Loss survey supports arguments against capital charges, say fund managers

BASLE II UPDATE

LONDON -- The results of a survey by global banking regulators of banks’ operational loss experience support arguments against using capital charges as the main protection against operational losses in fund management and broker activities. This is the claim made by some fund managers.

Losses from seven categories of operational risk, ranging from internal and external fraud to system failures and settlement errors, were modest or minimal compared with those in other business lines, the managers say.

They say the survey evidence supports the view that it is inappropriate to calculate an op risk capital charge for asset management and broking, as proposed by international banking regulators and the European Commission, on the same basis as that for the other activities of banks.

Operational losses in retail banking accounted for two-thirds of the number of operational losses suffered by banks, according to the survey.

And external fraud, together with execution and delivery failures in retail banking, accounted for more than half of a total of over 27,000 loss events recorded by 30 banks surveyed in 11 countries in Europe, North America, Asia and Africa.

By contrast, asset management accounted for 1.6% of the total loss events in the survey and retail brokerage 3.9%. The level of fraud was 0.01% of the total in each of the two categories. Failures in execution, delivery and process management were the biggest source of losses in both categories -- 2.22% of the survey total for retail brokerage and 1.32% in the case of asset management.

Counter-argument

However, regulators countered by cautioning against using the data to draw any conclusions about the extent of op risk exposures. They also said that op risk capital charges proposed under the risk-based Basle II bank capital adequacy accord were designed to reflect the level of actual risk in a bank -- the lower the risk, the lower the charge.

The evidence was contained in the second tranche of the second quantitative impact survey (QIS2) issued by the regulators to seek more information with which to gauge the effect of the op risk capital charges proposed under the Basle II bank capital accord.

The accord will determine from 2005 how much of their assets major banks must set aside as reserve capital to guard against the risk of losses from the hazards of banking, including credit and market risk as well as, for the first time, operational risk.

Basle II is intended by the Basle Committee on Banking Supervision, the architect of the accord and the body that in effect regulates international banking, to apply in the first instance to large international banks in the Group of 10 leading economies.

But the European Commission also plans to apply capital adequacy rules closely modelled on Basle II to all banks and investment firms in the 15-nation European Union from 2005.

Angela Knight, London-based chief executive of the Association of Private Client Investment Managers and Stockbrokers (Apcims), said the survey supported the view that fund management and broking were low-risk categories in terms of op risk. And investment firms already covered the risk adequately already, often through insurance, she said.

Apcims, which represents fund management and stockbroking firms serving private clients in Europe, argues that the European Commission’s plans to impose op risk capital charges on investment firms would impose unfair costs on them and make them uncompetitive internationally (see Operational Risk, May 2001, pages 10--11).

Flawed concept?

The European Asset Management Association believes a capital charge for operational risk in the asset management businesses owned by banks is a "deeply flawed" concept.

However, Apcims’ Knight stressed that the survey’s conclusions must be treated with caution at this stage.

In the survey, the banks were asked for data on operational losses in the years 1998 to 2000. The losses were categorised into eight business lines -- from corporate finance to retail brokerage -- and seven event types, ranging from internal fraud to business disruption and system failures. A matrix of 56 business line/event types was thus created.

Banks were asked to report losses above a minimum threshold of E10,000 or $10,000. In practice, banks used a variety of minimum cutoffs.

In cautioning against drawing hard and fast conclusions, either for banks or for the industry as a whole, the Basle regulators said the information reflected developing methods and approaches for data collection among the banks.

The short, three-year period spanned by the survey suggests the number or rare but potentially severe "tail events" represented in the data may be limited, the regulators said.