Learning Objectives:

  • Define operational risk and its sources.

  • Understand operational risk measurement under Basel III.

  • Explain the Standardised Measurement Approach (SMA).

5.1 Defining Operational Risk

Operational risk is the risk of loss from failed internal processes, people, systems, or external events . The University of Leeds module covers “Operational risks” as a core topic . The University of Bologna module covers “Operational Risk” . An effective operational risk capital framework allows banks to absorb unexpected losses resulting from inadequate or failed internal processes, people, systems, or external events. For example, a bank may face losses from events such as processing errors, internal and external fraud, legal claims, and business disruptions .

Sources of Operational Risk:

  • Processes: Errors in transaction processing, settlement failures.

  • People: Human error, fraud, inadequate training.

  • Systems: IT failures, cybersecurity breaches.

  • External Events: Natural disasters, regulatory changes.

5.2 The Standardised Measurement Approach (SMA)

Under the Basel III operational risk framework, banks must use a standardised approach to calculate their minimum capital requirements for operational risk . The SMA was adopted in 2017 after years of work, including at least two quantitative impact studies and two consultative documents issued for public comment in 2014 and 2016 . The approach uses specific risk measures—multipliers or dampeners—to calculate a bank’s minimum operational risk capital requirements .

The operational risk capital requirement takes into account the bank’s gross income, expenses, and internal operational losses .

Components of the SMA:

  1. Business Indicator Component (BIC): Banks must multiply a monetary proxy of their income and expense data by a marginal coefficient of 12 percent, 15 percent, or 18 percent . Greater measures of bank income and expenses result in banks using a higher marginal coefficient .

    • The final BIC was simplified by reducing the number of marginal coefficients from five (ranging from 11 percent to 29 percent) to three (from 12 percent to 18 percent) .

  2. Loss Component: Banks with a measure of bank income of the equivalent of 1 billion euros or more are required to calculate their average annual losses caused by operational risk events (over a 10-year period) and multiply the monetary value of those losses by 15 . Banks are to include all operational loss events with a value equivalent to 20,000 euros or more in the loss component . At national discretion, jurisdictions can set the threshold at the equivalent of 100,000 euros for banks with a measure of income greater than 1 billion euros .

  3. Internal Loss Multiplier (ILM): Banks must multiply the ratio of the loss component to the business indicator component by a 0.8 exponent as part of the calculation of the internal loss multiplier . At national discretion, regulators can require all banks in their jurisdiction to set the value for the ILM equal to 1 .

Capital Calculation:

  • Operational risk capital requirements are calculated by multiplying the business indicator component and the internal loss multiplier .

  • Risk-weighted assets for operational risk are equal to 12.5 times the operational risk capital requirements .

5.3 Comparison with Earlier Methods

The SMA replaces all existing basic, standardised and advanced approaches for calculating operational risk capital requirements . The BCBS’s stated aim was to achieve an appropriate balance between simplicity, comparability, and risk sensitivity for operational risk capital calculations . It also expected the revisions to have a relatively neutral impact on capital .

The SMA differs from the Advanced Measurement Approaches (AMA) by using a standardised formula rather than allowing banks to use their own internal models .

5.4 Implementation by Jurisdiction

Implementation timelines and details vary by jurisdiction :

  • Australia (APRA): 1 January 2023.

  • Brazil (BCB): 1 January 2025.

  • Canada (OSFI): 1 February 2023.

  • Europe (EBA): Implementation underway.

  • India (RBI): Not yet confirmed.

  • Japan (FSA): 31 March 2024 for internationally active banks, 31 March 2025 for non-internationally active banks.

  • Singapore (MAS): 1 July 2024.

  • United Kingdom (PRA): 1 January 2027.

  • United States (Fed): Under consultation.

 

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