Today, hardly a bank in the world can put a solid value against the operational risks it is running. Only a few try, despite a growing focus on operational risk management.

But from 2004, all banks will be obliged to reserve specific amounts of capital against risks such as fraud, rogue trading, legal risk and computer crashes. From that date, many banks will begin attributing regulatory operational risk capital to particular business lines, while the most sophisticated will use their own track record of operational losses to help calculate their capital charges.

This, at least, is the vision laid out in the proposals for a new Capital Accord published by the Basle Committee on Banking Supervision. If it becomes reality, banks are likely to see the operational costs and risks of their various business lines in a different light.

But will it become reality in its present form? Unless the regulators pin down exactly what they mean in terms of loss types and business lines, and relate these to solid data on operational losses, they won’t be able to specify the risk weightings in the more sophisticated approaches they have proposed. It’s a concern acknowledged in the US interagency summary of the proposals.

Bankers who have worked to set up operational risk measurement systems in their institutions over the past year also have mixed feelings. New-York based Mark Balfan, senior vice president, market and operational risk management at Bank of Tokyo-Mitsubishi (BTM), welcomes the new proposals as a move in the right direction but says the new ideas won’t tailor the charge closely enough to the different loss profiles of banks around the world. "We feel at Bank of Tokyo-Mitsubishi that the distribution of our operational losses is quite different to that at many US and European banks," he says. He points out that, for example, banks in Asia tend not to suffer from the lawsuits that plague US banks.

He says elements of the regulators' proposals that could capture this kind of difference – sophisticated loss distribution modelling and a risk profile index – need to be fleshed out in much more detail over the next few months. The risk profile index, described in an annexe of the January 16 paper, is a mechanism that would measure the relationship between levels of expected and unexpected loss in a bank’s loss history, against the equivalent industry-wide statistics. The capital charge could be adjusted to take account of this variability so that the charge better reflected the true, or economic, risk of a particular bank.

Bankers are worried that if the regulators get the formulas wrong, the new charge will distort bank capital allocation and investment – and might even hamstring banks in their competitive battle with firms outside the regulated sector. But they are relieved that the regulators have backtracked on an earlier proposal to include business strategic risk and reputational risk in their capital calculations, and that they have hinted charges might be reduced for banks that take out insurance against operational risks. The biggest shift since the initial June 1999 proposals, they say, is that the regulators have embraced an “evolutionary” approach to measuring operational risk.

That evolutionary approach will allow banks to select one of three possible options to calculating regulatory capital. The simplest option is likely to mean calculating operational risk in terms of a fixed percentage of the gross income of an institution. But some banks will be allowed to define their risk in terms of a standard set of business lines linked to industry-wide operational risk statistics. And in the most sophisticated option on offer for 2004, the capital charge associated with each of the business lines will be driven, to some extent, by the loss history at the individual institution.

[Click here for ERisk’s summary of the three proposed options]

What will all this cost the banking industry? The regulators are indicating that operational risk will probably turn out to be a sizeable 20–30 per cent of regulatory capital. The final figure for each bank will depend on the calculation method used by the bank and how much of a safety margin the regulators set in their calibration of the calculation when they finalise their ideas later this year. But it will also depend, critically, on the relative risks, and risk weightings, of the various business lines in banks.

The regulators’ preliminary quantitative study suggests banks that have different business mixes will end up setting aside very different amounts of operational risk capital. Tucked away in the annexe of the supporting documents to the January 16 paper, the study suggests: “There is a very wide dispersion of operational risk capital charges for individual banks above and below the assumed industry average of 20 per cent of current minimum regulatory capital.” Some banks might end up having to hold more than twice the average amount of operational capital.

For some time, experts have been suggesting that value-at-risk and economic capital calculations ought to take into account the various risks posed to banks by their different business lines. But the new Basle proposals are likely to boost the industry’s awareness of the operational risk dimension. From the January 16 document, the capital-expensive business lines look like being trading and sales, retail banking, commercial banking, and payment and settlement. But as Simon Wills of the British Banker’s Association says: “While it’s clear there will be winners and losers, it’s not yet certain who they’ll be.”

Business lines such as asset management and retail brokerage – which are likely to have relatively light risk weights – aren’t necessarily jumping for joy. That’s because the existing Capital Accord implicitly charges capital for operational risk by overcharging for credit and, to a lesser degree, market risk. Under the new regime, with its specific operational risk charge, businesses weighted towards non-interest and fee-based income will have to start paying their way. That’s part of the reason the non-banking investment industry in Europe was such a vocal critic of the proposals this week.

If the regulators find themselves in a tight corner as the year-end deadline draws near, some in the industry worry that more judgment than analysis will creep into their setting of risk factors and risk weightings – particularly in their risk weighting of business lines. As one long-term operational risk analyst in London commented: “There will be a lot of devils in the details of these operational risk proposals. I hope by the time we identify them, we still have time to sort them out.”

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