Regulators to review abolition of Basel II op risk floor

The ‘floor’ question is probably the most significant op risk issue still to be resolved in the complex Basle II capital adequacy Accord, now due for implementation in late 2006, banking regulators said.

Regulators with the Basel Committee on Banking Supervision, the architects of Basel II, want to ensure banks have adequate incentives to adopt sophisticated methods of measuring op risk using their own risk models and loss data.

Under current proposals, op risk charges for banks using advanced measurement methods are capped at 25% below those using cruder, gross-income based approaches. Regulators said they would review this floor two years after the introduction of the Accord, where they could abolish, lower or even raise it. Regulators fear an over-generous floor might result in banks reserving insufficient capital to guard against operational losses.

But critics argue that the 75% floor is not enough to make it worthwhile for banks to invest in the systems needed to qualify for the advanced approaches. One idea is to cut the floor to 50% with a review after two years. Another is to keep the floor at 75% for two years then remove it entirely, but many supervisors believe this provides too much leeway. Yet another is that the floor could be different for individual banks, according to their supervisors’ view of the efficiency of their risk management practices.

The Basel Committee’s capital task force, the senior Basel sub-grouping, decided in late April to seek a clearer definition of the circumstances under which the floor might be abolished, rather than adopt a particular solution at this stage. The Committee’s risk management group, responsible for developing the op risk aspects of Basel II, will handle the matter. “We’re not really going to know the right answer for some time,” said one regulator.

Regulators have wrestled with the incentive dilemma since last September, when they reduced the maximum amount of op risk capital to 12% of overall protective capital, down from an earlier 20% benchmark. The 12% figure reduced the scope for devising a floor that provided an effective incentive to move to the advanced approaches, although not all bankers agree.

So yet another option is to increase the 12% benchmark, which, according to some regulators, is regarded by a number of banks as too low. A higher benchmark would mean a 25% discount for the advanced approaches would be worth more than it would with a lower benchmark.

Basel II will determine the amount of capital banks will set aside to guard against the risks of banking, which includes operational risks like fraud, technology failure and trade settlement errors for the first time.