JURNAL OPRISK 1

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THE BASIC INDICATOR APPROACH AND THE STANDARDISEDAPPROACH TO OPERATIONAL RISK: AN EXAMPLE- AND CASE STUDY-

BASED ANALYSIS

Maike Sundmacher

Maike Sundmacher, School of Economics and Finance, University of Western SydneyLocked Bag 1797, Penrith South DC, NSW 1797, Australia,

Email: [email protected]


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THE BASIC INDICATOR APPROACH AND THE STANDARDISEDAPPROACH TO OPERATIONAL RISK: AN EXAMPLE- AND CASE STUDY-

BASED ANALYSIS

ABSTRACT

Pillar I of the Basel II framework developed by the Basel Committee on Banking Supervision(BCBS) deals with the calculation of minimum capital requirements for operational, credit andmarket risk exposures in banks. The BCBS proposes three increasingly sophisticated approachesto calculating operational risk capital. In order of increasing sophistication, these are the BasicIndicator Approach (BIA), the Standardised Approach (TSA) and the Advanced MeasurementApproach (AMA). The operational risk capital charge under the BIA and the TSA is dependenton a banks GI level and distribution. Banks that wish to use the TSA or the AMA are required tofulfil a set of qualifying criteria, resulting in compliance costs for the bank. The benefit would bea lower capital charge.

Our paper focuses on two distinct themes. In the first theme, we show that, based on ahypothetical example, banks with a particular GI distribution will not benefit from gradating fromthe BIA to the TSA.

In the second theme, we examine if the BIA and the TSA would have captured the operationalrisk build-up in the National Australia Banks between 2001 and 2004. These years relate to theperiod in which a cohort of traders engaged in fraudulent activities that resulted in foreignexchange trading losses of $360m. We find that while the TSA would have indicated such abuild-up, the BIA would have pointed towards a decline in the banks operational risk exposureand thus capital.

We are facing mixed results. While, dependent on a banks distribution of GI, the incentive forbanks to gradate from the BIA to the TSA might be marginal or non-existent, the approach wouldhave performed better as a predictor for the build up of operational risk in the National AustraliaBank.


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1. Introduction

In June 2004 the Basel Committee on Banking Supervision (BCBS) published a framework forthe international convergence of capital measurement and capital standards, known as Basel II.The framework was updated in November 2005 and a comprehensive version published in June2006. In the first pillar of the framework, the BCBS outlines methodologies for calculating

minimum capital requirements for financial institutions operational, credit and market riskexposures. In case of operational risk, the BCBS suggests three increasingly sophisticatedmeasurement approaches. In order of increasing sophistication, these are the Basic IndicatorApproach (BIA), the Standardised Approach (TSA) and the Advanced Measurement Approach(AMA). While the latter relies on a financial institutions internally generated loss data andinternally developed measurement and management methodologies, the former two are entirelypre-determined by regulatory authorities. The Basel Committee offers this range of calculationmethods with the intention that financial institutions seek to improve their risk managementsystems and procedures in order to meet the eligibility criteria for one of the more sophisticatedapproaches. 1 While improvements of risk management systems will incur development,implementation and maintenance costs for the institution, the resulting benefit would be a lowercapital charge.

In this paper, we show that a financial institution that initially uses the BIA might only marginallybenefit from moving to the next higher approach, the TSA. The benefits accruing from a lowercapital charge might be offset by the compliance costs associated with the fulfilment of Baselsqualifying criteria for the TSA. Further, the capital-saving in the TSA compared to the BIA willbe highly dependent on the business units in which the financial institution generates the bulk ofits GI. These issues are highlighted based on a hypothetical example. We further apply the BIAand TSA to annual report data of the National Australia Bank (NAB) to test if the approacheswould have indicated a built-up in the banks operational risk exposure over time.

The paper is structured as follows. The next section briefly summarises Basels methodologies tooperational risk capital calculations. In section 3 we illustrate the limited benefits that may arisefrom gradating from the BIA to the TSA dependent on a banks GI distribution across businesslines. In section 4 we summarise the operational risk losses that occurred at the National AustraliaBank between 2001 and 2004. We use the BIA and the TSA to examine if the capital chargeswould have captured a build-up in operational risk over this period. The final section concludes.

