rating agencies, Standard & Poor's, Moody's and Fitch. "They get privileged information. In future, maybe they should only get a standard pack, putting everyone on an equal footing," said one person familiar with the plan, cited by the FT. Also under discussion at the CFO meeting will be the topic of bank liquidity, amid concerns the ensuing euro zone crisis could freeze up interbank lending, the FT said. The "Big Three" credit rating agencies have been criticised by policymakers
European Union members agree a compromise CRD 4 package
Member states of the European Union will be allowed to impose stricter capital requirements than those set out in the Capital Requirements Regulation (CRR), under a compromise that member states agreed unanimously today. At the regular meeting of the Economic and Financial Council (Ecofin) in Brussels, member states agreed a common position on the proposed CRD 4 package, which comprises the CRR and a re-cast Capital Requirements Directive (CRD). The "trilogue" negotiations involving the Council, the European Parliament, and the European Commission, can now begin, with the aim of adopting the package, which will implement the Basel III agreement into European law, as early as next month. The draft CRR proposes raising the amount of EU banks' common equity tier 1 (CET 1) from the current 2 per cent of risk-weighted assets to a minimum of 4.5 per cent from 2015. (The requirement will rise in steps: a range of 3.5-4.5 per cent next year and a range of 4.0-4.5 percent in 2014. The total
Swiss regulator probes forex investment firm ASE
ZURICH, May 15 (Reuters) - Swiss foreign exchange investment firm ASE is under investigation by the financial markets watchdog, after a client of Basler Kantonalbank raised concerns. Investors may have placed up to 300 million Swiss francs ($321 million) with a foreign exchange manager being held in custody, sources told Reuters on Tuesday. The prosecutor's office said it was investigating two men associated with ASE and that one of them is under arrest. A spokesman for regulator FINMA declined to confirm the total amount that had been invested in ASE, but said FINMA considered the figure a high one. "It is estimated that more than 500 investors, to whom ASE had promised very high returns, were victims of business practices that are the subject of the ongoing investigations," FINMA said in a statement. "(FINMA) is investigating whether the company dealt in securities without holding a licence," the watchdog said. "It is also investigating whether ASE illegally accepted
Banking lobby warns of risks from capping bonuses
LONDON, May 15 (Reuters) - A cap on bank bonuses in the European Union would be intrusive and encourage banks to bump up basic pay instead, leading bank lobby officials said on Tuesday. Bankers often receive a bonus of several times their basic annual salary but the European Parliament's economic affairs committee agreed on Monday that bonuses should not be higher than a banker's fixed pay. The EU Parliament's action follows public outrage at high pay packages in the financial services industry when many banks are still supported by taxpayer money and when there are deep cuts in government spending and rising unemployment. But bank lobby groups urged caution in legislating over bankers' bonuses. "We believe that attempts by legislators to set a maximum ratio between fixed and variable remuneration intrudes on the important role of shareholders to determine key questions on pay and commercial strategy," said Simon Lewis, chief executive of the Association for Financial Markets
'Specialist knowledge' did not justify Habib Bank excluding Pakistan, Kenya and other countries from AML risk list, says FSA
Habib Bank AG Zurich's policy of excluding from its High Risk Country List (HRCL) countries where it believed it had "specialist knowledge", including Pakistan and Kenya, was "seriously misconceived", according to the Financial Services Authority (FSA). Fining Habib Bank £525,000, and its former money laundering reporting officer £17,500 for anti-money laundering control failings, both after a 30 percent discount for early settlement, the FSA said that while having a physical presence in a country and specialist local knowledge might help identify and manage higher risks of money laundering, they did not negate them. Employing Transparency International's Corruption Perception Index (CP Index), the privately owned Swiss bank, which has twelve branches in the UK, included in its HRCL all countries with CP Index scores below three. But, it excluded Pakistan, where almost 20 percent of its customers originated, and Kenya, although both have CP Index scores below three, because of the presence
MLROs turning away from CF11 roles because of FSA approach, conference hears
Authorised individuals are for the first time turning away from taking up money laundering reporting officer (MLRO) roles, because of the Financial Services Authority's tough new approach to enforcement, said a City lawyer. Daren Allen, a partner at Berwyn Leighton Paisner, said that the FSA's crackdown on authorised individuals has had a negative impact on the financial services industry. Allen, who was speaking at the Institute of Money Laundering Prevention Officers (IMLPO) conference in Manchester yesterday, said that people were for the first time saying they did not want to take up CF11 positions because of the personal liability they might face if something went wrong. Allen said that if he, as a solicitor, made a mistake he was covered by insurance and that the same applied to the accountancy profession. For those in compliance there was no such help, he said. Compliance officers were fined, face public censure, and were prevented from doing their jobs. "It's absolutely nuts,"
EU attempts to break deadlock on bank rules
BRUSSELS, May 15 (Reuters) - European Union finance ministers will try on Tuesday to break a deadlock on new capital rules aiming to cover banks' risks, a reform intended to prevent another financial crisis but which has exposed deep rifts between Britain and the rest of the EU. Britain refused to back a draft EU law earlier this month, when Chancellor of the Exchequer George Osborne accused fellow finance ministers from the bloc of trying to water down the rules to a point where they would make him "look like an idiot". Osborne is alone among the 27 EU ministers in calling for further changes to a law that introduces rules written by international regulators for the European Union's 8,300 banks next year. Seeking to block a deal supported by the rest of the European Union could result in an embarrassing defeat, making a compromise more likely. "Britain is now left standing alone," said one EU diplomat. Margrethe Vestager, the economy minister of Denmark - which
Marsh TMC conference puts spotlight on cloud contract complexity and other issues
Few cloud contracts deal adequately with complexity, according to Christopher Millard, professor of privacy and information law at Queen Mary, University of London. He said that a three-year London University study into 31 standard cloud contracts had suggested that the complexity was rarely transparent. "Many provisions in the contracts seemed to be inappropriate, unenforceable or illegal," he said. Most cloud processes would be better managed in terms of risk profile than if firms did it themselves, he told the 2012 Marsh Communications, Media and Technology Client Conference. Millard said that cloud contracts tended to be crude, although they were becoming less so. For specific risks, the service provider might accept minimal or no liability. In a cloud dispute, there tends to be an issue about which jurisdiction's laws should apply. Of the contracts reviewed during the study, a few specified English law, and about half specified U.S. law. Some had no choice of jurisdiction. Conventional
Italy watchdog attacks risky financial products
MILAN, May 14 (Reuters) - Authorities must regulate and even ban financial products that can wipe out people's savings, the head of Italian market watchdog Consob said on Monday, days after JP Morgan unveiled a $2 billion trading loss due to a failed hedging strategy. Consob chairman Giuseppe Vegas cited high frequency trading and exchange traded funds as potentially dangerous products and practices whose risks need to be monitored because they can have systemic repercussions. "Financial innovation can be positive, but lawmakers and authorities have a duty to prevent it from becoming a mechanism that destroys the savings of families," Vegas told Italy's financial community at Consob's watchdog annual meeting. Vegas said Consob had already intervened to regulate high frequency trading (HFT), which involves placing and then pulling multiple orders faster than the blink of an eye. Supporters say the practice boosts market liquidity but critics fear it can lead to market abuses

