The Basic Indicator Approach and the Standardised Approach to Operational Risk: An Example- and Case Study-Based Analysis

Abstract

Pillar I of the Basel II framework developed by the Basel Committee on Banking Supervision (BCBS) deals with the calculation of minimum capital requirements for operational, credit and market risk exposures in banks. The BCBS proposes three increasingly sophisticated approaches to calculating operational risk capital. In order of increasing sophistication, these are the Basic Indicator Approach (BIA), the Standardised Approach (TSA) and the Advanced Measurement Approach (AMA). The operational risk capital charge under the BIA and the TSA is dependent on a bank's GI level and distribution. Banks that wish to use the TSA or the AMA are required to fulfil a set of qualifying criteria, resulting in compliance costs for the bank. The benefit would be a lower capital charge. Our paper focuses on two distinct themes. In the first theme, we show that, based on a hypothetical example, banks with a particular GI distribution will not benefit from gradating from the BIA to the TSA. In the second theme, we examine if the BIA and the TSA would have captured the operational risk build-up in the National Australia Bank's between 2001 and 2004. These years relate to the period in which a cohort of traders engaged in fraudulent activities that resulted in foreign exchange trading losses of $360m. We find that while the TSA would have indicated such a build-up, the BIA would have pointed towards a decline in the bank's operational risk exposure and thus capital. We are facing mixed results. While, dependent on a bank's distribution of GI, the incentive for banks to gradate from the BIA to the TSA might be marginal or non-existent, the approach would have performed better as a predictor for the build up of operational risk in the National Australia Bank.