2. Basels Approaches to Calculating Operational Risk Capital

Both, the Basic Indicator Approach (BIA) and the Standardised Approach (TSA) rely on afinancial institutions gross income (GI). The BCBS (2006: 145) defines GI as net interestincome plus net non-interest income. It is intended that this income figure is gross of operatingexpenses, provisions, income from insurance, realised profits or losses from the sale of securitiesin an institutions banking book, and any irregular items.

The BIA is the simplest approach and can be applied by all banks that either do not qualify for orare not obliged by their regulator to use one of the more sophisticated approaches. In the BIA,operational risk capital is calculated as a fixed percentage of a financial institutions annual three-year average positive GI:

K BIA = [ (GI 1..n * )] / n ,

1 A financial institution with sufficiently advanced measurement systems would, subject to approval andinitial monitoring, move to the AMA immediately.


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whereby GI 1..n denominates the amount of GI in those years over the three year horizon, in whichthe financial institutions GI was positive and denominates the scaling factor, which is currentlyset at 15% (BCBS 2006: 145).

The TSA is a more sophisticated approach compared to the BIA. In order to be eligible to use theTSA, a financial institution needs to fulfil a set of qualifying criteria. 2 A financial institution that

uses the TSA is required to map its overall annual GI into eight business lines, which are pre-determined by the BCBS. The GI of each business line is scaled by a fixed scaling factor beta.Beta is determined by the BCBS, and its value contingent upon a business line's riskiness. TheBCBS identifies the following business lines and their respective betas (2006:147):

A financial institution's total operational risk capital is calculated as the sum of operational riskcapital calculated for each business line 3:

K TSA = { years1-3 max[ (GI 1-8 * 1-8 ), 0]} / 3

In contrast to the BIA, negative GI in one business line can be used to offset positive GI in otherbusiness lines, leading to an overall reduced capital charge. The overall capital charge, however,cannot be negative and thus cannot be used as a deduction from the financial institutions creditor market risk capital level.

The most sophisticated approach is the Advanced Measurement Approach (AMA). The AMArequires financial institutions to develop and implement their own measurement methodologiesbased on internal loss data and risk measurement systems. According to the BCBS (2001: 5-6) therationale of providing institutions with such a high degree of flexibility is to allow thedevelopment of innovation.

3. The TSA Conundrum

A bank has the choice of three approaches, the BIA, the TSA and the AMA. It is generallyassumed that financial institutions which move along the spectrum of approaches benefit from adecreasing capital charge. In addition, the use of one of the more sophisticated approaches isassumed to result in a better alignment of actual risks taken by the institution and the minimumcapital charge the institution is required to hold. Thus, financial institutions that use the BIA have

2 The qualifying criteria for the Standardised Approach are outlined in BCBS 2006: 148-149.3 With the permission of the national supervisor banks might be allowed to use an Alternative Standardised

Approach (ATSA). The ATSA differs from the TSA with respect to two business lines, namely RetailBanking and Commercial Banking. The principles of the Alternative Standardised approach are outlinedin BCBS 2006: 136, but are not relevant for the further discussion in this paper.


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an incentive to gradate to the TSA and, if justifiable based on its size and operations, to the AMAat a later point in time.

There may be circumstances, however, under which a bank would find a continuous use of theBIA advantageous. The beta levels for the different business lines in the TSA take the values oftwelve, fifteen or eighteen percent, compared to the single scaling factor (alpha) of fifteen percent

under the BIA. Subject to the nature of its businesses, a financial institution might generate thebulk of gross income (GI) in high-beta business lines, and only a small proportion in low-betabusiness lines. In such a situation, it is possible that the financial institution would need to hold ahigher regulatory capital level under the TSA compared to the BIA, despite the fact that its riskprofile has not changed. The institution would face little incentive to invest in the infrastructurenecessary to gradate to the TSA given the costs of such an investment would provide little returnin terms of capital relief. This point can be illustrated using a simple example. Table 1 shows theamount of capital a financial institution must hold at a minimum if it used the BIA for its capitalcalculations. We assume that the total three-year GI for the bank is $7.8m, of which $2.2m aregenerated in the first year, $2.6m are generated in year two and $3m in year three. The totalscaled GI is $1.17m, resulting in a capital charge for year four of $390,000.

