Operational Risk Model Assurance Checklist Bank: Date: Completed by: Contents 1. Granularity 2. Distributional assumptions: Building calculation dataset 3. Distributional assumptions: Identification of probability distributions 4. Distributional assumptions: Scenario analysis 5. Distributional assumptions: Aggregate loss distribution 6. Correlation and dependence 7. Use of four data elements: Internal loss data (ILD) 8. Use of four data elements: External data (ED) 9. Use of four data elements: Scenario data 10. Use of four data elements: BEICFs 11. Use of four data elements: Combining elements 12. Estimation of unexpected losses 13. Risk sensitive capital allocation 14. Insurance modelling 15. Documentation 16. Validation activities 17. Model governance References BCBS 196 - Basel Committee on Banking Supervision paper entitled Operational Risk – Supervisory Guidelines for the Advanced Measurement Approaches, published June 2011 Basel II – International Convergence of Capital Measurement and Capital Standards , a revised Framework, Comprehensive Version, published June 2006 Banks Act Reg – Basel III Regulations - Government Gazette, No.35950, published 12 December 2012 Page 1 of 24 No. Criteria 1 Granularity 1.01 When choosing its operational risk categories, a bank should take into account the nature and complexity of business activities and the operational risks to which they are exposed (BCBS 196, par 162). BCBS 196 162 Basel II Banks Act Reg. Attest procedures 1. Understand the bank’s policy for determining Operational Risk Categories (ORCs). 2. Inspect the bank’s documented methodology and process on the selection of ORCs. Through inspection of the documentation, confirm and document that the methodology; i. Is compliant with the policy. ii. Considers the structure, nature and complexity of the bank. iii. Has considered the four data elements. (Refer to sections 7 – 10) 1.02 When modelling operational risks, a bank should ensure that the model takes into account the bank’s idiosyncrasies. These may include the business profile, risk profile, history of operational losses, business environment and other factors. A bank should characterise operational risks along these factors. For modelling purposes, it is important that risks sharing common factors are grouped together (BCBS 196, par 163). 163 1. Refer above to attest procedure 1.01. 1.03 When a major change in the organisational or the risk profile of an institution occurs, the bank should ensure the choice of granularity remains valid (BCBS 196, par 164). 164 1. Through discussions with senior management, review of minutes of meetings, and review of the bank’s annual reports confirm and document whether major organisational changes have occurred. 2. Where major organisational changes have occurred, inspect the developmental evidence and confirm and document that the organisational changes have been considered in the assessment of ORCs used in the modelling process. 3. Where granularity has not been addressed appropriately, document management’s reasons for not considering the organisational changes. Inspect model developmental evidence and confirm and document that all available data has been considered in the assessment of granularity. 1.04 A bank should determine the optimum balance between granularity of the classes and volume of historical data for each class. Using one or only a few ORCs can lead to increased heterogeneity for the events in each category. A high number of ORCs can cause the number of losses in each category to fall below a model’s data threshold. As such an outcome is more likely for business lines where the underlying risk exposure is immaterial, the materiality of a business line may in effect be one of the factors determining the level of granularity. Supervisors should be wary when an institution uses either a very low or very high number of ORCs, especially when used in conjunction with a loss distribution approach (LDA) (BCBS 196, par 165). 165 1.05 A bank should provide evidence to supervisory authorities that its choice of operational risk categories is reasonable and does not adversely impact other factors of the operational risk model, such as diversification assumptions, correlations and capital allocation (BCBS 196, par 166). 1.06 A bank should support its choice of granularity by qualitative and quantitative means. It should be particularly aware of the impact its choice of granularity has on the capital charge and provide evidence that the choice is reasonable (BCBS 196, par 167). 1. 2. Confirm, and document, through the inspection of developmental evidence and discussions with management whether the bank considered external or industry data availability. 3. Enquire of management if the four data elements are available per the Basel II event type and business line matrix. 4. Where the bank’s ORCs differ from this matrix, enquire and document from management the reasons. 166 1. Refer above to attest procedures 1.01 to 1.04. 167 1. Inspect the developmental evidence and model documentation to confirm and document the extent to which both qualitative and quantitative factors were considered in determining the level of granularity. 2. For the quantitative factors considered, re-perform significant statistical techniques and tests performed by the bank. Compare the results to those of the bank. 168 & 232 A high number of ORCs may lead to an unrealistically high capital charge when no correlations are modelled and capital charges for all ORCs are Page 2 of 24 Findings Management comment No. Criteria BCBS 196 Basel II Banks Act Reg. Attest procedures summed together. On the other hand, a bank modelling correlations that use a high number of ORCs might have difficulty finding statistical means to validate correlation assumptions due to minimal loss data for each ORC (BCBS 196, par 168). Dependence should not be inappropriately affected by the choice of granularity. For example, many operational risk management frameworks assume statistical independence between losses within the same ORC. To the extent that a bank’s framework has only a few ORCs, the impact of dependence may be inappropriately minimised. In such a situation, it may be preferable to simply add capital estimates across ORCs (BCBS 196, par 232). 1.07 Capital allocation to internal business lines should be a factor when choosing ORCs, as these ORCs may be used as part of the capital allocation process. When using an allocation method that is very different in nature from the choice of ORCs, the bank should ensure that its choice of ORCs and allocation method was reasonable in the first place. Note that changes in the ORCs need not always correspond with changes in the capital allocation method. For example, banks often take continuous management actions leading to changes in their business units that may not lead to major changes in their business processes or risk profile. Such changes may not justify changing the ORCs used for capital modelling, even though they must be incorporated in the capital allocation process (BCBS 196, par 169). 2 Distributional assumptions: Building calculation dataset 2.01 A bank should have a policy that identifies when a loss or an event recorded in the internal (or external) loss event database is also to be included in the calculation dataset. This policy should provide a consistent treatment for loss data across the institution. Exceptions to the policy should be limited and, in any case, duly documented and properly addressed to prevent undue reduction of the capital charge (BCBS 196, par 178) The building of a proper calculation dataset from the available internal/external data requires that a bank develop policies and procedures to address its several features (i.e. perimeter of application, observation period, reference date, de minimis modelling thresholds and data treatment) (BCBS 196, par 179) A bank shall have in place duly documented procedures in order to assess the ongoing relevance of historical data, which documented procedures shall duly specify the situations in which judgment, scaling or other adjustments to internal loss data may be used, including the extent to which such judgment may be used and the officials who are authorized to make such decisions (Regulation 33(9)(d)(v)(B)(iv)) A bank’s internal processes relating to the collection of loss data shall include 169 178 & 179 33(9)( d)(v)(B )(iv) 1. Obtain and inspect model build, minutes of meetings and other relevant documentation to confirm and document whether the ORCs are used in the capital allocation process. 2. Confirm, through the inspection of the bank’s documentation, the consistency between capital allocation and level of granularity. Where these differ document management’s motivation. 1. Confirm that the bank has a documented internal process for the collection of loss data 2. Confirm that the documented process includes an appropriate loss threshold amount for the collection of internal loss data Confirm that this threshold is in line with any minimum gross loss threshold amount specified by the regulator 3. Inspect the bank’s documentation for use of internal (and external) operational risk data elements and document whether there is a policy that identifies the requirements of the use of the internal/external data in the calculation dataset. 4. Inspect the policy and document that the bank’s internal loss data are considered as direct inputs into the model. Where there is less than 5 years of internal loss data (or 3 years where the bank has just moved to AMA) document that the bank has documented the alternative inputs used. 5. Inspect the policy and document whether the process for incorporating internal (or external) loss data has been comprehensively documented, including exceptions and limitations of the policy. 6. Obtain the internal and external loss databases, confirm and document that the inclusion/exclusion of these losses in the calculation dataset is consistent with the bank’s policy by reperforming the filtering criteria on the loss database and comparing it to the bank’s calculation dataset. Confirm and document that any exceptions to the policy are motivated and approved by senior management. 7. Inspect the policies and procedures documentation and document whether the data policies are regularly reviewed internally and have also been subjected to independent review (e.g. Audit, or Business Experts). 8. Through inspection, ensure that the following is consistent 33(9)( d)(v)( C) 33(9)( d)(v)( D) Page 3 of 24 Findings Management comment No. Criteria BCBS 196 Basel II Banks Act Reg. Attest procedures with the bank’s policy/documentation: a. The data selection complies with any condition specified in the AMA approval; b. There is transparency around choice of observation periods across ORCs; c. The choice of reference date across ORCs; d. The application of the de minimis modelling threshold as defined for the ORC under consideration; e. The treatment of data outliers, if any; f. Any exceptions to the above or to areas of the bank’s policy/documentation are motivated. This test will be performed on the entire population except in cases where performing the test on a sample basis would be more efficient. an appropriate de minimis gross loss threshold amount for the collection of internal loss data provided that in order to ensure broadly consistent data collection between banks that adopted the advanced measurement approach for the calculation of their respective capital requirements relating to operational risk the Registrar may from time to time specify a minimum gross loss threshold amount. (Regulation 33(9)(d)(v)(C)) When a bank’s capital requirement in respect of operational risk is based on internal loss data, the said capital requirement shall be based on a minimum observation period of: 9. Confirm that the bank has in place documented procedures for assessing the ongoing relevance of historical data 10. Confirm that the ongoing relevance of historical data is assessed by the bank on a regular (at least annual) basis 11. Confirm that the latest assessment performed is in line with the documented procedures (i) five years of data; or (ii) when the bank originally adopts the advanced measurement approach, subject to such conditions as may be specified in writing by the Registrar, a minimum observation period of less than five years of data, but in no case less than three years of data, irrespective whether the internal loss data is used to calculate or validate the bank’s measure of loss. (Regulation 33(9)(d)(v)(D)) 2.02 2.03 The bank should base its internally generated operational risk measures on a minimum historical observation period of five years (three years when an institution first moves to an AMA). For certain ORCs with low frequency of events, an observation period greater than five years may be necessary to collect sufficient data to generate reliable operational risk measures and ensure that all material losses are included in the calculation dataset. If very long data series are used, banks will need to consider the heterogeneity arising from changes in the risk profile through time. In such cases, time trends or other adjustments should be strongly preferred to discarding older data. Discarding older data should be undertaken only as last resort for ORCs where loss experience is sparse. (BCBS 196, par 180). The bank should base its internally generated operational risk measures on a minimum historical observation period of five years (three years when an institution first moves to an AMA). For certain ORCs with low frequency of events, an observation period greater than five years may be necessary to collect sufficient data to generate reliable operational risk measures and ensure that all material losses are included in the calculation dataset. If very long data series are used, banks will need to consider the heterogeneity arising from changes in the risk profile through time. In such cases, time trends or other adjustments should be strongly preferred to discarding older data. Discarding older data should be undertaken only as last resort for ORCs where loss experience is sparse. (BCBS 196, par 180). 