Introduction

The Basel II accord of 2004 introduced three methods to measure operational risk, a new risk domain around capital adequacy for banks. In practice most banks adhered to the most simplified method, the basic indicator approach, whilst a smaller subset of banks applied the standardised approach. Only the largest banks were able to implement the Advanced Measurement Approach. These three methods are being replaced by the overhauled rules of Basel III-Reform, to introduce one single methodology, the standardised approach (‘New SA’) to capture the risk resulting from inadequate or failed internal processes, people or systems or from external events, including legal risk. The New SA combines a financial statement-based proxy (Business Indicator) multiplied by coefficients based on size of the operations (Business Indicator Component) and a historical internal loss multiplier.

Regulatory Framework

Europe introduced the Basel III Reform standards by adapting the definition of operational risk in 4(1)(52) CRR3 and replacing the entire Title III with the new provisions of 311a-323 CRR3. Several mandates are provided to EBA to develop RTS and guidelines, including the important RTS on the operational risk taxonomy and the qualitative risk management framework.

Purpose of the changes in regulation

The New SA aims to address weaknesses that appeared during the Global Financial Crisis of 2007/2008 and to improve risk sensitivity of the operational risk measurement and comparability among banks applying a wide diversity in approaches based on the permitted three methodologies introduced with Basel II. The lack of comparability was particularly caused by differences in internal modelling by banks applying the Advanced Measurement Approach. The New SA is non-model based and it is purported to achieve overall simplification.

Impact for the industry

If Europe would have applied the discretion to require banks (for instance larger banks) to consider historical loss data for the multiplier in the calculation method, a comparable bottleneck would have resulted from the application of the New SA as was the case when internal models were introduced for the weighting of credit risk and treatment of the probability of default parameter. Still, for smaller European banks the overhauled rules for operational risk assessment bring a considerable additional compliance burden, as the New SA brings much more refinement and requires significant efforts to develop risk sensitivity, compared to the basic indicator approach that was often applied by such smaller institutions. Whether the envisaged permissibility to mitigate operational risk through the taking up of insurance coverage will effectively reduce compliance costs for banks, shall depend on the manner of operationalisation of underwriting policies by insurers.