Op risk advances likely after dropping of Basel II floor, says Moody’s

Further advances in banks’ operational risk measurement and management are likely to be stimulated by the decision last week by global banking supervisors to drop the op risk ‘floor’ in their Basel II bank protective capital proposals, credit-rating agency Moody’s Investors Service said today.

Moody’s said a floor would have limited the incentive for banks to develop a more sophisticated approach to op risk measurement and management.

But now several major global banks that have made significant advances in managing op risk - hazards like fraud, technology failure and trade settlement errors - should find an additional incentive to further develop their efforts, said the agency.

Moody's added that more banks may now use advanced approaches to measuring op risk. This requires them to use internal risk models and operational loss databases.

“In this developing context, operational risk management is going to represent an increasingly central element in banks’ overall risk management practices,” Moody’s said.

A key aim of the Basel II capital Accord is to encourage major banks to use their internal risk models to calculate the amount of protective capital they need as a cushion against banking risks.

Basel II will from late 2006 determine how much of their assets major banks must set aside against credit and market risks and, for the first time, operational risk. Banks using advanced measurement techniques will enjoy lower capital charges than banks using cruder approaches.

The Basel Committee on Banking Supervision, the architect of Basel II, last week dropped the idea of a two-year 75% floor on op risk protective capital charges for banks using the advanced approaches. The floor had meant that op risk capital charges for such banks could not fall below 75% of the charge as calculated using the simpler, standardised Basel II op risk approach in the first two years of Basel II.

The Basel supervisors had proposed the floor because they wanted to make sure that the op risk aspects of Basel II worked properly before taking the brakes off completely. Critics among the banks said that the floor did not make it worthwhile for banks to invest in the systems and databases needed for the advanced approaches; the limited gain in lower capital charges would be outweighed by the cost of systems and databases needed for the advanced approaches.

Moody’s cautioned today that it remained critically important for banks to apply effective qualitative judgement in identifying op risk as well as quantitative techniques.

The decision to drop the op risk floor was part of a package of issues agreed last week by the Basel Committee. While dropping the specific op risk floor, the committee said there would instead be a single capital floor for the first two years of the Accord covering both credit risk and operational risk charges. In year one, the single floor will not fall below 90% of minimum charges under the current Basel I Accord. In year two, the floor will be 80%.