Table 1: Capital under the Basic Indicator Approach

Year GI Alpha Scaled GI1 $2,200,000.00 15% $330,000.002 $2,600,000.00 15% $390,000.003 $3,000,000.00 15% $450,000.00Total GI $7,800,000.00 Total scaled GI $1,170,000.00

Let us assume that the same institution uses the TSA for its operational risk capital calculations.In this case the operational risk capital amount will depend on how GI is distributed acrossbusiness units. We illustrate how differences in GI generation impact on the minimum capitalrequirement. Table 2 shows the banks minimum capital charge if the bulk of GI is generated inlow-beta business lines.

Table 2: Capital under the Basic Indicator Approach: Focus on Low-Beta Business Lines

Year 1 Business line GI Beta Scaled GICorporate finance $205,000.00 18.00% $36,900.00Trading and sales $205,000.00 18.00% $36,900.00Retail banking $325,000.00 12.00% $39,000.00Commercial banking $305,000.00 15.00% $45,750.00Payment and settlement $205,000.00 18.00% $36,900.00Agency services $305,000.00 15.00% $45,750.00Asset management $325,000.00 12.00% $39,000.00Retail brokerage $325,000.00 12.00% $39,000.00Total GI $2,200,000.00 Total scaled GI $319,200.00

Year 2 Business line GI Beta Scaled GICorporate finance $255,000.00 18.00% $45,900.00Trading and sales $255,000.00 18.00% $45,900.00Retail banking $375,000.00 12.00% $45,000.00Commercial banking $355,000.00 15.00% $53,250.00Payment and settlement $255,000.00 18.00% $45,900.00


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Agency services $355,000.00 15.00% $53,250.00Asset management $375,000.00 12.00% $45,000.00Retail brokerage $375,000.00 12.00% $45,000.00Total GI $2,600,000.00 Total scaled GI $379,200.00


While total GI remains unchanged at $7.8m, the total scaled GI is marginally smaller at $1.1376mcompared to the BIA. The resulting capital charge in this scenario is $379,200, which is $10,800lower than the capital charge that was determined using the BIA. While the bank benefits from aslight capital relief, it is not guaranteed that this decrease is sufficient to at least off-set thecompliance costs incurred by qualifying for the TSA. Such an analysis would need to beundertaken on a case-to-case basis.

Table 3 shows the case of a financial institution for which GI is evenly distributed across businesslines. In this case the institution does not benefit from using the more advanced TSA as scaled GIand thus the resulting capital charges are the same under the TSA and BIA. The reason is that theaverage beta value of all business lines is equal to the fifteen percent scaling factor alpha used inthe BIA.

Table 3: Capital according to the Basic Indicator Approach: Even Distribution of

GI across Business LinesYear 1

Business line GI Beta Scaled GICorporate finance $275,000.00 18.00% $49,500.00Trading and sales $275,000.00 18.00% $49,500.00Retail banking $275,000.00 12.00% $33,000.00Commercial banking $275,000.00 15.00% $41,250.00Payment and settlement $275,000.00 18.00% $49,500.00Agency services $275,000.00 15.00% $41,250.00Asset management $275,000.00 12.00% $33,000.00Retail brokerage $275,000.00 12.00% $33,000.00

Total GI $2,200,000.00 Total scaled GI $330,000.00

Year 2 Business line GI Beta Scaled GICorporate finance $325,000.00 18.00% $58,500.00Trading and sales $325,000.00 18.00% $58,500.00Retail banking $325,000.00 12.00% $39,000.00Commercial banking $325,000.00 15.00% $48,750.00


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Payment and settlement $325,000.00 18.00% $58,500.00Agency services $325,000.00 15.00% $48,750.00Asset management $325,000.00 12.00% $39,000.00Retail brokerage $325,000.00 12.00% $39,000.00Total GI $2,600,000.00 Total scaled GI $390,000.00


In such a scenario, a bank might decide not to gradate from the BIA to the TSA to avoid thecompliance costs that arise from obtaining regulatory approval for the TSA. A counter-argumentwould be that a bank learns more about the risks it takes when refining its methodologies, whichmight result in more efficient management and better reputation. In Table 4 we show the case of afinancial institution that generates the bulk of its GI in high-beta business units.

