Impact of Operational Risk in Banking Essay


Standard Chartered Bank Ghana Limited Standard Chartered Bank Ghana Limited (SCBGL) is a 65% owned subsidiary of Standard Chartered Holdings (Africa) BV which, in turn is owned 100% by the Standard Chartered PLC of United Kingdom (UK). Standard Chartered Holdings (Africa) BV is incorporated in the Netherlands. SCBGL is a limited liability entity registered in Ghana on 18th September ,1970 pursuant to the Companies Code 1963 (179), under Certificate of Incorporation number 4576.

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Standard Chartered Bank Ghana Limited initially commenced its operations in the then Gold Coast in 1896, under the name of “Bank of British West Africa”. This was the first bank to be established in Ghana with a unique role in monetizing the economy whilst acting as the Central Bank of the then British colony. On Ghana’s attainment of independence in 1957, the bank’s name was change to “Bank of West Africa Limited”. In 1965, as a result of a merger with Standard Bank Limited (England), the name was further changed to “Standard Bank of West Africa Limited” and subsequently, “Standard Bank Ghana) Limited” (SCBGL, 2005). The Banking Industry of Ghana Currently, the banking system in Ghana consists of the central bank called the Bank of Ghana (BOG), 28 licensed (universal) banks and 124 rural banks. The rural banks are supervised by the ARB Apex Bank under the direction of BOG. According to the GBS Report (2008), 6 out of the 28 banks are currently trading on the Ghana Stock Exchange. They are Ghana Commercial Bank, SG-SSB Bank, Standard Chartered Bank Ghana Limited, Cal Bank, HFC Bank, and Eco Bank Ghana.

The Ghanaian banking industry through the universal banking license has created a level playing field and has opened the industry to high level of competition, innovation and entry of new banks. Between 2005 and 2007, seven banks entered Ghana’s banking industry. Two of them that obtained their licenses in 2007 are Bank of Baroda and Sahara Bank of Indian and Libyan nationality, respectively. The current ownership structures of banks in Ghana are made up of Ghanaians, British, Nigerians, South Africans, Malaysians, French, Indians and the Arabs.

Some of these banks have concentrated primarily on the retail segment while others have their focus on corporate clients. As at June 2008, the industry had registered a total of 15 foreign banks (non-Ghanaian banks) that are actively engaged in the banking business. The table 1 represents registered names and abbreviations, number of branches of licensed local and foreign banks operating in the banking industry (GBS 2008). Table 1: Local and foreign banks in Ghana Name| Abbreviation| Branch| Ownership| Agriculture Development Bank| ADB| 50| Ghanaian|

Amalgamated Bank Limited| ABL| 10| Non-Ghanaian| ARB Apex Bank(Rural banks)| ARB| 124| Ghanaian| Bank of Baroda| -| 1| Non-Ghanaian| Banque Sahelo-Saharienne | BSIC| 1| Non-Ghanaian| Barclays Bank of Ghana Ltd| BBG| 95| Non-Ghanaian| BPI Bank Limited| BPI| 7| Non-Ghanaian| Cal Bank Ghana Limited| CAL| 10| Ghanaian| Citi Bank Ghana Limited| -| -| Non-Ghanaian| Eco Bank Ghana Limited| EBG| 32| Non-Ghanaian| Fidelity Bank Limited| FBL| 6| Ghanaian| First Atlantic Merchant Bank| FAMBL| 4| Ghanaian| Ghana Commercial Bank| GCB| 136| Ghanaian|

Ghana International Bank Ltd. | -| -| Ghanaian| Guaranty Trust Bank| GTB| 3| Non-Ghanaian| HFC Bank Limited| HFC| 11| Ghanaian| Intercontinental Bank| Intercont. | 8| Non-Ghanaian| International Commercial Bank| ICB| 11| Non-Ghanaian| Merchant Bank Ghana Limited| MBG| 16| Ghanaian| National Investment Bank| NIB| 24| Ghanaian| Prudential Bank Limited| PBL| 10| Ghanaian| SG-SSB Ghana Limited| SG-SSB| 36| Non-Ghanaian| Stanbic Bank Ghana Limited| Stanbic| 10| Non-Ghanaian| Standard Chartered Bank| SCB| 19| Non-Ghanaian| The Trust Bank Limited| TTB| 13| Ghanaian|

Unibank Ghana Limited| UGL| 11| Ghanaian| United Bank of Africa| UBA| -| Non-Ghanaian| Zenith Bank| ZBGL| 8| Non-Ghanaian| | | | | Sources: BOG (2007) and GBS (2008) Databank (2006) observed that the re-energized Ghanaian banking sector has been characterized by ardent competition due to increasing sophistication of customers, globalisation, improvement in technology, banks ability to engage in universal banking and the entrance of new banks in the industry. These have resulted in product development, increased technology and emphasis on customer-friendly staff.