system must be closely integrated into the day-to-day risk management processes of the bank and its output must be an integral part of the process of monitoring and controlling the bank’s operational risk profile. This information must play a major role in risk reporting, management reporting, internal capital allocation, and risk analysis.

•Operational risk exposures and loss experience must be reported regularly to business unit management, senior management, and to the board of directors.

•The bank’s operational risk management system must be well documented and the bank must have a routine in place for ensuring with a documented set of internal policies, controls and procedures concerning the operational risk management system, which must include policies for the treatment of noncompliance issues.

•Internal and/or external auditors must perform regular reviews of the operational risk management processes and measurement systems. This review must include both the activities of the business units and of the independent operational risk management function.

•The validation of the operational risk measurement system by external auditors and/or supervisory authorities must include the verification that the internal validation processes are operating in a satisfactory manner; and making sure that data flows and processes associated with the risk measurement system are transparent and accessible. In particular, it is necessary that auditors and supervisory authorities are in a position to have easy access, whenever they judge it necessary and under appropriate procedures, to the system’s specifications and parameters.

Because the analytical approaches for operational risk continue to evolve the approach or distributional assumptions used to generate the operational risk measure for regulatory capital purposes is not being specified by the Basel Committee. A bank must however be able to show that its approach captures potentially severe ‘tail’ loss events. Irrespective of the approach is used, a bank must demonstrate that its operational risk measure meets a soundness standard comparable to that of the internal ratings-based approach for credit risk.

Based on this, bank supervisors will require the bank to calculate its regulatory capital requirement as the sum of expected loss (EL) and unexpected loss (UL), unless the bank can demonstrate that it is adequately capturing EL in its internal business practices (to base the minimum regulatory capital requirement on UL alone, the bank must be able to demonstrate to the satisfaction of its national supervisor that it has measured and accounted for its EL exposure).

A bank needs to have a credible, transparent, well-documented and verifiable approach for weighting these basic elements in its overall operational risk measurement system.

Internal loss data is critical to linking a bank's risk estimates to its actual loss experience. Such data is most relevant when it is clearly linked to a bank's current business activities, technological processes and risk management procedures. To do this a bank must have documented procedures for assessing the on-going relevance of historical loss data, including those situations in which judgment overrides or other adjustments may be used, to what extent they may be used and who is authorized to make such decisions. Internally generated operational risk measures used for regulatory capital purposes must be based on a minimum five-year observation period of internal loss data. However, when the bank first moves to the AMA, a three-year historical data window is acceptable.

To qualify for regulatory capital purposes, a bank's internal loss collection processes must be able to map its historical internal loss data into the relevant supervisory categories as are defined in detail in the Basel II Annexes. The bank must have documented objective criteria for allocating losses to the specified business lines and event types. A bank's internal loss data must be comprehensive. It must capture all material activities and exposures from all appropriate sub-systems and geographic locations. The bank must be able to justify that any excluded activities or exposures, both individually and in combination would not significantly impact the overall risk estimates. This should be based on an appropriate minimum gross loss threshold for internal loss data collection. Additionally, a bank should collect information relating the date of the event, any recoveries of loss amounts, as well as descriptive information about the drivers or causes of the loss event. The level of detail in any descriptive information should be appropriate to the size of the gross loss amount.

Operational risk losses that are related to credit risk and have traditionally been included in banks’ credit risk databases (e.g. collateral management failures) must continue to be treated as credit risk for the purposes of calculating minimum regulatory capital. It follows that such losses will not be subject to the operational risk capital charge. Nevertheless, for the purposes of internal operational risk management, banks must identify all material operational risk losses consistent with the scope of the definition of operational risk and the defined event types, including those related to credit risk.

A bank’s operational risk measurement system must use pertinent external data (either public data and/or pooled industry data), especially when there is any possibility to believe that the bank is potentially exposed to severe losses, however infrequent. Additionally a bank must use scenario analysis of expert opinion in conjunction with external data to evaluate its exposure to high-severity events.

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