Table 4: Capital according to the Basic Indicator Approach: Focus on High-Beta Business Lines


Year 2 Business line GI Beta Scaled GICorporate finance $375,000.00 18.00% $67,500.00Trading and sales $375,000.00 18.00% $67,500.00

Retail banking $255,000.00 12.00% $30,600.00Commercial banking $355,000.00 15.00% $53,250.00Payment and settlement $375,000.00 18.00% $67,500.00Agency services $355,000.00 15.00% $53,250.00Asset management $255,000.00 12.00% $30,600.00Retail brokerage $255,000.00 12.00% $30,600.00Total GI $2,600,000.00 Total scaled GI $400,800.00


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Due to the generation of the bulk of GI in high-beta business lines the overall scaled GI is higherat $1.2024m compared to the previous scenarios. The resulting capital charge for operational riskin year four is $400,800, which is $10,800 above the minimum capital level of $390,000calculated under the BIA. In this scenario, the institution is doubly-penalised. In addition to thecompliance costs resulting from the TSA approval, the institution faces a higher minimum capitalcharge.

We find that, dependent on the structure and income sources of a financial institution, the BaselCommittees aim to provide institutions with an incentive to move from the least sophisticatedBIA to the more sophisticated TSA in order to reduce capital cannot be necessarily validated. 4

4. Operational Risk Exposures at the National Australia Bank

4.1 Brief Summary of Losses

In January 2004 the NAB announced $A360m losses resulting from foreign exchange trading.The losses were attributed to the activities of a small cohort of individuals, David Bullen, LukeDuffy, Gianni Gray and Vincent Ficarra. After investigating the incident, it was found thatbetween 2001 and 2004 the traders took excessive risks in their trading activities and incurredlosses due to adverse market movements. The traders concealed their losses by 'smoothing' profitsand losses, stating incorrect dealer rtes for trades and entering into fictitious transactions. Despiteseveral reports that indicated significant control weaknesses in foreign exchange trading (PWC2004: 28-30) and extensive knowledge about previous operational risk losses suffered by theAllied Irish Banks in 2003 due to fraudulent behaviour in the banks trading department, NABdid not follow up on any warning signs. The losses were detected when a currency options deskemployee raised concerns about the activities in foreign exchange. The Australian PrudentialRegulatory Authority (APRA) responded to the losses by setting NAB's total capital ratio to tenpercent, two percent above the general regulatory requirement (APRA 2004: 8). The losses werelargely attributed to poor operational risk management.

4.2 Changes to NABs Corporate Structure During 1998 and 2004

During the observation period from 1998 to 2004 NAB changed its corporate structure threetimes. In 1998 the bank was divided into three major segments, these being Banking, Finance &Life Insurance, and Merchant & Investment Banking. Due to changes in the Australian

4 For further problems associated with the TSA see Sundmacher (2004).


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Accounting and the Financial Accounting Standards 5, from 1999 onwards banks were required todisclose the performance of their various operating segments. Thus, in 1999 NAB reported on thefollowing five major segments: Business & Personal Financial Services, Products & Services,Global Wholesale Financial Services, HomeSide, and Information Technology. However, in May2000 NAB re-organised itself into six major operating segments (NAB 2000: 67). The newoperating segments that were established were: Business & Personal Financial Services, WealthManagement, Wholesale Financial Services, Specialist & Emerging Businesses, HomeSide, andNational Shared Services. This structure was maintained in the financial years ending 2000 and2001. In January 2002 NAB underwent another re-organisation and decreased the number ofoperating segments back to five, namely Financial Services Australia, Financial Services NewZealand, Financial Services Europe, Wholesale Financial Services 6, and Wealth Management(NAB 2002: 86). 7 This structure has been maintained for the rest of the observation period.

In the remainder of this section we use annual report data to calculate hypothetical operationalrisk capital charges for the financial years ending 2001 up to and including 2005, i.e. those yearsleading up to and including the year of loss detection as well as the year succeeding the lossannouncement. As the BIA and the TSA use a banks average three-year GI as risk proxy tocalculate an operational risk capital charge for the following financial year, we require annualreport data for the financial years ending 1998 up to and including 2004.

4.3 Hypothetical Operational Risk Capital Charges for NAB under the BIA

In this sub-section we calculate hypothetical operational risk capital charges for NAB usingBasels BIA. We further introduce alternative risk proxies in order to assess how the banks GIcompares to other measures in relation to its capacity to predict a build-up in operational riskexposure.

