Operational Risk

Under Basel 3.1, all existing Pillar 1 operational risk approaches (basic indicator approach, standardised and advanced measurement) are being replaced by a new standardised approach which aims to encompass a firm’s size, complexity and historic operational risk performance. the latter is dictated by the internal loss multiplier (ILM) calculation.

The expectation is that this, more sophisticated approach, is likely to increase Pillar 1 operational risk capital. The standardised approach is calculated as below:

The business indicator component (BIC) is equal to the sum of ILDC (interest, leases and dividend component), services component (SC) and financial component (FC). Items included are displayed in the table.

However, the PRA has decided to set the ILM to one. By setting the ILM to one the PRA are essentially trying to smooth the capital impact of the new requirements. This decision has the effect of neutering a key element of the new standardised approach to operational risk, its risk sensitivity.

Consequently, it is highly likely this will mean that firms will have to continue to hold heightened levels of Pillar 2 Operational Risk capital to compensate. It is worth noting that the PRA is not proposing to hardcode the ILM to one. Meaning that there is a possibility this figure will change in the future and essentially ‘turn on’ the risk-sensitive element of the standardised approach.

What banks should consider

The business indicator component (BIC) calculation is largely predicated on the correct application of balance sheet accounting definitions. Firms will need to perform a close analysis of the PRA’s proposals to ensure their inputs align to the regulatory expectations.

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