A calculated approach

The good news from this year's operational risk economic capital survey is that the industry seems firmly committed to the concept of capital calculation. It was not always so. The early days of the discipline's development were wracked with arguments over whether op risk calculation was possible at all, and whether or not it should be included in Pillar I of the Basel II agreement.

In this month's OpRisk & Compliance Intelligence survey, carried out in conjunction with software firm Ci3, 75% of respondents say they have an overall strategy for op risk capital calculation.

However, the bad news is that 32.3% of those who say they have an op risk capital calculation strategy confess they are not sure that it is possible, or that it will soon be possible, to calculate a single number that correctly represents the level of op risk in a financial institution. Another 29.3% either disagree or strongly disagree that such a calculation is possible.

This means that just 38.4% of those who have an op risk capital calculation strategy agree or strongly agree that it is possible to calculate a single number that correctly represents the level of op risk in a financial institution. So one is led to question exactly what people consider an op risk capital calculation strategy to be. Perhaps one has to dig a bit deeper to understand the motivations behind those who have bought into the op risk capital framework.

Of course, those who have an op risk capital calculation strategy have a higher level of confidence in the kind of improvements such a framework will deliver. More than 67% believe a calculation strategy will produce improved overall business operations and effectiveness, while 66% say it will result in a lower overall capital requirement. Some 43% believe an op risk capital calculation strategy will produce better corporate disclosure, and improved product pricing and risk capital allocation.

Those who do not have an op risk capital calculation strategy in place are more pessimistic about the framework's ability to deliver value. A high number agree that a strategy would produce improved overall business operations and efficiencies, but just 32% say it would deliver improved product pricing and risk capital allocation, and a mere 21.4% say it would result in better corporate disclosure and lower overall capital requirements.

It is clear that the firms implementing an op risk capital calculation strategy are probably not doing it for the final number that the computer model spits out. They are implementing the methodology for the range of value-adding benefits it can bring. It is the journey that is motivating executives, not the destination - at least not at this stage.

When putting together their op risk capital frameworks, most firms seem to stick closely to Basel II, that is, a balanced framework that blends internal data, external data, scenario analysis and risk control self assessments. Some 33% of respondents who have op risk capital calculation strategies in place blend these components in various ways to reach their capital number. Another 26% focus their capital calculation strategy on internal losses, while 21% favour bottom-up risk and control self assessments. Those who do not have an op risk capital calculation strategy mirror these approaches up to this point - 32% use a blended approach, while 23% emphasise internal losses and 23% emphasise the bottom-up risk and control self-assessment approach. However, there is a divergence towards the bottom end of this question's response. Of those who say they have an op risk capital calculation strategy in place, 14% say they focus their calculation strategy on top-level scenarios, while just 5% rely on key risk indicators.

Among those who claim to not have an op risk capital calculation strategy, 19% say they focus on key risk indicators when doing their op risk calculations, while just 3% use top-level scenarios. So it seems respondents who do not have a capital calculation strategy in place take a more quantitative approach, while those who do have an op risk capital framework favour 'touchy-feely' scenario analysis.

This is fascinating. It is possible it is because those who are not focused on op risk capital calculation instead have their sights set on improving the op risk management at their firms - and so they are more likely to have developed robust key risk indicator programmes. These are usually designed to track data that could indicate the potential for specific losses, and so are pragmatic and bound to deliver value in firms where value is a strong focus.

In contrast, firms using scenario analysis as the core component of an overall op risk capital calculation strategy are, generally speaking, turning to scenario analysis to develop data points on the tail of their op risk model distribution. This is a strategy that has been deployed particularly by the large US investment banks, which lack the business lines that would give them large quantities of data (such as retail banking) and instead have fewer, more substantial losses (think Enron, Worldcom, and the current credit crunch.)

With this in mind, it's not surprising that the content of what is reported to the board of directors varies between whose who claim to have an op risk strategy and those who say they do not. Among those with a strategy, 60% provide their boards with a mix of quantitative and qualitative material. Some 23% say their reports are mainly quantitative, while another 17% say their reports are mainly qualitative.

Of those without an op risk capital calculation strategy, 47% provide reports that mix quantitative and qualitative data, while 41% say they provide mainly qualitative information about the op risks their firms are exposed to.

And there is a big difference between those who have a strategy and those who don't regarding who has responsibility for op risk capital calculation. At firms that do have a strategy in place, either the head of risk management/chief risk officer spearheads the effort (34.4%), or else the head of op risk (44.8%). At firms that say they do not have an op risk capital calculation strategy, the responsibility at 48% of firms lies with the chief financial officer.

There are also strong differences in the way that those who have a strategy spend their money, versus those who claim not to have a strategy. Respondents were asked to rate areas of expenditure on a scale of 1, for a lower spend, to 8 for a higher spend. Those who have a strategy plough their departments' funds into training (which earned an overall average score of 4.9), staff (4.6) and data gathering (4.4). Data gathering had the highest number of high spenders, followed by consultants and outsourcing. However, these also had high numbers of people who rated these as their lowest areas of expenditure, creating a kind of divergence in implementation approach. Bizarrely, those who claimed to not have an op risk economic capital calculation strategy said their highest expenditure was quantitative analyst support, followed by training and technology.

Perhaps the most heartwarming finding for the op risk industry is that expenditure is set to increase. Some 26.6% of respondents who have op risk capital calculation strategies say they expect their costs to rise 10% or more next year. Some 16% say their costs will rise between 1% and 9%, while 33% say their costs will remain the same. And while 46% of those who do not have an op risk capital calculation strategy say they do not expect their costs to change, 25% expect costs to rise between 1% and 9%, while 22% expect costs to rise by 10% or more.

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