180 1. 2. 180 Inspect the bank’s policy regarding the use of loss data and document whether this policy mandates the use of at least 5 years of loss information once this data is available. Inspect an extract from the loss data repository and assess whether 5 years of loss data is currently available. When data is available but has not been used in the capital model, inspect whether reasons for not using available loss data have been clearly explained within the model methodology of the bank. 3. Inspect the AMA modelling documentation (policy and procedures) and document whether the bank included a statement on heterogeneity arising from changes in the risk profile (i.e. dealing with older data in cases where long data series are used). 4. Where heterogeneity may exist due to long data series, confirm and document, by performing a walkthrough, that appropriate time trends or other adjustments have been considered prior to discarding old data. 5. Perform a walkthrough and confirm, and document, that the discarded internal data is documented, motivated and approved by senior management. 6. 1. Confirm and document that the documented procedures specify situations in which judgment, scaling or other adjustments to internal loss data may be used, including the extent to which such judgment may be used and the officials who are authorised to make such decisions. Obtain and inspect the data set received from management and confirm, for each ORC, that the bank has used a minimum of five years of historical data (or three years if the bank has recently moved (up to a period of 2 years) to AMA. Document the period. (Refer to 2.01 procedure 3 when testing this for individual ORCs) 2. Re-perform any adjustments made to historical loss data. 3. Refer to 2.02 procedure 6 Page 4 of 24 Findings Management comment No. Criteria BCBS 196 2.04 A bank may use one of the reference dates (occurrence date, discovery date, contingent liability date or accounting date) for building the calculation dataset, as long as material loss data are not omitted. No other dates are acceptable for building the calculation dataset. (BCBS 196, par 181). 181 2.05 The discovery date or accounting date are the most prudent choices for developing a bank’s dataset for the quantification of operational risk capital related to that event. However, a bank may use the occurrence date for building the calculation dataset if the bank has not constrained or limited the observation period. (BCBS 196, par 182). 2.06 A bank should use a date no later than date of reserve for including legal related losses/exposures in the calculation dataset. (BCBS 196, par 183). 2.07 A bank may establish a de minimis modelling threshold for an ORC, so that frequency and severity distributions in each ORC are fitted to the data only in excess of the threshold. The de minimis modelling threshold may differ across ORCs. The choice of threshold for modelling should not adversely impact the credibility and accuracy of the operational risk measures. (BCBS 196, par 184). Basel II Banks Act Reg. Attest procedures 1. Inspect the bank’s documentation and confirm, and document, that the bank has included a reference date as per the regulatory requirement for building the calculation dataset. 2. Select a sample of ORCs and confirm that the bank is using the appropriate reference date as stipulated in the policy and that it is consistent across the ORCs. 3. Verify through re-calculation that no material loss data are omitted due to the selected reference date. 182 1. Inspect the bank’s policy and confirm and document that the bank’s motivation for its reference date is in line with the bank’s policy. 183 1. Inspect the bank’s measurement methodology, policy and procedures documentation and confirm, and document, that the bank has a comprehensive policy statement on the date of reserve for including legal related losses/exposures in the calculation dataset. 2. Inspect the data set and confirm, and document, that the bank has used a date no later than the date for reserve for including legal related losses / exposures in the calculation dataset Obtain and document the bank’s motivation and justification for the choice of minimum modelling threshold with reference to the impact on capital requirements. 184 33(9)( d)(v)(B )(iv) 1. 2. Through the inspection of the bank’s developmental evidence: Confirm that the documents incorporate processes and governance requirements regarding changes in the de minimis modelling threshold. Confirm and document that the bank has assessed the impact of different de minimis thresholds. Confirm that changes in the de minimis modelling thresholds are documented and approved by senior management 1. Inspect the bank’s modelling methodology, policy and procedures documentation and confirm and document that the identification and treatment (including any specific techniques) of abandoned business lines and related events are documented. 2. Where a bank has identified data points related to abandoned business lines within the calculation data, inspect the bank’s documentation and confirm, and document, that the treatment of these data points is consistent with the bank’s policy. 1. Refer above to attest procedure 2.07. 1. Obtain the loss dataset from management and apply the de minimis threshold to the data. Compare the results to the bank’s calculation dataset 2. Perform a walkthrough and confirm, and document, that losses above the set de minimis modelling threshold are all included in the calculation dataset regardless of the amounts; by comparing the loss dataset to the calculation dataset Refer to 2.01 procedures for tests on regulation 33(9)(d)(v)(C) Refer also Regulation 33(9)(d)(v)(B)(iv) tested in 2.01 above 2.08 On an exceptional basis, a bank may identify data points related to abandoned business lines within the calculation data. It may adopt specific techniques for the treatment of these data points to address an undesired effect on capital measures. However, a bank should justify and clearly document the identification and treatment of these data points and provide estimates of the capital requirements with and without this treatment. (BCBS 196, par 185). 185 2.09 Use of de minimis modelling thresholds that are much higher than the data collection thresholds should be limited and properly justified by sensitivity analysis at various thresholds. Moreover, changes in the de minimis modelling thresholds, when not embedded in the model engine and driven by specific reasons (for example discount rates), should be limited in number and duly motivated by the need to better capture the risk profile of the ORC. (BCBS 196, par 186). 186 2.10 All operational losses above the set de minimis modelling threshold should be included in the calculation dataset and used, whatever their amounts, for generating the regulatory measures. (BCBS 196, par 187). 187 Refer also regulation 33(9)(d)(v)(C) as tested in 2.01 above 33(9)( d)(v)( C) 3. Page 5 of 24 Findings Management comment No. Criteria BCBS 196 2.11 Losses caused by a common operational loss event should be grouped and entered into the calculation dataset as a single loss, unless a bank chooses to model causality or dependence among those losses in a different manner. A bank’s internal loss data policy should establish guidelines for deciding the circumstances, types of data and methodology for grouping data as appropriate for their business, risk management and capital charge modelling needs. They should also clarify and document their individual judgments in applying these guidelines. A bank’s policy about the threshold and dates for single losses should also be applied to grouped losses. (BCBS 196, par 188). 188 A bank that groups small losses above the threshold for modelling with no causal relations for data collection and registration purposes generally should not include them in its calculation dataset. (BCBS 196, par 189). 189 A bank should consider applying appropriate adjustment rates on data when inflation or deflation effects are material. For example, when the observation period for a specific ORC is extensive (for example 15-20 years) due to the infrequent occurrence of loss events and the loss data series is not stationary, adjusting loss amounts due to discount effects could be the solution to recover stationarity. (BCBS 196, par 190). 190 2.12 2.13 Basel II Banks Act Reg. Attest procedures 1. 2. Inspect bank’s policy regarding grouping. Perform a walk through to confirm, and document, that the bank’s treatment is in line with its policy. Confirm appropriate condonation exist where grouping is not applied. 1. Determine, and document, by performing a walkthrough whether small losses above the threshold for modelling with no causal relations have been grouped for data collection and registration purposes 2. Discuss with management, and document, that grouped losses with no causal relation have not been included in the calculation data set. Perform a walk through to confirm that these losses have been excluded. Perform a walkthrough and confirm, and document, the bank’s consideration of the impact of inflation or deflation. 1. 2. Where it has been determined that the effects are material as per the bank’s assessment, perform a walkthrough to determine whether the bank has applied adjustment rates on data according to their documented approach. 3. Reperform the calculation of adjustment rates applied to allow for the effect of inflation or deflation. Compare results to those of the bank. 4. 2.14 A bank should not use loss net of insurance recoveries as an input for its AMA models. An approach using loss net of recoveries and insurance recoveries may prove especially difficult in the calculation of the maximum 20% capital requirements reduction permitted for insurance mitigation in the Basel III Framework. (BCBS 196, par 191). 191 1. Where adjustment rates have not been applied, obtain and document the bank’s justification for their approach. Through discussions with management confirm and document that the bank has not used loss net of insurance recoveries as an input into the AMA model 2.15 The recognition of insurance in operational risk capital models is in an early stage of development. A bank should calculate the total operational risk capital charge gross of insurance recovery in order to determine the 20% limit and isolate the bank’s methodology for modelling insurance mitigation. (BCBS 196, par 192) 192 1. Refer below to attest procedure 14.05 3 Distributional assumptions: Identification of probability distributions 3.01 A bank should follow a well specified, documented and traceable process for the selection, update and review of probability distributions and the estimate of their parameters This process should result in consistent and clear choices and be finalised to properly capture the risk profile in the tail. 193 1. Inspect the bank’s developmental evidence, model documentation, polices and minutes of meetings and confirm and document that the bank has a documented process for; Selecting the probability distributions, Review of the probability distributions Parameter estimation 3.02 Severity distributions play a crucial role in AMA models. That the models are often medium/heavy tailed implies that the final outcome is significantly impacted by the chosen distribution. The choice of frequency distributions has a lesser impact on the final 194 1. Confirm, and document, through discussions with management and through inspection of the bank’s documented methodology, processes and minutes of meetings that greater emphasis is placed on fitting severity rather than frequency. 2. Refer to 3.14 Page 6 of 24 Findings Management comment No. Criteria BCBS 196 Basel II Banks Act Reg. Attest procedures outcome. 3.03 The selection of probability distributions should be consistent with all elements of the AMA model. In addition to statistical goodness of fit, Dutta and Perry (2007) have proposed the following criteria for assessing a model’s suitability: 3.04 195 realistic (eg it generates a loss distribution with a realistic capital requirements estimate, without the need to implement “corrective adjustments” such as caps), well specified (eg the characteristics of the fitted data are similar to the loss data and logically consistent), flexible (eg the method is able to reasonably accommodate a wide variety of empirical data) and simple (eg it is easy to implement and it is easy to generate random numbers for the purpose of loss simulation). The process of selecting the probability distribution should be welldocumented, verifiable and lead to a clear and consistent choice. To this end, a bank should generally adhere to the following: 196 1. Re-perform the probability distribution selections based on the bank’s policy and compare distribution selections to those made by the bank. 2. Re-perform the goodness of fits tests performed by the bank and compare results to those of the bank. Re-performance of goodness of fit tests must be conducted on both the data used to perform the latest fit and any more recent loss data not yet included in the model. 