Operational Risk Measurement in Banks: Arbitrage, Adjustments and Alternatives

Abstract

In June 2004 the Committee published a revised framework for the international convergence of capital measurement and capital standards, known as Basel II. The proposal includes a formal capital charge against operational risk in the business activities of banks. The calculation of an operational risk capital charge is based on a spectrum of three increasingly sophisticated measurement approaches. The less sophisticated approaches, the Basic Indicator Approach and the Standardised Approaches, use a financial institution's individual average annual gross income of the three previous years as the basis for a capital charge for operational risk, while the most sophisticated approach, the Advanced Measurement Approaches, use a bank's internal models to determine regulatory operational risk capital. This paper identifies issues resulting from the Basel Committee's recommendations regarding operational risk measurement. We find that gross income as an operational risk indicator may produce unintended consequences and deem this significant given the volume of banks that are expected to adopt the Basic Indicator and Standardised Approaches. We identify and evaluate alternative leading indicators that may form the basis of an operational risk capital charge.