Fitch Ratings builds op risk capital into risk calculator

LONDON - Fitch Ratings has always included op risk management as an element in determining the rating of financial institutions, but with the launch of its new risk data calculator, it is embedding this analysis into a more quantitative tool.

The new risk calculator is an internal analytical tool aimed at enhancing Fitch's analysis of bank regulatory capital adequacy, which reflects the advance in industry use of risk-based capital models supported by the introduction of the Basel II capital framework.

"We decided to build the calculator because we recognise banks are looking at capital charges from lots of different angles but the only real output from that is the capital ratio," says Gordon Scott, managing director in Fitch's financial institutions group. "However, it takes some effort to understand how the risk-weighted assets are incorporated, which banks all do differently, and such a system is sensitive to even small changes that can have a substantial effect on the capital charge. It is important for us to understand how this works rather than rely on the data the banks give us. As well as doing that for credit risk, where there is a lot of transparency, we thought it would be beneficial to add on the notional charge for operational risk as well as high-level market risk numbers to be able to get a truer picture of capital that we can then compare with banks' own regulatory and economic capital numbers."

For credit risk, the calculator enables Fitch to determine regulatory capital at individual asset-class and aggregated levels, evaluate risk exposures by estimating risk weights and analyse underlying risk parameters. The systematic collection of relevant data will enable Fitch to perform peer analysis of risk parameters, identify patterns or trends in risk profile, compare capital requirements across Basel II approaches and estimate the effect of stressed economic conditions through sensitivity analysis of individual risk parameters.

Although at the moment the calculator only captures credit risk, Fitch is gathering high-level data of the capital charges for market and operational risk reported by banks, to build up a more complete picture of where the capital charges are coming from.

"Because of Basel II and the fact banks have spent more time and effort improving their operational risk management and calculations, it makes sense for us to leverage what Basel II is doing, as op risk management becomes more mature," says Will Knight, associate director in Fitch's financial institutions group.

Scott adds: "We have always looked at operational risk and paid a lot of attention to banks' systems, controls and risk management practices. Including operational risk capital into our calculator is really an extension of that to try to quantify it more accurately," says Scott. "We recognise operational risk and the balance within the capital charge can change over time, which we see during a recession, where there are more incidences of fraud and other operational errors as staff get distracted by the economic situation. We will probably want to look at how we can factor that into our analysis to see how the risk has changed."

Op risk and market risk will be included in the calculator from Q1 2010, but this will initially only be included from banks taking the advanced measurement approach to operational risk under Basel II.