The Basel Committee Perspective on Operational Risk (2024)

What is operational risk and how was it addressed?

Operational risk is all banking risk other than credit, interest rate, market, and liquidity risk. According to the Basel Committee, operational risk is “the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems, or from external events.” With complex products and systems in today’s markets, the Basel Committee decided sophisticated methods were appropriate, and introduced new approaches to operational risk with Basel II in 2004.

The Global Financial Crisis saw a huge spike in operational risk losses, with banks paying out over $400 billion in fines for misconduct since 2012. By 2016, the Basel Committee determined that bank developed-models were too complex and not comparable across entities or jurisdictions, and came up with a new non-model based approach combining the simplicity of basic revenue calculations with some adjustments for risk.

How is operational risk categorised?

Basel II set out seven categories of operational risk:

  • Internal Fraud
  • External Fraud
  • Employment Practices and Workplace Safety
  • Clients, Products and Business Practices
  • Damage to Physical Assets
  • Business Disruption and System Failures
  • Execution, Delivery, and Process Management

Basel II required banks to analyse eight business lines to create a risk matrix. These are commercial banking, retail banking, payments and settlement, agency services, trading and sales, corporate finance, asset management and retail brokerage.

How is operational risk mitigated?

Unlike the credit risk that emanates from lending or the market risk that emanates from trading, new operational risks are not acquired with a view to build revenue and profits. Operational risks can be more difficult to foresee and cannot be diversified, sold off, or hedged in the banking market. The only potential mitigation and pricing tool is insurance, which is only generally available in the form of property, business interruption, director and officer liability and employer liability insurance. Operational risk is a test of management and corporate governance. Focus is on internal processes, people, systems and external events.

What are Basel II's approaches to operational risk management?

Basel II allowed banks to use one of three approaches: the Basic Indicator Approach, the Standardised Approach and the Advanced Measurement Approach. Of all the approaches, the Advanced Measurement Approach required the most value judgment by the bank and therefore the most supervisory oversight, as it involved quantitative and qualitative inputs. Basel Committee guidance stated that in blending inputs banks must “avoid arbitrary decisions” and use a “logical and sound statistical methodology”. There was no one standard for AMA and capital allocation needed to be monitored and revised regularly.

Banks organised regular internal workshops to discuss operational risk, with managers completing risk scorecards by business line and event. Besides frequency and financial severity, factors such as reputation and employee retention and morale could be scored or assigned a “metric”. Risk management attempted to ensure it was asking the right people when calling for expert opinion. Depending on the bank’s culture, vested interest could bias and affect responses.

What is the next approach proposed by The Basel Committee?

In 2016, The Basel Committee proposed scrapping the existing approaches, replacing them with a new, single Standardised Measurement Approach. Basel complained about the “inherent complexity” of the old Advanced Measurement Approach, and its “lack of comparability from a wide range of internal models” which “exacerbated variability in risk-weighted asset calculations, and eroded confidence in risk-weighted capital ratios”.

The SMA is designed to “build on the simplicity and comparability of the standardised approach, and embodies the risk sensitivity of the advanced approach while promoting consistency and comparability.” The revised methodology combines a financial statement-based measure called the “Business Indicator” (BI) with each bank’s historical operational losses.

While the system-wide effect on capital requirements is largely neutral, some banks will have higher while others will have lower requirements. Some large banks will feel their investment in technology for, and expertise gained from, the old AMA approach is now wasted. Some medium and small banks may now need to spend more to collect historic operational loss data.

The Basel Committee Perspective on Operational Risk (2024)


What are the Basel Committee operational risks? ›

The Basel Committee defines operational risk in Basel II and Basel III as: The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk.

What are the important recommendations of Basel Committee in Basel Norms 3? ›

Basel III introduced a non-risk-based leverage ratio as a backstop to the risk-based capital requirements. Banks are required to hold a leverage ratio in excess of 3%, and the non-risk-based leverage ratio is calculated by dividing Tier 1 capital by the average total consolidated assets of a bank.

