Banks' Hands Tied as Basel Tightens Rules on Operational Risk

  • Global regulator set to scrap internal models for assessment
  • Basel's Ingves says rules `relatively neutral' on capital

Banks’ options for gauging the risk of incurring losses from events such as fraud, cybercrime and litigation are set to shrink as the Basel Committee on Banking Supervisiontries to stop firms gaming the rules.

The global regulator, whose members include the U.S. Federal Reserve and the People’s Bank of China, proposed scrapping an “unduly complex” internal model-based method for calculating so-called operational risk, which “has resulted in excessive variability in risk-weighted assets and insufficient levels of capital for some banks.” Instead, the Basel committee proposed a single standardized method for risk assessment.

A recent move by Banco Santander SA, Spain’s biggest bank, gives a sense of what’s at stake in Basel’s revamp. By altering the way it calculates operational risk at its Brazilian unit, Santander cut its risk-weighted assets by 7.8 billion euros ($8.5 billion), the lender said in its 2015 consolidated financial statement, and raised its common equity Tier 1 capital ratio by about 14 basis points, according to a spokesman.

“The proposals are an important step towards completing the post-crisis reforms during the current year,” said Stefan Ingves, chairman of the Basel committee. While the plan’s impact on bank capital should be “relatively neutral” on the industry overall, “it is inevitable that minimum capital requirements will increase for some banks,” he said.

Legal Risks

Operational risk describes the potential for losses from inadequate or failed internal processes, people and systems, including legal risks, and from external events. It accounts for about 15 percent of a typical lender’s regulatory capital. Costs resulting from misconduct claims against the world’s biggest banks added up to 206 billion pounds ($292 billion) from 2010 to 2014, according to the CCP Research Foundation, a London-based consultancy.

Banks must set aside funds to protect against the risk of such losses under global banking rules set by Basel. The current rules set out three standardized methods for calculating a bank’s capital charge for operational risk, as well as the “advanced measurement approach,” which allows the use of internal models subject to supervisory approval.

The new “standardized measurement approach” for operational risk will provide a risk-sensitive gauge and deliver consistency of results across banks and jurisdictions, the Basel committee said. This combines a so-called business indicator, “a simple financial statement proxy of operational-risk exposure, with bank-specific operational loss data,” the regulator said.

Excessive Variability

The question of how to model consistently for events that by their nature are rare and uncertain, such as misconduct or trading losses, is behind the proposal. William Coen, secretary general of the Basel committee, raised the possibility of eliminating internal models for operational risk in October, citing their lack of reliability and consistency.

The models banks have been allowed to use, instead of converging over time as best practice emerged, “have exacerbated variability in risk-weighted asset calculations and have eroded confidence in risk-weighted-asset capital ratios,” the regulator said.

Basel set a June 3 deadline for responses to its proposal. It plans to produce a study of the costs associated with the approach before publishing the final standard. 

Before it's here, it's on the Bloomberg Terminal. LEARN MORE