Abstract
Operational risk is the ‘risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events’. Banks are required to control their operational risk exposure. This chapter discusses the three approaches Basel 2 offers to determine operational risk: the basic indicator approach, the standardized approach, and the advanced measurement approach (AMA). The first two mechanisms which Basel provides for calculating operational risk eschew the analysis of operational risks themselves, and operate on a percentage of lead indicator basis. However, the third approach, i.e. the AMA, permits banks to assess the actual incidence and severity of operational risk within the institution, and to model a charge based on that information.
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