Operational Risk Capital Charges for Banks: Consideration and Consequences

Abstract

In January 2001 the Basel Committee on Banking Supervision published the proposal for a new capital framework, the 'New Basel Capital Accord' (Basel II). One of the most significant factors in the proposal is a formal capital charge against operational risk in the business activities of banks. One of the motivations for including operational risk in Basel II has been the increased number of large losses in financial institutions, which could be, at least partly, attributed to operational risks. Examples of such operational losses include the collapse of Barings Bank in 1995 and the $691.2 million losses suffered at the Allied Irish Banks (AIB) in 2002, both of which occurred due to unauthorised trading on the part of individual employees. In April 2003 the Basel Committee published and put up for discussion a third consultative paper (CP3) on Basel II, in which it refined its early recommendations regarding capital requirements for operational risk. The comments received by industry participants, regulatory authorities and individuals show, however, that the regulation of operational risks is still controversial and needs further clarification. This paper identifies and explores issues resulting from the Basel Committee's recommendations regarding operational risk measurement and management. The paper also makes an assessment of the soundness of the Committee's suggestions in CP3, with reference to the operational risk losses in the AIB.