Basel cuts op risk charge benchmark to 12%

Global banking regulators will base their proposed capital charge for operational risk on a 12% benchmark, down from the controversial 20% originally proposed.

The Basel Committee on Banking Supervision, the body that in effect regulates international banking, confirmed the lower figure in a working paper on the regulatory treatment of operational risk issued today.

The regulators are proposing that from 2005, large international banks should for the first time set aside capital to guard against the risk of financial losses from such operational hazards as the September 11 attacks on New York’s financial district as well as fraud, technology failure and trade settlement errors.

The proposal is part of the Basel II bank capital adequacy accord that will stipulate what proportion of their assets the banks should set aside as a protection against the risks of banking in general.

Today’s paper also introduces a slightly adjusted definition of operational risk, looks at a range of advanced approaches to calculating an op risk capital charge, and sets out the regulators’ views on possibly allowing op risk insurance a role in reducing the charge for those banks using advanced approaches.

The regulators originally estimated on the basis of a sample of firms that banks on average allocated 20% of their economic capital to operational risk. Economic capital is capital that a bank sets aside on the basis of its own assessment of the risks it faces, as distinct from capital reserve rules laid down by regulators.

Many banks objected that this figure was far too high. The Basel regulators said in June that they accepted the criticism, and earlier this month supervisors said the figure would be below 15%.

The working paper says preliminary analysis indicates a 12% figure. This provides a so-called alpha factor used in the basic approach to calculating an op risk charge, in the range of 17-20% of a bank’s gross income.

The basic indicator approach is the simplest of the three-stage menu of approaches to calculating op risk capital charges proposed under Basel II. In line with Basel II’s risk-sensitive philosophy, the more complex the approach used by a bank, the lower will be its capital charge.

The paper’s analysis suggests the beta factors used in the more complex second stage – the standardised approach – fall around the 17-20% range of the alphas. Under the standardised approach banks are divided into business lines and the beta factors applied to those lines.

The regulators specify a preliminary floor for banks using the advanced measurement approaches to be set at 75% of the capital requirement under the standardised approach, which implies a capital level of 9% of minimum regulatory capital under the advanced measurement approaches.

Banks will use their own loss data and internal risk models under the advanced approaches that are the most complex of the three stages.

As expected, the regulators have dropped their reference to direct and indirect losses in their definition of operational risk. The definition now reads: “The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.”