3. Obtain and document management’s assessment of alternative distributions. Re-perform the fitting of the distribution and the goodness of fit test for the final distribution selected by the bank. Where no alternatives have been suggested, this must be noted. Re-performance will be done on a sample basis. 1. Inspect the developmental evidence and confirm, and document, that probability distribution selection has been adequately documented. 2. Inspect the latest developmental evidence and all relevant documentation, confirm that the utilized methodology which is used to select the probability distributions are applied consistently in subsequent input updates. Where there have been changes, changes are documented and the impact of the change has been considered by management. 3. Inspect the developmental evidence and confirm, and document, that the bank has performed EDA for each ORC and that the results have been used in the distribution selection process. 4. Obtain and document the bank’s justification for the statistical distribution selected. (a) Exploratory Data Analysis (EDA) for each ORC to better understand the statistical profile of the data and select the most appropriate distribution; (b) Appropriate techniques for the estimation of the distributional parameters; and (c) Appropriate diagnostic tools for evaluating the quality of the fit of the distributions to the data, giving preference to those most sensitive to the tail. 3.05 3.06 3.07 In order to examine the statistical properties of each ORC (i.e. homogeneity, independence, stationarity), a bank should make use of statistical tools which include, but are not limited to, scatter plots, time series autocorrelation plots, empirical distribution plots, histograms and regression analysis. Other tools, such as p-p plots, q-q plots and meanexcess plots provide preliminary evidence on the type and shape of the probability distributions which better represent the data. (BCBS 196, par 197). 197 The Range of Practice Paper reveals a wide range of practices for the estimate of the severity distributions, with 31% of AMA banks applying a single distribution to all the data and nearly 50% using two separate distributions for the body (or HFLI region) and the tail (or LFHI region). 198 The operational risk data from a severity perspective clearly illustrate positive skewness and medium-heavy tailedness (leptokurtosis). In statistical terms, this may mean that not all the 199 Inspect the developmental evidence and minutes of meetings and confirm, and document, that the bank used a range of appropriate statistical tools to examine loss data and; 1. Document the bank’s statistical technique. 2. Re-perform the statistical tests performed, by the bank, on the loss data and compare results to those of the bank. 1. Inspect the developmental evidence and confirm, and document, whether the bank has utilised splice-distributions. Where splice-distributions are utilised, confirm the accuracy of the bank’s results and selected splice distributions through reperformance and compare results to those of the bank. 2. Where splice-distributions are utilised, re-perform the goodness of fits tests performed and compare results to those of the bank. Re-performance will be done on a sample basis. Inspect developmental evidence and confirm, and document, that medium-heavy tailedness is identified in loss data and considered, by management, in the distribution selection process. 1. Page 7 of 24 Findings Management comment No. Criteria BCBS 196 statistical moments of the severity distribution exist; in many cases the 2nd moment (ie the standard deviation) and higher moments, although always empirically calculable, are often enormous due to the relevant dispersion of the data. Basel II Banks Act Reg. Attest procedures 2. Inspect the developmental evidence and confirm, and document, the bank has performed statistical tests to assess medium-heavy tailedness of the data. 3. Re-perform the statistical tests performed by the bank and compare results to those of the bank. 3.08 A bank should pay particular attention to the positive skewness and, above all, leptokurtosis of the data when selecting a severity distribution. In particular, when the data are medium/heavy tailed (therefore very dispersed in the tail), the use of empirical curves to estimate the tail region is an unacceptable practice due to the inability to extrapolate information beyond the last observable data point. 200 1. Refer above to attest procedure 3.07. 3.09 In such cases the use of so-called subexponential distributions is highly recommended. Subexponential distributions, which sometimes have a higher number of parameters than light tailed curves, can better represent the shape of the data in the tail (other than their skewness in the body) by allowing estimates of parameters that do not depend on the higher order statistical moments. 201 1. Refer above to attest procedure 3.07. 3.10 When separate distributions for the body and the tail are used, a bank should carefully consider the choice of the body-tail modelling threshold that distinguishes the two regions. The bank should provide documented statistical support, supplemented as appropriate by qualitative elements, for the selected threshold, as the threshold may significantly impact the capital requirements. Ideally the estimate of the body-tail modelling threshold should be made conjunctly with the parameters of the distribution; however for practical reasons banks tend to first identify the threshold and then estimate the parameters. EDA instruments like the hill plot and the mean excess function plot can be useful in the determination of the threshold. A bank should employ sound methods to connect the body and tail distributions. In particular, jumps in the probability mass function when attaching the body and tail of the distributions should be avoided, in order to guarantee that the LFHI and HFLI regions are mutually exclusive and are properly reflected in the aggregated distribution. 202 1. Inspect the developmental evidence and confirm, and document, that an inflection point analysis has been performed by the bank that assesses the modelling threshold between the two distributions. 2. Inspect whether management have investigated the impact of alternate thresholds between the tail and the body of the population. If this has been done then review the statistical tests and validations performed. Re-perform the statistical tests performed by the bank. Compare results to those of the bank. When estimating the parameters of the distribution, a bank should take into account the incompleteness of the calculation dataset in the model (eg due to the presence of de minimis modelling threshold(s) which may or may not coincide with the data collection threshold). The bank should provide evidence that an incomplete calculation dataset does not adversely impact the credibility and accuracy of the parameter estimates and capital requirements. 203 1. Obtain the bank’s developmental evidence and through inspection, confirm, and document, that the choice of thresholds above which data is captured and modelled is justified and documented, by management, including: Rationale in considering the thresholds used to collect data; Rationale in considering the modelling thresholds used to determine the data set used in the model; The application of a de minimis threshold Whether the severity distribution parameter estimation is conditional on this threshold Whether the frequency distribution parameter takes this threshold into account Whether the conditional-fitting methodology is statistically sound Whether provision is made in the capital simulation for the de minimis modelling threshold. 2. Inspect the developmental evidence and confirm, and document, that management has considered the impact of the thresholds above which data is captured and modelled in the model. (Refer to 2.02) 3.11 Page 8 of 24 Findings Management comment No. 3.12 Criteria A bank should pay particular attention to the estimate of the kurtosis-related parameters, which describe the tail region of the losses. Because of data scarcity, the estimates can be highly unstable. The bank should put in place methodologies to reduce estimate variability and provide measures of the error around these estimates (eg confidence intervals, p-values). BCBS 196 204 Basel II Banks Act Reg. Attest procedures 3. If the minimum modeling threshold is significantly higher than the minimum data collection threshold without qualitative and/or quantitative justification, test appropriateness of modelling threshold using goodness of fit tests on collected data and final data used from modelling. Where quantitative and/or qualitative justification is provided, document appropriateness of the justification. 1. Inspect the bank’s policy and documentation and confirm, and document, that a transparent and verifiable process is documented to review and approve data adjustments such as exclusions, scaling etc. 2. Inspect evidence that any adjustments are documented and in line with the bank’s policy. 3. Re-perform the adjustments made by the bank and compare results to those of the bank. 4. Obtain the bank’s developmental evidence and through inspection, confirm, and document the following: 3.13 Robust estimation methods (such as alternatives to classical methods as the Maximum Likelihood and the Probability Weighted Moments), proposed recently in operational risk literature, are reasonably efficient under small deviations from the assumed model. These methods also highlight which observations or deviating substructures have the greatest influence on the statistic to be estimated. A bank may adopt alternatives to classic estimators, provided it can demonstrate that its use does not underestimate risk in the tail. These estimators may also be used as a diagnostic technique for evaluating the sensitivity of the capital charge to the chosen parameter estimation method. 205 3.14 A bank should assess the quality of fit between the data and the selected distribution. The tools typically adopted for this purpose are graphical methods (which visualise the difference between the empirical and theoretical functions) and quantitative methods, based on goodness-of-fit tests. In selecting these tools, a bank should give preference to graphical methods and goodness-of-fit tests that are more sensitive to the tail than to the body of the data (e.g. the Anderson Darling upper tail test). 3.15 While diagnostic tools provide information on the quality of fit between the data and each distribution, they do not always lead to a clear choice of the best-fitting distribution. Moreover, the results of the goodness-of-fit tests are usually Rationale for dealing with data outliers, Whether the Quantile-Quantile plot error bands of the severity distribution are produced and used in the distribution selection process. 5. Inspect the developmental evidence and confirm, and document, that sensitivity analysis was conducted, by the bank, to assess the variance within the tail region. Refer to 3.02. 6. Inspect developmental evidence and confirm, and document, that the bank has considered the fit parameters in determining whether the estimator of kurtosis is appropriate. Where the bank has used an alternative to the classical estimators, inspect developmental evidence and confirm, and document, that the statistical significance of the estimator has been verified and documented and results have been compared to classical methods. 1. Document the classical methods considered by the bank. Where classical methods have not been considered, document the bank’s motivation and justification. 2. Inspect the developmental evidence and confirm that the bank has considered the fit parameters in determining whether the estimator used is appropriate. 3. Where the bank has used an alternative to the classical estimators, inspect developmental evidence and confirm, and document, that justification has been documented for any variance specific to tail risk. 206 1. Inspect the bank’s documented polices on the assessment of quality of fit and confirm that: a. The ranking of the goodness-of-fit test statistics have been considered such goodness-of-fit tests could include the Chi Square, Anderson-Darling, Kolmogorov-Smirnov. b. The statistical results support the method used to fit the tail and that it accurately represents tail risk. c. In assessing the graphical method used confirm that: The bank’s documented policies/documentation address the graphical method to be used. That the graphical method described in the bank’s policy/documentation is repeatable. The graphical method used is in line with the bank’s policy/documentation. 207 1. Inspect the developmental evidence and confirm, and document, that relative performance of the prescribed statistics (such as the Likelihood Ratio, the Schwarz Bayesian Criterion and the Violation Ratio) is used for each of the distributions being considered for the fitting process. 2. Inspect the developmental evidence and confirm, and Page 9 of 24 Findings Management comment No. Criteria BCBS 196 sensitive to the sample size and the number of parameters estimated. In such cases, a bank should consider selection methods that use the relative performance of the distributions at different confidence levels. Examples of selection methods may include the Likelihood Ratio, the Schwarz Bayesian Criterion and the Violation Ratio. 