Table 5 shows selected annual report data for NAB for the financial years ending 1998 to 2004.Gross income (GI) has been calculated in accordance with the Basel Committees definition itincludes net interest income plus other income, adjusted for irregular and extraordinary items.Operating expenses, insurance business, provisions and profits and losses from the sale ofsecurities in the banking book are omitted from this figure. Total revenue (TR) refers to theconsolidated entity, while total revenue Australia (TR-A) refers to the proportion of totalrevenue generated in Australia. It should be noted that total revenue was denominated GI in the1998 annual report, total operating revenue in the 1999 2001 annual reports and totalrevenue from there onwards. Trading income (TI) refer to the consolidated entity.

Table 5: Selected NAB Annual Report Data

NAB ($m) 1998 1999 2000 2001 2002 2003 2004Gross income (GI) 15,083 16,113 17,119 12,519 14,292 12,429 12,022Total revenue (TR) 19,380 19,629 24,040 26,185 16,521 25,658 30,184Trading income (TI) 360 457 468 721 563 625 575Total revenue

Australia (TR-A) 8,763 9,243 12,385 12,867 11,425 15,905 19,980

5 This change refers to the introduction of AASB 1005 Financial Reporting by Segments and SFAS 131Disclosures about Segments of an Enterprise and Related Information which became effective on 1October 1998.

6 The name of this operating segment was changed to Corporate & Institutional Banking in 2003.7 HomeSide was sold in 2002.


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Figure 1 shows the hypothetical operational risk capital charge the NAB would have had to holdover the years 2001 to 2004 using the BIA. We find that using the BCBS measure the minimumoperational risk capital charge would have fallen from 2001 to 2004. Using the banks GI asmeasurement basis hypothetical minimum operational risk capital would have steadily fallen from$2,415.75m in 2001 to $1,962.00m in 2004. 8 If NAB had used the BIA, not only would haveoperational capital at its lowest when the losses were detected in 2004, but the steadily fallingcapital charge would have further indicated that the banks operational risk exposure wasdecreasing over time, providing a false sense of security.

Figure 1: Hypothetical Operational Risk Capital under the BIA

Hypothetical Capital Charge: BIA

0500

1000

1500200025003000

35004000

2001 2002 2003 2004

Time

$ m

TR

GI

TR-A

TI

In addition to the hypothetical capital using GI as the measurement basis, Figure 1 showsoperational risk exposure trends using alternative risk measures, these being the TR, the TR-A 9 and the TI. In all three cases, we treated the measurement bases as alternative risk proxies,meaning that we formed the three-year average and scaled by the fixed scaling factor alpha offifteen per cent. All three indicators would have predicted increasing capital charges and thusincreasing operational risk exposures over time. Particularly interesting is continuous increase inthe TR-A.

4.4 Hypothetical Operational Risk Capital Charges for NAB under the TSA

In this sub-section we apply Basels TSA to annual report data of the NAB in order to assesswhether this approach would have better predicted the operational risk build-up in the bank. Inorder to use the TSA, a financial institution has to map its overall GI into eight pre-set businesslines. Due to the structure of annual reports, it is difficult for external readers to get an accuratepicture of the GI allocation across business lines. It is possible, however, to estimate thisallocation using data provided in the segment analysis of the annual reports. This approach allowsus to identify trends regarding the usefulness of GI and other risk proxies in assessing the banksoperational risk exposures under the TSA.

We mapped NABs overall GI into the eight business lines based on the mapping and principlesfor business line mapping as outlined by the BCBS (2006: 302-303). Obviously, the resultscannot be accurate due to limited publicly available data and further due to the different segment

8 The capital figures for 2002 and 2003 were $2,287.55m and $2,196.50m respectively.9 TR-A was included since the trading losses were incurred by traders operating in the banks Australian

division.


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reporting methods over the observation period. Notwithstanding, using different scenarios it ispossible to identify a trend in the overall hypothetical capital charge over time. Table 6, 8, 9, and10 show selected segment data for NAB from 1998 to 2004.

Table 6: Selected Segment Data for the Financial Years Ending 1998 and 1999

Total assets

Operating profit

after tax andoutside equityinterests

Total operating income

($m) 1998 1999 1998 1999 1998 1999 Banking 237,802 239,330 1,857 2,505 8,522 8,730Finance & Life Insurance 10,786 11,271 112 200 562 924

Merchant & Investment Banking 3,126 3,480 45 116 155 435

The Banking segment in Table 6 consists of three broad portfolios, being Global BusinessFinancial Services, Global Premium & Private Financial Services, and Retail Financial Services& Channel Management (NAB 1999: 16-17). Due to the limited information in the bankssegment analysis of the 1998 annual report, the year has been omitted in analysing thehypothetical operational risk capital charge under the TSA.