What are the Basel Committee recommendations on risk management? ›

Basel Committee consults on guidelines for counterparty credit risk management
  • Conduct comprehensive due diligence of counterparties both at initial onboarding and on an ongoing basis.
  • Develop a comprehensive credit risk mitigation strategy to effectively manage counterparty exposures.
Apr 30, 2024

What is the Basel II basic indicator approach operational risk? ›

The Basic Indicator Approach is an approach to calculate operational risk capital under the Basel II Accord, and uses the bank's total gross income as a risk indicator for the bank's operational risk exposure and sets the required level of operational risk capital as 15% of the bank's annual positive gross income ...

What are the 4 operational risks? ›

Operational risk is usually caused by four different avenues: people, processes, systems, or external events. For many aspects of operational risk, companies must simply try to mitigate the risk within each category as best as possible with the understanding that some operational risk will likely always be present.

What was the main risk of concern in Basel? ›

What Is the Key Weakness of Basel I? One of the primary concerns regarding Basel I was that minimum capital requirements were determined by analyzing only credit risk. This only factored in part of the variables that institutions could face. For example, in this framework, operational risk was ignored.

What are the main objectives of the Basel Committee? ›

To set and promote global banking regulation standards, monitoring their implementation. To exchange information on the banking sector, identifying the associated risks. To exchange experiences, approaches and techniques among supervisors and central banks.

What is the Basel summary? ›

The Basel Accords refer to a series of three international banking regulatory meetings that established capital requirements and risk measurements for global banks.

Why is Basel so important? ›

The Basel Accords were formed with the goal of creating an international regulatory framework for managing credit risk and market risk. Their key function is to ensure that banks hold enough cash reserves to meet their financial obligations and survive in financial and economic distress.

What is the basic principles of Basel Committee? ›

The Basel Committee formulates broad supervisory standards and guidelines and recommends statements of best practice in banking supervision; the purpose of the committee is to encourage convergence toward common approaches and standards.

What are the Basel principles of risk management? ›

The Risk Management Principles fall into three broad, and often overlapping, categories of issues that are grouped to provide clarity: Board and Management Oversight; Security Controls; and Legal and Reputational Risk Management.

What are the three pillars of Basel Committee? ›

The three pillars of Basel III are market discipline, Supervisory review Process, minimum capital requirement. Basel III framework deals with market liquidity risk, stress testing, and capital adequacy in banks.

What is the Basel Committee operational risk? ›

As part of the revised Basel framework,1 the Basel Committee on Banking Supervision set forth the following definition: Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events.

What are the 3 approaches to measure operational risk according to the Basel Committee? ›

According to the Basel Committee, there are three ways to measure operational risk: the basic indicator approach (BIA), the standard approach (SA) and the advanced measurement approach (AMA). Here we explain each of them.

What are the Basel II operational risk categories? ›

Basel II set out seven categories of operational risk:
  • Internal Fraud.
  • External Fraud.
  • Employment Practices and Workplace Safety.
  • Clients, Products and Business Practices.
  • Damage to Physical Assets.
  • Business Disruption and System Failures.
  • Execution, Delivery, and Process Management.

What is the Basel 3.1 operational risk? ›

The Basel 3.1 standards include a national discretion to neutralise the impact of historical internal operational risk losses by setting the ILM equal to 1. If this discretion is applied, then a firm's operational risk capital requirements would not be mechanically linked to its past loss history.

What are the types of risk in Basel norms? ›

Basel Norms Types

This Basel norm focused on credit risk. Credit risk arises when a borrower fails to repay a loan or meet contractual obligations. This norm defined the capital and structure of risk weights for banks. The minimum capital requirement was set as 8% of risk-weighted assets.

What are three 3 risks that covered under the Basel II in determining bank's capital adequacy standard? ›

Market discipline.

Basel II also mandated a standardized approach to how operational risk, market risk and credit risk are separated and quantified. Banks must meet minimum capital requirements against all three types of risk and exposures.

What are the operational risks of banks? ›

Operational risk losses from internal scams can stem from asset misappropriation, forgery, tax non-compliance, bribes, or theft. Fraud committed by external parties includes check fraud, theft, hacking, system breaches, money laundering, and data theft.

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