3.16 A bank should have a regular cycle to verify assumptions underlying the probability distributions they have selected. These verifications may follow the criteria and tests a bank’s use in the selection of the probability distribution. If assumptions are invalidated, alternative methods should be tested and implemented. However, any change should be properly justified. In particular, after suffering one or more significant losses in an ORC, a bank should not decide to replace the probability distributions used in that ORC with lighter-tailed curves. Basel II Banks Act Reg. Attest procedures document, that the distribution with the best relative performance at different confidence levels is used and that any deviations from this are documented and expressly justified. 208 3. Re-perform the statistical tests performed by the bank (such as the Likelihood Ratio, the Schwarz Bayesian Criterion and the Violation Ratio) and compare results to those of the bank. 4. Where these statistical tests have not been performed by the bank, this must be noted. Inspect documented evidence and confirm, and document, that the process the bank has in place to review and verify assumptions underlying probability distributions used to represent ORCs: Is clearly documented, approved in line with policy and guidelines and reviewed at least semi-annually. Any updates to assumptions are thoroughly tested and signed off by management prior to implementation, including detailed justification for any change. Confirm through the review of developmental evidence that the bank performs back-testing. Where back-testing has not been performed, discuss reasons with management. 1. 2. 3. 4 Distributional assumptions: Scenario Analysis 4.01 A bank should ensure that the loss distribution(s) chosen to model scenario analysis estimates adequately represents the risk profile of the ORCs. In doing so, banks should also consider the potential differences with an LDA in terms of level of granularity and dependence across the ORCs. 211 5 Distributional assumptions: Aggregate Loss Distribution 5.01 The techniques to determine the aggregated loss distributions should ensure adequate levels of precision and stability of the risk measures. The risk measures should be monotonic, reasonable and supplemented with information on their level of accuracy. 5.02 Banks use several statistical techniques to generate the aggregated loss distributions from frequency and severity curves and parameter estimates. Given the type of 212 213 Inspect developmental evidence and confirm, and document, that mean expected loss is compared by management to historical data to assess potential for error. Where back-testing has been performed, re-perform backtests done by the bank and compare results to those of the bank. 1. Inspect the bank’s policy and guidelines and confirm, and document, that the bank has documented and approved scenario analysis methodology. 2. Inspect developmental evidence and confirm, and document, that scenario analysis is used to assess the impact of deviations from the correlation assumptions embedded in the bank’s operational risk measurement framework, to evaluate potential losses arising from multiple simultaneous operational risk loss events. 3. Inspect developmental evidence and confirm, and document, that assessments are validated and re-assessed through comparison to actual loss experience to ensure their reasonableness. 4. Inspect and confirm that documented policies and procedures identify when an operational risk event becomes an operational risk loss for the purpose of collection within the operational risk loss database and when it is to be included in the calculation data set. 5. Inspect the bank’s documentation and process for fitting points in the tail; reperform the fitting of the scenario analysis data to a distribution. 1. Inspect the developmental evidence and confirm, and document, the techniques selected by management and confirm and document that management considered alternative techniques. Where the bank has performed statistical tests to assess the various aggregation techniques, re-perform tests performed by the bank and compare results to those of the bank. 2. Confirm, by re-performing statistical tests performed by the bank on the risk measures in the build data, that risk measure being used is monotonic. 3. Inspect, and document, management’s developmental evidence and confirm that the measure is estimated with a low degree of error that is consistent with the bank’s guidelines. The bank’s results must be measured against their own policies. It must be noted by management if the bank’s threshold is contravened. Inspect the developmental evidence and confirm, and document, that statistical techniques used to generate an aggregate loss distribution result in a positively skewed loss distribution; (methods used could include for example Monte Carlo simulations, Fourier Transform-related methods, Panjer 1. Page 10 of 24 Findings Management comment No. Criteria BCBS 196 distributions adopted in the context of operational risk, it is especially difficult to represent the aggregated loss distributions by closed form curves. As such, simulation, numerical or approximation methods are necessary to derive aggregated curves (e.g. Monte Carlo simulations, Fourier Transform-related methods, Panjer algorithm and Single Loss Approximations). 5.03 5.04 5.05 Basel II Banks Act Reg. Attest procedures algorithm and Single Loss Approximations) A bank should adopt criteria that mitigate sample and/or numerical related errors and provide a measure of the magnitude of these errors, regardless of the techniques used to aggregate frequency and severity distributions. 214 Where Monte Carlo simulations are used, the number of steps to be performed is an important variable. Good modelling practice suggests that the number should be consistent with the shape of the distributions and with the confidence level to be achieved. In particular, where the distribution of losses is heavy tailed and measured at a high confidence level, the number of steps should be sufficiently large to reduce sampling variability to an acceptable level. In order to do this, a bank can use either (i) a very large number of iterations or (ii) a dynamic number of iterations. The latter, which is typically more accurate, allows the simulation process to stop when the marginal variation of the risk measure, or some other dispersion index, is close to zero. 215 If Fourier Transform or other numerical methods are used, a bank should pay attention to algorithm stability and error propagation issues. 216 2. Where Monte Carlo simulation has not been performed, inspect developmental evidence and through discussions with management, confirm, and document, management’s assessment of alternative techniques prior to selecting a technique. 3. Re-perform the aggregations performed by the bank and compare results to those of the bank 1. Inspect developmental evidence and confirm, and document, that management use and evidence techniques that minimise sampling errors (for example clustering of sample data). Re-perform the tests performed by the bank and compare results to those of the bank. 2. Review developmental evidence and confirm, and document, that the measurement by management of the magnitude of error is within defined limits (as defined by management) i.e. the standard error of the sampling statistic is not larger than expected. 1. For banks that have performed Monte Carlo simulations, confirm and document the accuracy of the simulations through the re-performance of the simulations and compare results to those of the bank. Perform a walk-through to confirm, and document, that what the bank has done is in line with their policy. 2. Inspect developmental evidence and confirm, and document, that a sufficient number of simulations have been performed in line with the bank’s policy. 3. If a dynamic approach is chosen inspect and document, that this is justified by management with empirical evidence, for example comparing results across different number of cycles and verification and assessment as to whether results are appropriate or significantly different in relation to dispersion index. 4. Confirm, and document, the accuracy of empirical evidence simulations through re-performance of this alternative methods performed by the bank Compare results to those of the bank. In the event that Fourier Transform or other numerical methods are used: 1. Inspect evidence and document analysis relating to algorithm stability; and 2. Inspect developmental evidence and confirm, and document, that error propagation has been minimised through appropriate techniques, for example use of floating-point numbers. Accepted risk measures should be used to extract the risk statistic and justification in support of this risk measure must be documented by the bank; If approach considers VaR only then inspect developmental evidence and confirm, and document, that management at a minimum includes an assessment of the quality of data, quality of the distribution and evidence of back-testing; If approach considers Shortfall methods then inspect developmental evidence and confirm, and document, that management at a minimum includes assessment justifying preference for a coherent risk measure including a comparison to VaR and any concerns relating to distribution fit or quality of data, or instances where back-testing evidences concerns that VaR is not sufficiently conservative. 5.06 The risk measure is a single statistic extracted from the aggregated loss distribution at the desired confidence level. The most common and, so far, most adopted measure in risk management, including operational risk, is the Value at Risk (VaR). However, in certain applications and fields, including risk management, Shortfall measures (e.g. Expected Shortfall, Median Shortfall) have also gained acceptance in representing the whole tail region and in providing a coherent risk estimate (under a subadditively perspective). 217 1. 5.07 Whichever risk measure is adopted, a bank should ensure that the measure (and the overall AMA model) fulfils the monotonic principle of risk, which can be seen in the generation of higher capital requirements when the underlying risk profile increases. 218 1. Refer to 5.01 5.08 It is also crucial that the risk measures (while using conservative criteria and assumptions for prudential purposes) are realistic from a managerial and economical perspective. In specific cases, banks may adopt distributions 219 1. In the event that a severity distribution that does not have a defined mean is used in a specific ORC, inspect developmental evidence to understand the bank’s approach and inspect detailed evidence that supports this. 2. At a minimum this evidence would include: Page 11 of 24 Findings Management comment No. Criteria BCBS 196 Basel II Banks Act Reg. Attest procedures that envisage the non-existence of the first moment (i.e. the mean), as this would determine high capital requirements and would not be easily and clearly justifiable and applicable within the firm. 5.09 5.10 A bank should recognise that the estimated capital charge is inherently uncertain due to the heaviness and scarcity of operational risk losses in the tail region. As such, the bank should explicitly recognise this variability in their estimates and provide measures of the error around these estimates. A bank should also gather information on the expected loss. Due to its high sensitivity to extreme losses, the arithmetic mean can cause an inaccurate picture for the expected losses. In light of this, the use of statistics that are less influenced by extreme losses (eg median, trimmed mean) is recommended, especially in the case of medium/heavy tailed datasets. 6 Correlation and Dependence 6.01 Dependence assumptions should be supported to the greatest extent possible by an appropriate combination of empirical data analysis and expert judgment. It is important to recognise that using internal and external data to model dependence presents challenges, as data limitations observed in the univariate context (modelling loss distributions for single ORCs) are likely to be more significant in the multivariate context (modelling multiple ORCs). Using judgment to model dependence presents its own challenges, as eliciting accurate but subjective estimates is more difficult in the multivariate context than in the univariate context. As such, the specification of dependence structures represents one of the most significant challenges in AMA modelling. 1. 220 Results confirming that the goodness-of-fit test statistics are significant, such goodness-of-fit tests could include the Chi Square, Anderson-Darling, Kolmogorov-Smirnov; Results confirming that back-testing evidence that expected value from loss distribution corresponds to actual loss experiences. Evidence that benchmarking of the severity distribution has been performed and that the results have been considered. Inspect the developmental evidence and confirm, and document, that the degree of error in measuring estimated capital in relation to relevant models used is documented and validated by management; using an expected p value or defined confidence intervals. Re-perform the statistical tests performed by the bank and compare results to those of the bank. Inspect the developmental evidence and confirm that the bank confirms that their estimation is consistent with their own policies. 3. Where the bank performs smoothing or averaging on the model to eliminate variability, re-perform the smoothing and compare results to those of the bank. Where EL is used for capital set-off: Inspect whether the arithmetic mean is used as the measure of EL. Where this is the case obtain, and document, the banks justification of the approach. Confirm, through the inspection of developmental evidence, that other measures (like median etc.) are utilised for analytical EL estimations in cases where high model sensitivity to large losses could inflate EL measures such as the mean Where analytical estimations have been performed, re-perform these estimations. 