Basel regulators put op risk charge below 15%

Global banking regulators will cut to below 15% from 20% the benchmark figure on which they intend basing the controversial operational risk capital charge they propose for large international banks from 2005.

The decision will be contained in a 25-page discussion document on operational risk that the Basel Committee on Banking Supervision, the body that in effect regulates international banking, intends to publish by the end of next week.

But regulators will not be providing a specific figure for the new benchmark – that is still a matter for further debate between regulators and the global banking industry.

In June, bankers worried that a 20% benchmark would impose a higher than necessary op risk charge on their banks were pleased when the committee agreed its earlier 20% estimate was too high and would be reduced. But regulators declined then to say what they thought was a more appropriate figure.

The 20% benchmark was based on the regulators’ earlier view that banks generally appeared to set aside about 20% of their economic capital to guard against losses from operational hazards such as the terrorist attacks in New York’s financial district last week as well as fraud, technology failure and trade settlement errors. Economic capital is the protective capital that banks set aside according to their own perceptions of the risks they face as distinct from the reserve requirements laid down by regulators.

The initial charge proposal for op risk attracted some of the fiercest criticism of the regulators’ plan to reform the Basel II bank capital adequacy accord, which will stipulate what proportion of their assets banks will have to set aside to guard against banking risks generally from 2005.

Basel II is intended by regulators to be more risk-sensitive than the one-size-fits-all minimum capital/asset ratio imposed by Basel I, the current banking accord that dates from 1988, and has been adopted by bank supervisors in over 100 countries.

However, regulators say that bankers shouldn’t assume that an op risk benchmark below 15% would necessarily retain the same relationship to the so-called alpha factor that is used in the simplest method of calculating an op risk capital charge under Basel II – the basic indicator approach.

When suggesting the 20% benchmark in their Basel II consultative paper earlier this year, regulators said it would imply an alpha of 0.3 which would be applied to a bank’s gross revenue to arrive at a capital charge.

Regulators said a benchmark below 15% does not imply the same 1.5 ratio to give an alpha of under 0.23, for instance. “There’s a lot more number-crunching to do before we get to a final figure,” said one regulator.

Nevertheless, the paper will enable bankers to gauge alpha fairly well and also give them some idea of the calibration of the beta factors that will be used in the more complex standardised approach to calculating op risk charges.

Under the standardised approach, the beta factors are applied to a bank’s business lines to arrive at the charge.

But the paper will give no guidance on the gamma factors used in one of the advanced, and most complex, approaches – the so-called internal measurement approach.

Advanced approaches allow banks to use their own risk models based on internal operation loss data to calculate their op risk charges. At first, the Basel regulators put forward only the internal measurement approach, but later said they wanted to expand the range of advanced methods.

In line with Basel II’s risk-sensitive approach, the more complex the approach used by a bank, the lower will be its op risk charge.

The paper will discuss two other advanced approaches – a loss distribution approach and a method using scorecards – without precluding further debate on other advanced approaches, said regulators.

The Basel regulators, who mainly comprise banking supervisors from the Group of 10 leading economies, want to hear bankers’ reactions to the op risk discussion paper as soon as possible. That will enable the regulators to take the views on board as they prepare their third Basel II consultative paper, planned for publication in January.

The Basel Committee wants to publish the final version of Basel II by the end of next year. In June, the committee delayed Basel II’s coming-into-force to 2005 from 2004, following mounting concern in the world’s banking industry about many aspects of the accord.

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