Table 7: Selected Segment Data for the Financial Year Ending 1999

($m) GI 10 Total revenue after

interest expenses Total assets Business & Personal Financial Services 7,053 7,280 141,492Products & Services 1,364 2,034 11,046Global Wholesale Financial Services 1,037 1,042 86,380

HomeSide 731 671 10,631 IT -13 545 302Other 517 623 4,230

Table 8: Selected Segment Data for the Financial Year Ending 2000

($m) GI 11 Total revenue afterinterest expenses Total assets

Business & Personal Financial Services 7,675 7,850 175,959Wealth Management 1,859 1,859 33,488Wholesale Financial Services 1,293 1,301 107,402Specialist and Emerging Businesses 1,325 1,530 12,369

HomeSide 576 576 13,151 National Shared Services -68 1,472 2,717Other 234 394 -1,409

Table 9: Selected Segment Data for the Financial Years Ending 2001 to 2004GI 1 Total revenue after interest expenses

($m) 2001 2002 2003 2004 2001 2002 2003 2004Financial Services 4,754 5,033 5,419 5,445 4,833 5,087 5,469 5,545

10 Due to limited data availability we define GI as net interest income plus non-interest income.11 Due to limited data availability we define GI as net interest income plus non-interest income.12 Due to limited data availability we define GI as net interest income plus non-interest income.


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AustraliaFinancial Services

Europe 3,145 3,262 3,136 2,833 3,202 3,415 3,265 2,970Financial Services New

Zealand 791 830 1,756 1,013 798 832 980 1,026Corporate &

Institutional Banking13

1,944 1,998 4,386 1,734 1,952 1,990 1,950 1,726Wealth Management 1,323 893 4,386 6,670 1,324 891 4,398 6,677Other 1,269 2,581 116 37 6,728 5,307 182 1,162

Based on the banks descriptions of business segments in the annual reports, we allocated beta-levels to be used under the TSA that best matched the pre-set business lines under Basel II. Theresults are shown in Table 10.

Table 10: Beta-Levels for NABs Business Segments and Corresponding Basel Business Lines Business Segment Allocated Beta Best match: Basel Business Lines Basel BetaBusiness & Personal FinancialServices

13.5% 1. Commercial Banking2. Retail Banking

15%12%

Corporate & Institutional Banking 17% 1. Commercial Banking2. Corporate Finance3. Trading & Sales

15%18%18%

Financial Services Australia 13.5% 1. Commercial Banking2. Retail Banking

15%12%

Financial Services Europe 13.5% 1. Commercial Banking2. Retail Banking

15%12%

Financial Services New Zealand 13.5% 1. Commercial Banking2. Retail Banking

15%12%

HomeSide 12% Retail Banking 12%IT (1999) 12.89% N/A N/ANational Shared Services (2000) 13.795% N/A N/AOther (1999) 12.89% N/A N/AOther (2000) 13.795% N/A N/AOther (2001) 11.91% N/A N/AOther (2002) 11.98% N/A N/AOther (2003) 12.63% N/A N/AOther (2004) 11.93% N/A N/AProducts & Services 15% N/A N/ASpecialist & Emerging Businesses 15% 1. Commercial Banking

2. Retail Banking (card services)3. Trading & Sales

15%12%18%

Wealth Management 12% Asset Management 12%

As the segment Business & Personal Financial Services comprises both, elements of commercialand elements of retail banking we apply an average beta of 13.5%. This assumes that GI in thissegment is evenly distributed, a necessary assumption as there is no detailed data availableregarding the actual GI generation within the segment. The same applies to the business segmentsFinancial Services Australia, Financial Services New Zealand, and Financial Services Europe.

We calculate the beta level for the segment Corporate & Institutional Banking in the samemanner. In this case, based on the information provided, the products & services offered in this

13 This business unit was called Wholesale Financial Services in the financial year ending 2001.14 The data for this segment also corresponds to the segment Global Wholesale Financial Services in the

financial year ending 1999 and Wholesale Financial Services in the financial year ending 2000.


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segment consist of a mix of commercial banking, corporate finance and trading & sales activities.Thus, we apply a weighted average beta of 17%, again assuming that the GI generation is equallydistributed. Similarly, we derive at a beta level of 15% for the Specialist & Emerging Businessessegment, which comprises elements of the commercial banking, retail banking, particularly cardsservices, and trading & sales business lines described in Basel II.