1. 221 228 2. 669(d) Reg 33 (9) (e) (ii) (B) 2. Obtain reasons for differences between analytical EL estimations and budgeted EL measures from management and document 1. In case the bank recognises diversification benefits for regulatory capital, confirm through inspection of regulatory approval, that regulatory approval was received to recognise diversification benefits. 2. Confirm and document through inspection of the Bank’s policy document that a motivation for the inclusion of diversification benefits in the capital estimation is available. 3. Recalculate a sample of the correlation matrix using the source data of the model development team. 4. Confirm through inspection of the Bank’s policy documentation, that expert judgement is incorporated into the determination of the correlation matrix and/or the choice of copula (if applicable). If expert judgement is incorporated, confirm and document through inspection of the Bank’s policy documents that documentary evidence contains the motivation and procedure for incorporating judgement. 5. Compare the method used to estimate correlation and the choice of copula (if appropriate) to relevant benchmarks where these benchmarks are available, (either to the auditors or to the banks). The auditors should note where there are discrepancies from these benchmarks. Page 12 of 24 Findings Management comment No. Criteria BCBS 196 Basel II Banks Act Reg. Attest procedures 6.02 Assumptions regarding dependence should be conservative given the uncertainties surrounding dependence modelling for operational risk. Consequently, the dependence structures considered should not be limited to those based on Normal or Normal-like (eg T-Student distributions with many degrees of freedom) distributions, as normality may underestimate the amount of dependence between tail events. 229, 230 669(d) Reg 33 (9) (e) (ii) (A) 1. Confirm and document through inspection of the Banks documentation, that sensitivity tests are performed in respect of different correlation values, different copulas, and different copula fitting parameters (where appropriate). 2. Confirm through inspection of the Bank’s documentation and code used (where applicable) in the modelling of operational risk, that a degree of conservatism is present, for example: a. Correlation values are floored at zero; b. Rank correlations are used instead of linear correlation; c. A copula which includes tail dependence is used, for example the t-copula instead of the Gaussian copula. d. Correlation values are adjusted upwards using, for example expert judgement, or rounding up to the nearest 5%. e. In cases where data are not sufficient to estimate a correlation matrix, perfect correlation should be used (correlation values equals one). 1. Through inspection of the Bank’s documentation, document that the statistical method and/or logical arguments that is used to confirm the independence of losses with ORCs. Note that qualitative assessments can be considered based on BCBC196: “Given that it could be challenging to prove statistically the independence of losses within an ORC, sound logical arguments may be used to evaluate the independence of such losses. For example, losses arising from the same root cause would not generally be considered independent.” 1. Confirm and document through inspection of the Bank’s documentation and code used (where applicable) that the diversification benefit (percentage difference between diversified and undiversified capital) is within the ranges reported in relevant benchmarks, where these are available to the auditors or to the bank. 2. Confirm and document through inspection of the Bank’s documentation and code used (where applicable) that the number of ORCs is within the ranges reported in relevant benchmarks, where these benchmarks are available either to the auditors or from the banks. 1. Confirm and document through inspection of the Bank’s documentation and code used (where applicable) that the bank can demonstrate at least the difference in diversified and undiversified capital. 2. Through an inspection and documentation of the sensitivity analyses performed by the bank, confirm that the bank can demonstrate the difference in capital with different correlation values. 3. Through an inspection and documentation of the sensitivity analyses performed by the bank, confirm that the bank can demonstrate the difference in capital with different choices of copulas (if applicable). 1. Confirm and document through inspection of the Bank’s documentation and code used (where applicable) that the correlation matrices used in the dependence modelling are The degree of conservatism should increase as the rigor of the dependence model and the reliability of the resulting capital requirements estimates decrease. Accordingly, models assuming statistical independence across all loss events would require a very high degree of rigour. Such rigor may be difficult to attain given the evolving nature of dependence modelling for operational risk. It is important to note that the trade-off between rigor and conservatism will function only within certain bounds; supervisors would not accept a high degree of conservatism to compensate for an approach to dependence that suffered from fundamental deficiencies. 6.03 Losses within each ORC should be independent of each other. If this is not the case, either within-ORC dependence should be modelled explicitly or the input data should be modified to achieve independence across individual losses. 231 6.04 A high number of ORCs may lead to an unrealistically high capital charge when no correlations are modelled and capital charges for all ORCs are summed together. On the other hand, a bank modelling correlations that use a high number of ORCs might have difficulty finding statistical means to validate correlation assumptions due to minimal loss data for each ORC. 168 & 232 669(c) Dependence should not be inappropriately affected by the choice of granularity. For example, many operational risk management frameworks assume statistical independence between losses within the same ORC. To the extent that a bank’s framework has only a few ORCs, the impact of dependence may be inappropriately minimised. In such a situation, it may be preferable to simply add capital estimates across ORCs. 6.05 6.06 A bank should perform sensitivity analyses and stress testing (eg different parameter values and different correlation models) on the effect of alternative dependence assumptions on its operational risk capital charge estimate. A bank should have a rigorous process in place specifying the conditions under which the results based on alternative dependence assumptions would lead to a revision of the operational risk capital requirements estimate. 233 Given the evolving nature of dependence modelling for operational risk, it may be difficult to meaningfully 234 669(d) 669(d) Page 13 of 24 Findings Management comment No. Criteria BCBS 196 Basel II differentiate the impact of dependence at one bank versus another. One would thus expect some degree of cross-bank consistency in the overall impact of dependence. 6.07 Banks Act Reg. Attest procedures calculated in a consistent way across the bank. Subject to supervisory approval as discussed in paragraph 669(d), the incorporation of a well-reasoned estimate of diversification benefits may be factored in at the group-wide level or at the banking subsidiary level. However, any banking subsidiaries whose host supervisors determine that they must calculate stand-alone capital requirements (see Part 1) may not incorporate group-wide diversification benefits in their AMA calculations (e.g. where an internationally active banking subsidiary is deemed to be significant, the banking subsidiary may incorporate the diversification benefits of its own operations — those arising at the sub-consolidated level — but may not incorporate the diversification benefits of the parent). 657, 669(d) 2. Confirm and document through inspection of the Bank’s documentation and code used (where applicable) that the copula used in the dependence modelling is the same across the bank. 3. Confirm and document through inspection of the Bank’s documentation and code used (where applicable) that any expert-based judgemental adjustments made to correlation values and copula fitting parameters (where applicable) are done consistently across the bank. 4. Confirm and document through inspection of the Bank’s documentation and results of procedures performed by the bank, that the resultant relative diversification benefit is similar across the bank. 5. In case of differences across the bank in any of the above attest procedures, confirm and document through inspection that an explanation for the presence of any apparent inconsistency is available and has been documented. 1. Through inspection of the Bank’s documentation and code used (where applicable) document that the factoring in of diversification benefits at a group-wide level or banking subsidiary level is done consistent with the AMA approval received. Risk measures for different operational risk estimates must be added for purposes of calculating the regulatory minimum capital requirement. However, the bank may be permitted to use internally determined correlations in operational risk losses across individual operational risk estimates, provided it can demonstrate to the satisfaction of the national supervisor that its systems for determining correlations are sound, implemented with integrity, and take into account the uncertainty surrounding any such correlation estimates (particularly in periods of stress). The bank must validate its correlation assumptions using appropriate quantitative and qualitative techniques. 7 Use of four data elements: Internal Loss Data (ILD) 7.01 Refer section 2.01 to 2.14 for criteria and attest procedures relating to BCBS paragraphs 178 to 191 178 191 7.02 Refer 3.04 196a Refer 3.04 procedures 4 and 5 relating to BCBS paragraph 196a 7.03 Refer 3.05 for criteria and attest procedures relating to BCBS paragraph 197 197 Refer 3.05 7.04 Refer 5.10 for criteria and attest procedures relating to BCBS paragraph 221 221 Refer 5.10 7.05 Inputs to the AMA model should be based on data that represent or the bank’s business risk profile and risk management practices. Internal loss data (ILD) is the only component of the AMA model that records a bank's 247 - Refer 2.01 – 2.14 Confirm that internal loss data (ILD) has been used in the operational risk measurement system (ORMS): to assist in the estimation of loss frequencies to inform the severity distributions to serve as an input into scenario analysis Page 14 of 24 Findings Management comment No. Criteria BCBS 196 Basel II Banks Act Reg. actual loss experience. ILD should be used in the operational risk measurement system (ORMS) to assist in the estimation of loss frequencies, to inform the severity distribution(s) to the extent possible and to serve as an input into scenario analysis as it provides a foundation for the bank’s scenarios within its own risk profile. Many banks have limited high severity internal loss events to inform the tail of the distribution(s) for their capital charge modelling. It is therefore necessary to consider the impact of relevant external data and/or scenarios for producing meaningful estimates of capital requirements. (BCBS 196, par 247). Attest procedures If only ILD is used in a particular cell to calculate capital, confirm and document that - - the bank has considered relevant external data and/or scenarios for producing estimates for the tail of the loss distribution the bank has considered the impact of relevant external data and/or scenarios for producing estimates for the tail of the loss distribution 7.06 A bank’s internal processes relating to the collection of loss data shall include an appropriate de minimis gross loss threshold amount for the collection of internal loss data provided that in order to ensure broadly consistent data collection between banks that adopted the advanced measurement approach for the calculation of their respective capital requirements relating to operational risk the Registrar may from time to time specify a minimum gross loss threshold amount. (Regulation 33(9)(d)(v)(C)) 179, 184 and 187 33(9)( d)(v)( C) Refer 2.01 and 7.01 7.07 A bank shall have in place duly documented procedures in order to assess the ongoing relevance of historical data, which documented procedures shall duly specify the situations in which judgment, scaling or other adjustments to internal loss data may be used, including the extent to which such judgment may be used and the officials who are authorized to make such decisions (Regulation 33(9)(d)(v)(B)(iv)) 178 and 179 33(9)( d)(v)(B )(iv) Refer 2.01 and 7.01 7.08 When a bank’s capital requirement in respect of operational risk is based on internal loss data, the said capital requirement shall be based on a minimum observation period of: 180 33(9)( d)(v)( D) Refer 2.01 and 7.01 (i) five years of data; or (ii) when the bank originally adopts the advanced measurement approach, subject to such conditions as may be specified in writing by the Registrar, a minimum observation period of less than five years of data, but in no case less than three years of data, irrespective whether the internal loss data is used to calculate or validate the bank’s measure of loss. (Regulation 33(9)(d)(v)(D)) 8 Use of four data elements: External Data (ED) 8.01 ED provides information on large actual losses that have not been experienced by the bank, and is thus a natural complement to ILD in modelling loss severity. Supervisors expect ED to be used in the estimation of loss severity as ED contains valuable information to inform the tail of the loss distribution(s). ED is also an essential input into scenario analysis as it provides information on the size of losses experienced in the industry. Note that ED may have additional uses beyond providing information on large losses for modelling purposes. For example, ED may be useful in 248 1. Confirm and document that AMA measurement methodology, policy documents and procedures: 2. contain the process for considering external loss data in the modelling process contain details on the impact of ED on Capital, where applicable contain details that the process is repeatable and commentary on the volatility caused by the use of ED, where applicable clearly distinguish between the use of consortium and public domain databases are approved Confirm through inspection of model documentation that the bank has considered the reputability of external data vendors used. Page 15 of 24 Findings Management comment No. Criteria BCBS 196 Basel II Banks Act Reg. Attest procedures assessing the riskiness of new business lines, in benchmarking analysis on recovery performance, and in estimating competitors’ loss experience. 