Regulators won’t charge against expected op losses

BASLE, SWITZERLAND -- Global banking regulators will not require capital charges under the proposed Basle II banking accord for expected operational losses -- such as from credit card fraud -- where a bank shows it has budgeted adequately for such losses.

The decision is a milestone in the regulatory treatment of operational risk, say banking industry analysts. It is likely to relieve the concerns of bankers who feared banks would have to reserve more capital than necessary to guard against both expected and unexpected operational losses.

Expected op losses arise from the high-frequency/ low-impact hazards of banking that are easily measured and provided for. Credit card fraud is a classic example. Bankers say the rate of card fraud -- that is, the percentage of credit card activity that is fraudulent -- varies little from year to year regardless of economic conditions. The rate of fraud is covered by the higher credit card charges that a bank’s honest customers have to pay as a result of it.

Unexpected losses are caused by low-frequency/ high-impact events such as major fraud or a catastrophe like the September 11 attacks in New York, which are difficult to predict, but could bring a bank to its knees.

Major banks will be required for the first time to set aside capital specifically against the risk of loss from operational hazards such as fraud, technology failure and trade settlement errors under the terms of the Basle II accord.

The complex, risk-based accord will determine how much of their assets the banks must hold as reserve capital against the risks of banking, including credit and market risk as well as operational risk.

Regulators with the Basle Committee on Banking Supervision, the architect of Basle II and the body that in effect regulates international banking, had previously suggested that many banks do not provide for expected operational losses. The regulators argued that therefore some capital was required to cover expected as well as unexpected losses.

But now regulators say their new position means banks will have to show clearly how they measure and budget for expected losses. If the regulators aren’t satisfied with a bank’s management of its expected losses, they will require capital charges to be set aside against the risk.

Banks are likely to learn formally of the shift in regulator opinion in the guidance to banks that will be issued with the Basle Committee’s third quantitative impact survey (QIS3), which -- like its two predecessors -- will seek to gauge the effects on banks of the Basle II proposals.

QIS3 is scheduled for release at the end of March, but there is speculation among bankers that the survey will be delayed, thus further endangering the regulators’ aim of bringing Basle II into effect by 2005. Many bankers think 2006 is a more likely date.

The timing of the third consultative paper (CP3) on Basle II, on which the banking industry will be invited to comment, is dependent on the completion of QIS3. And the Basle Committee’s final Basle II paper, still scheduled for late this year, is dependent on the publication of CP3.

Many bank industry analysts believe confining capital charges to unexpected losses is both a good idea in principle and should help bank management to concentrate on managing and modelling the essence of op risk -- low-frequency/high-impact hazards.

But bankers noted there are technical problems involved in measuring unexpected and expected losses, dependent on whether charges are calculated as a function of the mean of the loss distribution curve. But regulators do not think these technical arguments are crucial to the issue.

The question of unexpected losses was debated in late January at the London OpRisk 2002 conference organised by Operational Risk’s sister publication, Risk magazine.

David Lawrence, London-based vice-president of risk architecture at investment bank Schroder Salomon Smith Barney, argued that the Basle II charge should be based on unexpected losses. Expected losses are covered out of normal revenue, he told a panel discussion.

Mark Laycock, a London-based member of group operational risk management at Deutsche Bank, noted that bank reserves are subject to different accounting standards in different countries.

"An unexpected loss depends on which bit of the [distribution curve] tail you are looking at," he said.

-- David Keefe