There is no information provided regarding the business segment Products & Services. Thus wesimply assume the middle-risk beta level of 15%, which would also be applicable under the BIA.The business segments IT, National Shared Services and Other are assumed to be support linesfor the remaining segments. According to the BCBS (2006: 303) any GI generated by supportlines needs to be mapped into those business lines that the ancillary segment supports. As this issubject to an institutions internal accounting methods, it is impossible for external parties to mapthese GI figures. For simplicity reasons we assume that the business segments use these ancillaryfunctions in line with the proportion of total GI generated in the respective business segment.Thus we calculate the respective betas based on the average beta levels of all business segmentsthat the ancillary unit supports in any given year.

Figure 2: Hypothetical Operational Risk Capital Charges under the TSA

Hypothetical Capital Charge: TSA

0

500

1,000

1,500

2,000

2,500

2002 2003 2004 2005

Time

$ m

GI

Total revenue afterinterest expenses

Figure 2 shows the hypothetical operational risk capital charges using the individual segment GIsas measurement basis. For comparison purposes we included the total revenue after interestexpenses. Due to aggregated data it was not possible to extract the individual segments interestexpense figures. Using approximated GI figures for NABs business segments, we find that thehypothetical operational risk capital charge would have increased over time, clearly indicating abuild-up in the banks operational risk exposure. It needs to be noted, however, that while the GIfigures are gross of operating expenses, provisions and irregular items, they are also gross of anyexpenses that do not qualify for one of these categories. The reason is that there is no break-downof segment expenses in the banks annual report. Thus the annual GIs and the resulting capitalcharges are likely to be overstated. In fact, depending on the behaviour of expenses acrossbusiness lines and over time we might be looking at a different trend for the calculated capitalcharge.

5. Conclusions

The BCBSs rationale for introducing three increasingly sophisticated approaches to thecalculation of operational risk capital is to create an incentive for banks to improve their riskmanagement and measurement methods while benefiting from lower capital throughout theprocess from gradating from the least to the most sophisticated measurement tool. In case ofmoving from the BIA to the TSA, there might be, however, little incentives for financial


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institutions to do so. We showed that the operational risk capital under the TSA compared to theBIA is smaller in only one of the three hypothetical scenarios that we discussed in section 3, thisbeing the case in which the focus of GI generation lies in the low-beta business units.

In section 4 we applied Basels BIA and TSA methodologies to actual annual report data of theNAB. As the losses that occurred at the NAB between 2001 and 2004 were classified as

operational risk losses, we assessed whether the Basels methodologies would have captured thebuild-up in the banks operational risk exposure over time. We found that, using the BIA, theinstitutions GI would have been a poor indicator for operational risk. In fact, it showed adeclining capital charge over time. We introduced benchmark figures all of which provided abetter indication of an operational risk build-up in the bank. The TSA, on the other hand, clearlyindicated an increasing operational risk exposure in the bank over the observation period. Therewere, however, problems in clearly identifying the GI levels for the eight pre-set business lines bythe BCBS and in establishing appropriate beta-levels for those business units that seemed toincorporate elements of more than one business line. A further problem arose from aggregatedinformation regarding segment expenses and from the several structural changes that NABunderwent from 1998 to 2004.

Due to NABs size and scope of operations the bank will be required to use the AMA for

calculating its operational risk capital. It is not possible to apply the AMA to annual report data asthe AMA are based on internally-gathered data, validated by external data and are further relianton internally-developed measurement methodologies. While the resulting hypothetical capitalcharges might have been more in line with the banks actual risk profile over the observationperiod and thus would have provided a better buffer once the losses were announced, one thing isfor sure: no matter whether the bank would have used the BIA, the TSA or the AMA to calculateoperational risk capital, the true sources of the operational risk losses would not have beendetected. All methodologies would have provided the institution with a re-active measure toabsorb losses once they were detected, but would have captured neither the traders fraudulentbehaviour, nor the control deficiencies in the bank.

REFERENCESAPRA (2004) "Report into Irregular Currency Options Trading at the National Australia Bank",

23 March.

BCBS (2001) Working Paper on the Treatment of Operational Risk, Bank for InternationalSettlements, Basel, September.

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JURNAL OPRISK 1

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Transcript of JURNAL OPRISK 1