8.02 8.03 While the ED can be a useful input into the capital model, external losses may not fit a particular bank’s risk profile due to reporting bias. Reporting bias is inherent in publicly-sourced ED and therefore focuses on larger, more remarkable losses. A bank should address these biases in their methodology to incorporate ED into the capital model. 249 As ED may not necessarily fit a particular bank’s risk profile, a bank should have a defined process to assess relevancy and to scale the loss amounts as appropriate. A data filtering process involves the selection of relevant ED based on specific criteria and is necessary to ensure that the ED being used is relevant and consistent with the risk profile of the bank. To avoid bias in parameter estimates, the filtering process should result in consistent selection of data regardless of loss amount. If a bank permits exceptions to its selection process, the bank should have a policy providing criteria for exceptions and documentation supporting the rationale for any exceptions. A data scaling process involves the adjustment of loss amounts reported in external data to fit a bank’s business activities and risk profile. Any scaling process should be systematic, statistically supported, and should provide output that is consistent with the bank’s risk profile. 250 1. Confirm and document that the bank’s documentation adequately describes how reporting biases in public domain databases are considered 2. If ED is used as a direct input in the capital modelling process, document and re-perform any adjustments made for bias on a sample of the data and compare the results with those obtained by the bank. 3. Where ED has been used as a direct input in the capital modelling process, confirm and document whether the bank has calculated the effect of bias adjustments on the capital model. 1. When a bank uses a scaling methodology confirm and document that: 2. the documentation describes the methodology as well as the endogenous and exogenous factors that are utilised The scaling factors used have been tested for appropriateness by management, either by statistical methods or benchmarking. Reperform the tests performed by the bank, for a sample of ORCs. (Sample selected will be the 10 ORCs with the largest individual contribution to the final capital number. Total sample selection should contribute no less than 50% to the final capital number) Compare results to those of the bank. When a bank uses a filtering methodology confirm and document that: The documentation is clear on the methodology for excluding events and all exceptions are clearly documented. The filtering criteria have been tested for appropriateness and re-perform the filtering methodology documented by the bank to confirm that the results are the same. When a bank does not use ED directly in the modelling process confirm and document that the bank has clearly indicated where in the AMA methodology ED is utilized to inform model inputs and that the bank demonstrates how the usage enables repeatable and robust modelling. 8.04 To the extent that little or no relevant ED exists for a bank, supervisors would expect the model to rely more heavily on the other data elements. Limitations in relevant ED most frequently arise for banks operating in distinct geographic regions or in specialised business lines. 9 Use of four data elements: Scenario data 9.01 The AMA of a bank requires the use of four data elements which are: internal loss data (ILD); external data (ED); scenario analysis (SA) and business environment and internal control factors (BEICFs). This section outlines the Committee’s expectations with respect to the use of these four data elements to produce a credible and robust estimate of the operational risk capital charge. 9.02 A robust scenario analysis framework is an important element of the ORMF. This scenario process will necessarily be informed by relevant ILD, ED and suitable measures of BEICFs. While there are a variety of integrated scenario approaches, the level of influence of scenario data within these models differs significantly across 251 1. Confirm and document that the methodology contains a process for the more extended usage of other elements of the AMA framework to compensate for a lack of ED. 235 1. Confirm and document that four data elements are being used; if not confirm and document that the documented bank policy explicitly outlines the rationale for this. 252 1. When a bank uses qualitative processes to inform scenario analysis with ILD, BEICF and ED, confirm and document that the bank’s process is documented The methodology is repeatable, through a walkthrough of the methodology, with commentary offered on whether governance is followed or not. the methodology contains a process for addressing biases Page 16 of 24 Findings Management comment No. Criteria BCBS 196 banks. Basel II Banks Act Reg. Attest procedures 2. When a bank uses quantitative and qualitative processes to inform scenario analysis with ILD, BEICF and ED, confirm and document through a walk-through that 9.03 9.04 The scenario process is qualitative by nature and therefore the outputs from a scenario process necessarily contain significant uncertainties. This uncertainty, together with the uncertainty from the other elements, should be reflected in the output of the model producing a range for the capital requirements estimate. Thus, scenario uncertainties provide a mechanism for estimating an appropriate level of conservatism in the choice of the final regulatory capital charge. Because quantifying the uncertainty arising from scenario biases continues to pose significant challenges, a bank should closely observe the integrity of the modelling process and engage closely with the relevant supervisor. 253 Scenario data provides a forwardlooking view of potential operational risk exposures. A robust governance framework surrounding the scenario process is essential to ensure the integrity and consistency of the estimates produced. Supervisors will generally observe the following elements in an established scenario framework: 254 1. Inspect and document that documentation for coverage on how the scenario analyses outputs are used in the capital model and contains justification for the chosen approach. For a sample of ORCs, re-perform the model using the same scenario results obtained and used by the bank. Compare results to those obtained by the bank.(See Section 4) 2. Perform a walk-through and document the rationale used by the bank in getting to their scenarios. (See 9.02). 1. Confirm and document that a policy for scenario analysis approved at a senior governance committee exists. 2. Confirm and document that the scenario analysis process and outputs are subject to the bank’s governance processes and structures, including various levels of review, challenge and approval. 3. Confirm and document that the scenario framework includes and utilises: A defined and repeatable process Background preparation of the participants in the scenario generation process Qualified and experienced facilitators with consistency in the facilitation process Representatives of the business, subject matter experts and the operational risk management function as participants involved in the process A structured process for the selection of data used in developing scenario estimates Documentation which provides reasoning and evidence supporting the scenario output An independent challenge process and oversight by the operational risk management function to ensure the appropriateness of scenario estimates A process that is responsive to changes in both the internal and external environment Mechanisms for mitigating biases inherent in scenario processes. Such biases include anchoring, availability and motivational biases. 4. Confirm and document that the bank uses scenario analysis and external data to assess exposures to high impact events and losses that may arise from multiple simultaneous operational risk events. 5. Confirm and document whether scenario analysis and external data policies and implementations support the assessment of high severity loss events, and that double counting does not occur as a result of using two mechanisms to assess large exposures. (a) A clearly defined and repeatable process; (b) Good quality background preparation of the participants in the scenario generation process; (c) Qualified and experienced facilitators with consistency in the facilitation process; (d) The appropriate representatives of the business, subject matter experts and the corporate operational risk management function as participants involved in the process; (e) A structured process for the selection of data used in developing scenario estimates; (f) High quality documentation which provides clear reasoning and evidence supporting the scenario output; (g) A robust independent challenge process and oversight by the corporate operational risk management function to ensure the appropriateness of scenario estimates; (h) A process that is responsive to changes in both the internal and external environment; and the process is documented the methodology contains a process for addressing biases the methodology is sensitive to internal and external changes The methodology clearly indicates any filtering criteria applied when including ILD, ED and BEICF, and also demonstrates the appropriateness of the filtering. (i) Mechanisms for mitigating biases inherent in scenario processes. Such biases include anchoring, availability and motivational biases. 10 Use of four data elements: BEICFs Page 17 of 24 Findings Management comment No. Criteria BCBS 196 10.01 The AMA of a bank requires the use of four data elements which are: internal loss data (ILD); external data (ED); scenario analysis (SA) and business environment and internal control factors (BEICFs). This section outlines the Committee’s expectations with respect to the use of these four data elements to produce a credible and robust estimate of the operational risk capital charge. 235 1. Confirm and document, through the review of developmental evidence, that four data elements are being used; if not documented bank policy should explicitly outline the rationale for this. (See 9.01) 10.02 BEICFs are operational risk management indicators that provide forward-looking assessments of business risk factors as well as a bank’s internal control environment. However, incorporating BEICFs directly into the capital model poses challenges given the subjectivity and structure of BEICF tools. Banks continue to investigate and refine measures of BEICFs and explore methods for incorporating them into the capital model. 255 1. When a bank uses BEICF directly in the model confirm by inspection and document that: the documentation is clear on the methodology utilised any weighting factors used have been tested for appropriateness, either by statistical methods or benchmarking That this testing has been performed correctly, through re-performance of quantitative statistical testing used by the banks The sensitivity in capital to changes in BEICFS is documented That the methodology for direct incorporation into the model is repeatable. 2. When a bank uses BEICF as an ex-post model adjustment confirm by inspection and document that: the process is documented The methodology is repeatable, through reperformance of quantitative aspects of the methodology, and a walk-through of qualitative aspects. the methodology produces capital adjustments that are sensitive to changes in BEICFs the methodology contains approved thresholds for adjustments Statistical methods and/or expert judgement that were utilized in the setting of thresholds are documented Statistical methods and/or expert judgement that were utilized in the setting of thresholds were performed correctly, through re-performance of quantitative aspects and a walk-through of qualitative governance. that the adjustments are back-tested against scenarios and ILD That the back testing has been performed correctly, through reperformance explicit regulatory approval was received to perform ex-post adjustment for regulatory capital purposes 3. When a bank does not use BEICF as a direct input or for model adjustments confirm by inspection and document that: The bank has documented the reason for not using BEICF directly in the model. The bank has clearly indicated where and how in the AMA methodology BEICF is utilized to inform model inputs The usage of BEICFs in other model input components is repeatable. Confirm and document the rationale used by the bank, and that these are included appropriately in the scenario analysis where needed. (See 10.03) 1. When BEICFs are not used as direct model inputs or for expost adjustments, confirm by inspection and document that BEICFs are used as inputs into the scenario analysis process. 