Product development, according to the publication, has assumed greater importance with banks rolling out products targeted at both the corporate and retail ends of the market. Information, Communication and Technology has become a critical success factor in the Ghanaian banking industry with investment at various levels of computerization and networking. Some new developments in the banking industry in terms of technology are computerized banking, telephone banking through the mobile phone, SMS banking, and internet banking.

Retail segment of banking has brought products and services closer to customers at school campuses, hospitals, shopping malls, and petrol stations. Service payment of utilities, payment of mobile phone unit transfers, payment of insurance fees and money transfers have characterised retail service delivery in the industry. Other electronic transactions such as e-cards, e-statements, credit cards, debit cards and visa cards have been widely introduced into commercial banking service delivery.

Competition is forcing the banks to dialogue and consider sharing service delivery platforms as a way of reducing cost and delivering more value to customers. EZI Cash is a common automated teller machine (ATM) platform shared by Ecobank, SCBGL and SG-SSB. The EZI Cash can be found at Shell filling stations and Nandos Food Courts. Some banks have also developed off site ATMs that can be found at petrol filling stations, hospitals, stadia and some market centers. This collaboration has moved some of these banks to higher level of total networking and service delivery irrespective of where the customer banks.

Increased competition and customer sophistication has also forced banks to pay attention to client needs through improved customer service and the introduction of products that meet the needs of customers. As such, banks are tailoring products to better suit the needs of retail and corporate clients. Some of the new products include mortgage loans, car loans, and asset management services. Customers are demanding good quality service like courtesy, reliability, and convenience from banks and as such banks are training their staff to produce excellent service delivery to their clients.

In addition, due to increasing competition in the industry, banks are bringing their services to the doorsteps of their customers thereby giving their customers the chance to be price sensitive in their search for value in terms of quality of service and interest rates. In order to satisfy the needs of their customers, the industry has witnessed the following: the extension of working hours from 3 pm. to 5pm; working on Saturdays; and half day during public holidays. Competition in the industry will continue to step up as banks compete to carve out niches for themselves (Gakpo, 2008)

Regulation of Banking Hull (2007) intimated that the central objective of governments all over the world is to provide sound and stable economic environments for private individuals and businesses to carry-out their business activities with utmost confidence and hope for protection in the systems of governance. One way they do this is by providing a reliable banking system where bank failures are rare and depositors are protected. Shortly after the disastrous crash of 1929, the US took a number of pragmatic steps to increase confidence in the banking system to protect depositors.

It created the Federal Deposit Insurance Corporation (FDIC) to provide safeguards to depositors in the event of a failure by a bank. It passed the famous Glass-Steagall Act that prevented deposit-taking commercial banks from engaging in investment banking activities. Deposit Insurance continues to exist in the US and many other countries today. However, many of the provisions of the Glass-Steagall Act in the US have now been repealed. There has been a trend worldwide toward the development of progressively more complicated rules on the capital that banks are required to keep.

Saidenberg and Schuermann (2003) discussed two sets of reasons often given for capital regulation in financial institutions and banks in particular. The first is the protection of consumers from exploitation by opaque and better informed financial institutions and for banking institutions; the objective is depositor protection. The second is systemic risk. Banks are often thought to be a source of systemic risk because of their central role in the payment systems and in the allocation of financial resources, combined with the fragility of their financial structure.

Banks are highly leveraged with relatively short-term liabilities, typically in the form of deposits, and relatively illiquid assets, usually loans to firms or households. In that sense, banks are said to be special and hence subject to special regulatory oversight. Saidenberg et al. (2003) further stated that, capital requirements are intended to mitigate the risks of adverse selection by ensuring that a bank has at least some minimal level of resources to honor its commitments to its customers.

Capital requirements are intended to mitigate moral hazard by ensuring that the owners of a financial institution have a stake in ensuring that the firm does not engage in fraud but rather conforms to sound business practices in accordance with business rules. To be effective in this role, capital requirements must be sensitive to the risks to which the institution is exposed. Hull (2007) described the performance of the banking industry and the financial sector at large as orming the basis of assessment and management of the economy in general. This is why governments all over the world commit so much of their nation’s resources to deepening the sector so as to achieve economic development and prosperity for their citizenry. It is in this vein that both local and international collaborations, continually fashion-out models and strategies for regulating the banking industry. As enshrined in Microsoft Students Encyclopedia (2007) “the foremost monetary institution in a free market economy is the central bank.

These are usually government-owned institutions, but even in countries where they are owned by the nation’s banks (such as Switzerland and the United States), the responsibility of the central bank is to the national interest. