3 Methods to Calculate Capital Required to Protect Against Operational Risk
Financial Institutions Management Chp 20, Pg. 611-612
i) Basic Indicator Approach
This approach was structured so that banks, on average, would hold 12% of their regulatory
capital for operational risk. To achieve this target the approach focuses on the bank’s gross
income, given by:
Gross Income = Net Interest Income + Net Noninterest Income
According to BIS calculations, if a bank holds 15% of its gross income for operational risk
capital, it will generate enough capital so that it would amount to 12% of its total regulatory
capital holdings for all risks.
The problem with this approach is that it is too aggregative or ‘top-down’ and it doesn’t
consider that operational risk may differ in different areas of the bank.
ii) Standardised Approach
This approach rectifies the problem of the previous approach whilst still maintaining a topdown approach. It divides a bank’s activities into 8 business lines. The capital requirement for
each line is then calculated by multiplying the “indicator” of each line by its β. The capital
requirement for the bank is then the sum of the products of each business line. The indicator
relates to the gross income of each business line. βs are set by regulators and are calculated
from average industry figures given as a %. It reflects the importance of each activity in the
average bank.
iii) Advanced Measurement Approach
Under this approach, banks are allowed to use internal data subject to regulatory approval.
Banks are required to calculate its regulatory capital requirement as the sum of the expected
losses (EL) and the unexpected loss (UL) for each event type. The data used must be based on
a minimum 3 year observation period, and must capture all material activities and exposures
from all appropriate subsystems and geographical locations.