2. Confirm by inspection and document that the scenario analysis policy details how BEICFs are used in scenario analysis. 10.03 BEICFs are commonly used as an indirect input into the quantification framework and as an ex-post adjustment to model output. Ex-post adjustments serve as an important link between the risk management and risk measurement processes and may result in an increase or decrease in the AMA capital charge at the group-wide or business-line level. Given the subjective nature of BEICF adjustments, a bank should have clear policy guidelines that limit the magnitude of either positive or negative adjustments. It should also have a policy to handle situations where the adjustments actually exceed these limits based on the current BEICFs. BEICF adjustments should be well-supported and the level of supervisory scrutiny will increase with 256 Basel II Banks Act Reg. Attest procedures Page 18 of 24 Findings Management comment No. Criteria BCBS 196 Basel II Banks Act Reg. Attest procedures the size of the adjustment. Over time, the direction and magnitude of adjustments should be compared to ILD, conditions in the business environment and changes in the effectiveness of controls to ensure appropriateness. BEICFs should, at a minimum, be used as an input in the scenario analysis process. 11 Use of four data elements: Combining elements 11.01 There are various ways that an AMA model can be constructed to effectively incorporate the four data elements. A bank should carefully consider how the data elements are combined and used to ensure that the bank’s operational risk capital charge is commensurate with its level of risk exposure. A bank should provide a clearly articulated rationale for their modelling choices and assumptions and conduct sufficient research and analysis to support their decisions. The approach adopted should also encourage ownership of the outcomes and be readily understood by the business. It is highly desirable that there is no disconnect between the measurement and the management of operational risk within the bank. The Committee recognises that operational risk modelling continues to evolve and encourages further investigation into the combination of the four data elements within AMA models. 257 The Range of Practice Paper recognises that “[t]here are numerous ways that the four data elements have been combined in AMA capital models and a bank should have a clear understanding of the influence of each of these elements in their capital model”. In some cases it may not be possible to: 258 & 259 11.02 1. When combining the inputs into the capital modelling process confirm by inspection and document that: The methodology contains the process for combining inputs That the methodology is repeatable, through performing a walk-through of the process employed, and re-performance of any specific quantitative methods used for combining the inputs. That the methodology contains reference on how modeller biases are limited and addressed The sensitivity in capital results due to changes in parameters that drive the data convolution process have been documented. The process of combining and weighting the data elements is documented 2. For a sample of ORCs, walk-through and document the combination and weighting of data elements into the model as documented by the bank, taking into account modeller biases. Where there are quantitative aspects of the combination, these should be re-performed. 3. Confirm through discussions with management that the Operational Risk capital numbers which are allocated to each ORC drive the Operational Risk behaviour of business units. 1. Confirm through inspection and document whether the role of each of the four elements in the model are documented. 2. Confirm through inspection and document that the impact on capital due to data elements used directly in the model can be explained and demonstrated, and that results are documented by management. 3. Confirm through inspection and document that the bank has assessed the impact of the different data elements, either through a using specific pieces of the data or assessing the impact of removing specific pieces of data on the overall capital value. Document and quantify these sensitivities. If this is not possible, then a walk-through of the methods used by the bank in developing their understanding of the impact should be performed. 1. Confirm through inspection and document that the capital modelling methodology and all associated documentation include sections that detail the methodologies used for the combination of the four elements in the modelling process and ensure that the applied methodology conforms to the documented methodology via inspection (a) Perform separate calculations for each data element; or (b) Precisely evaluate the effect of gradually introducing the different elements. While in principle this may be a useful mathematical approach, certain approaches to modelling may not be amenable to this style of decomposition. However, regardless of the modelling approach, a bank should have a clear understanding of how each of the four data elements influences the capital charge. 11.03 A bank should avoid arbitrary decisions if they combine the results from different sub-models within an AMA model. For example, in a model where internal and external loss data are modelled separately and then combined, the blending of the output of the two models should be based on a logical and sound statistical methodology. There is no reason to expect that arbitrarily weighted partial capital requirement estimates would represent a bank’s requisite capital requirements commensurate with its operational risk profile. Any approach using weighted capital charge estimates needs to be defensible and supported, for example by thorough sensitivity analysis that considers the 260 & 261 Page 19 of 24 Findings Management comment No. Criteria BCBS 196 Basel II Banks Act Reg. Attest procedures impact of different weighting schemes. The combination of data elements within the capital model can provide the opportunity for the development of an integrated and self-consistent modelling framework. However, there are significant challenges that banks will need to address when combining data elements (eg combining scenario data or ED directly with ILD). The combination of data elements should be based on a sound statistical methodology. The Committee will continue to monitor progress in the development of robust techniques to combine data elements. 12 Estimation of unexpected losses 12.01 Given the continuing evolution of analytical approaches for operational risk, the Committee is not specifying the approach or distributional assumptions used to generate the operational risk measure for regulatory capital purposes. However, a bank must be able to demonstrate that its approach captures potentially severe ‘tail’ loss events. Whatever approach is used, a bank must demonstrate that its operational risk measure meets a soundness standard comparable to that of the internal ratings-based approach for credit risk, (i.e. comparable to a one year holding period and a 99.9th percentile confidence interval). 667 12.02 Supervisors will require the bank to calculate its regulatory capital requirement as the sum of expected loss (EL) and unexpected loss (UL), unless the bank can demonstrate that it is adequately capturing EL in its internal business practices. That is, to base the minimum regulatory capital requirement on UL alone, the bank must be able to demonstrate to the satisfaction of its national supervisor that it has measured and accounted for its EL exposure. 669 (b) 13 13.01 Reg 33 (9) (e) (i) 1. Confirm and document through inspection of the Bank’s documentation and results produced by the Bank that the UL is the 99.9th percentile of the aggregated loss distribution. 1. In cases where the EL is excluded from the solvency requirement, confirm through inspection of the Bank’s documentation that specific regulatory approval was received to exclude EL from the solvency requirement. 2. Confirm and document through inspection of the Bank’s documentation and process for producing and communicating results that the EL is calculated periodically in line with the periodicity of capital estimation. 3. Confirm and document through inspection of the Bank’s documentation and code used (where applicable) that the EL is calculated using appropriate methods, for example the mean, median, or truncated mean of the loss distribution. 4. Confirm and document through inspection of the Bank’s documentation that an adequate motivation for the choice of EL calculation method is in place. 5. Confirm and document through inspection of the Bank’s documentation and communications that the EL is periodically compared to subsequent realised losses in order to assess the accuracy of the EL calculation. 6. Confirm and document through inspection of the Bank’s documentation that if actual losses and EL are not comparable over time, a sufficient explanation is available. 1. Confirm and document through inspection of the Bank’s documentation and code used (where applicable) that where allocation of capital is done, it is done using a risk-sensitive approach (as defined by management) that relates to the business areas impacted by the allocation. 2. Confirm and document through inspection of the Bank’s documentation and code used (where applicable) that allocation approaches are motivated and documented. Risk sensitive capital allocation As a minimum, a bank that wishes to adopt the advanced measurement approach for the calculation of the bank’s capital requirement in respect of operational risk shall demonstrate to the satisfaction of the Registrar that the bank’s measurement system is capable of supporting the allocation of economic capital for operational risk across business lines in such a manner that incentives are created to improve the risk management capabilities in each relevant business line. Reg 33 (9) (d) (i) (E) Page 20 of 24 Findings Management comment No. Criteria 14 Insurance modelling 14.01 A bank that adopted the advanced measurement approach for the calculation of the bank’s capital requirement relating to operational risk may recognise the risk mitigating impact of insurance, provided that the insurance provider BCBS 196 Basel II Banks Act Reg. Attest procedures Reg 33 (9) (f) (i) 1. Confirm and document through inspection of publically available information, that the insurance provider has a minimum rating of A, or equivalent, in respect of its ability to pay claims. Where not, confirm that the bank has received condonation from the SARB through inspection of the relevant SARB communication. 2. Document the relationship between the Bank and its insurance provider based on information made available by management, to confirm that the insurance provider is independent from the reporting bank, that is, a third party entity or institution, provided that when a bank obtains insurance through captives or affiliates the bank shall lay off its risk exposure to an independent third-party entity or institution. 1. Confirm and document through inspection of the Bank’s insurance policies that all insurance policies used in capital mitigation have an initial term of at least one year, provided that when an insurance policy has a residual term of less than one year appropriate haircuts should be in place to reflect the declining residual term of the policy. 2. Confirm and document through inspection of the Bank’s documentation and code used (where applicable) that insurance policies with remaining term of 90 days or less are excluded for capital mitigation purposes. 3. Confirm and document through inspection of the Bank’s insurance policies that insurance policies have a minimum notice period for cancellation of 90 days. 4. Confirm and document through inspection of the Bank’s insurance policies that the insurance policies do not contain any exclusions or limitations triggered by supervisory actions or, in the case of a failed bank, that preclude the bank, receiver liquidator from recovering for damages suffered or expenses incurred by the bank, except when an event occurs after the initiation of receivership or liquidation proceedings in respect of the bank, provided that the insurance policy may exclude any fine, penalty or punitive damages resulting from supervisory actions. 1. Confirm and document through inspection of the Bank’s documentation that the method for including insurance mitigation in the capital estimation is reasoned and documented by management. 2. Confirm and document through inspection of the Bank’s documentation and code used (where applicable) that the mapping of insurance cover to relevant model inputs or ORCs is justified by management. 3. Confirm and document through inspection of the Bank’s documentation and code used (where applicable) that any (A) Shall have a minimum rating of A, or the equivalent thereof, in respect of its ability to pay claims; (B) Shall be independent from the reporting bank, that is, a third party entity or institution, provided that when a bank obtains insurance through captives or affiliates the bank shall lay off its risk exposure to an independent third-party entity or institution, for example, through reinsurance, provided that the entity or institution that provides the re-insurance shall comply with the eligibility criteria specified in this paragraph (f) 14.02 A bank that adopted the advanced measurement approach for the calculation of the bank’s capital requirement relating to operational risk may recognise the risk mitigating impact of insurance, provided that the insurance policy – Reg 33 (9) (f) (ii) (A) Shall have an initial term of no less than one year, provided that when an insurance policy has a residual term of less than one year the bank shall make provision for appropriate haircuts that reflect the declining residual term of the policy, which haircut shall be equal to 100 per cent in respect of policies with a residual term of 90 days or less; (B) Shall have a minimum notice period for cancellation of 90 days; (C) Shall not contain any exclusions or limitations triggered by supervisory actions or, in the case of a failed bank, that preclude the bank, receiver or liquidator from recovering for damages suffered or expenses incurred by the bank, except when an event occurs after the initiation of receivership or liquidation proceeding in respect of the bank, provided that the insurance policy may exclude any fine, penalty or punitive damages resulting from supervisory actions. 14.03 A bank that adopted the advanced measurement approach for the calculation of the bank’s capital requirement relating to operational risk may recognise the risk mitigating impact of insurance, provided that the bank’s calculations relating to risk mitigation – (A) Shall duly reflect the bank’s insurance coverage (B) Shall be consistent with the Reg 33 (9) (f) (iii) Page 21 of 24 Findings Management comment No. Criteria BCBS 196 Basel II Banks Act Reg. actual likelihood and impact of loss used in the bank’s overall determination of its operational risk capital 14.04 Attest procedures insurance deductibles and claim discounts are correctly considered in the capital estimation. A bank that adopted the advanced measurement approach for the calculation of the bank’s capital requirement relating to operational risk may recognise the risk mitigating impact of insurance, provided that by way of appropriate discounts or haircuts, the bank’s methodology for the recognition of insurance shall duly capture – Reg 33 (9) (f) (vi) 4. Confirm and document through inspection of the Bank’s documentation and code used (where applicable) that the risk mitigating impact of insurance is modelled consistent with the likelihood and impact of losses used in the bank’s overall determination of its operational risk capital. 1. Confirm and document through inspection of the Bank’s documentation and code used (where applicable) that discounts (haircuts) are in place to recognize the following: a. The likelihood that the insurance claim will be repudiated by the insurer due to a contractual mismatch between the claim and the cover; b. The likelihood that the insurance claim will not succeed due to the bank either not lodging the claim or exceeding the maximum time period required to notify claims to the insurer; c. In case the claim is contractually valid, the likelihood that the insurer will not be able to pay the claim; d. The time-value-of-money due to the time taken to receive the claim payment from the insurer; e. The residual term of the policy – if the residual term is less than one year, a discount should be applied which increases to 100% for a residual term of less than 90 days. 2. Confirm and document through inspection of the Bank’s documentation that the use of discounts and any exceptions to the use of the above discounts are motivated and documented. 1. In case the bank recognises the mitigating impact of insurance in respect of regulatory capital, confirm and document through inspection of the regulatory approval, that explicit regulatory approval was received to recognise insurance mitigation. 2. Confirm through inspection and document that the capital mitigating impact of insurance does not exceed 20% of the bank’s total Pillar I capital requirement in respect of operational risk, calculated in terms of the advanced measurement approach. This verification should be done considering capital pre- and post-inclusion of the insurance recoveries. The bank should quantify the impact of including the insurance recoveries or not. 1. Confirm and document through inspection of the Bank’s documentation and code used if model documentation is adequate to allow a suitably skilled person to replicate the model independently with minimal interaction with the model developer. 2. Obtain and inspect the Bank’s documentation and confirm, and document, that the following aspects are adequately documented: a. Choice and motivation of granularity in respect of ORCs; b. Approach to determine the data calculation set; c. Approach to determine distributional assumptions in respect of the four data elements; d. Approach to determine the aggregate loss distribution; e. Approach to model dependence; f. Approach to perform risk-sensitive capital allocation; g. Approach to model insurance mitigation; h. Approach to determine expected losses; i. Independent model validation report. 1. Inspect the bank’s documentation and confirm, and document, that the validation activities cover the following relevant items: a. Distribution assumptions; b. Correlation assumptions; c. Documentations; d. The four elements of the AMA, namely: o Internal loss data o Scenario data o External data (A) The insurance policy’s cancellation terms and residual term; (B) Any uncertainty of payment (C) Any mismatches in protection 14.05 A bank that adopted the advanced measurement approach for the calculation of the bank’s capital requirement relating to operational risk may recognise the risk mitigating impact of insurance, provided that the bank’s recognition of operational risk mitigation through insurance shall be limited to 20 per cent of the bank’s total capital requirement in respect of operational risk, calculated in terms of the advanced measurement approach. 15 Documentation 15.01 As a minimum, a bank that wishes to adopt the advanced measurement approach for the calculation of the bank’s capital requirement in respect of operational risk shall have in place a duly documented and robust approach for the measurement of the bank’s exposure to operational risk, which approach, amongst other things, shall ensure that the bank has in place rigorous procedures for the development of a robust operational risk model. 16 Validation Activities 16.01 The validation activity is designed to provide a reasoned and well-informed opinion of whether AMA models work as predicted, and whether their results (capital requirement estimates and other information produced by the ORMS) are suitable for their various internal and supervisory purposes. Reg 33 (9) (f) (vii) Reg 33 (9) (d) (iii) (A) 56 669 (e) Reg 33 (8) (b) (ii) (B) (i) (bb) Page 22 of 24 Findings Management comment No. Criteria BCBS 196 Basel II Banks Act Reg. Attest procedures Validation activities should: e. (a) Have a broad scope, evaluating all relevant items of the ORMS, such as: 16.02 Distributional assumptions; Correlation assumptions; Documentation; The four elements of the AMA Qualitative aspects (including the internal controls, use test, reporting, role of senior management and organisational aspects); Technological environment relating to the computational processes; and Procedures for the approval and use of new and modified estimation models or methodologies (such procedures should seek explicit opinion from the validation function in the approval process); (b) Evaluate the bank’s processes for escalating issues identified during validation reviews to ensure that: f. o BEICF Evidence that the AMA model is not only used for regulatory capital estimation i.e. use test; Technological environment relating to the computational processes. 56 666 (f) Reg 33 (8) (b) (ii) (B) (i) (bb) 1. Inspect the bank’s documentation and confirm, and document, the following regarding the escalating of issues identified during validation: a. Escalation processes are documented; b. Issues raised during the validation are considered and acted upon by senior management; c. Issues raised during the validation are escalated to the bank’s governance committees. Escalation processes are sufficiently comprehensive; All significant ORMS concerns are appropriately considered and acted upon by senior management; and All significant ORMS concerns are escalated to appropriate governance committees; 16.03 (c) Evaluate the conceptual soundness – including benchmarking and outcome analysis – of the ORMS and of the modelling output; 56 666 (f) Reg 33 (8) (b) (ii) (B) (i) (bb) 1. Inspect the bank’s documentation and confirm, and document, that the following elements of a soundness standard were assessed by the bank: a. The model development team’s staffed and skill complement; b. Appropriate modelling methods (as defined by the bank) are used, e.g. LDA; c. Appropriate model inputs (as defined by the bank) are used; d. Material aspects (as defined by the bank) of the model are benchmarked to peers and/or with other models; e. Model results are available at the 99.9th percentile of the aggregated loss distribution; f. Model validation is performed independently of model development; g. The model approval process includes challenge by technical specialists; h. Model results behave intuitively sound in relation to changes in model inputs and assumptions; i. The impacts of uncertain model inputs and/or assumptions are mitigated through conservative choices for these inputs and/or assumptions. 16.04 (d) Reflect policies and procedures to ensure that model validation efforts are consistent with board and senior management expectations. 56 666 (f) Reg 33 (8) (b) (ii) (B) (i) (bb) 1. Inspect the bank’s developmental evidence and confirm, and document, that model validation is done in accordance with policies approved by senior management. 2. Inspect the bank’s policies and confirm, and documents, that these policies were approved according to the agreed approval cycle, and by the appropriate governance committee(s). Reg 33 (8) (b) (ii) (B) (i) (bb) 1. Inspect the bank’s policies and procedures and confirm, and document, that the policies and procedures include the following critical elements of the validation process: a. Responsibilities for model development and validation; b. Model documentation; c. Validation procedures and frequency; d. Audit oversight. 16.05 (e) Assess whether policies and procedures are sufficiently comprehensive to address critical elements of the validation process. These include independent review; clearly defined responsibilities for model development and validation; model documentation; validation procedures and frequency; and audit oversight; 56 666 (f) Page 23 of 24 Findings Management comment No. Criteria BCBS 196 16.06 (f) Confirm that the relationship between the model’s inputs and outputs are stable and that the techniques underlying the model are transparent and intuitive. 56 17 Model Governance 17.01 The development, use and enhancement of the capital model should occur within the ambit of a formal governance process. Basel II 666 (f) Banks Act Reg. Attest procedures Reg 33 (8) (b) (ii) (B) (i) (bb) 1. Inspect developmental evidence and confirm, and document, that validation assessed the relationship between the model’s inputs and outputs. 2. Inspect developmental evidence and confirm, and document, that validation assessed whether the techniques underlying the model are transparent and intuitive. Through inspection of the work performed by internal audit or a similar independent function within the bank, confirm that the following has been performed: 1. 2. 3. 4. Inspect that the model methodology was subjected to challenge, for example a Technical Committee comprising of risk model specialists. Inspect that the model methodology was formally approved at a senior risk management committee. Inspect that an approved model development policy is in place. This policy should cover at least the following aspects: a. Model development is part of a formalised process which is independent from model validation and internal audit. b. The model should produce sufficiently predictive realistic capital estimates supported, for example, by motivation and/or evidence of the following: i. Capital estimates should be forwardlooking; ii. Idiosyncratic risk should be captured with adequate granularity; iii. Model parameters should be stable; iv. Results should be sensitive to changes in risk position; v. Should produce realistic capital estimates; vi. Should be technically sound; vii. Should be explainable. c. The continued appropriateness of the model should be monitored periodically. d. Model documentation should be sufficiently detailed to allow an unambiguous understanding of the model and its applicability. Inspect if relevant policies require the use of conservatism in cases where model assumptions and/or model inputs are uncertain. Inspect that the conservatism was applied in cases where model assumptions and/or model inputs are uncertain. Where the above procedures have not been performed internally by the bank, perform these procedures. Page 24 of 24 Findings Management comment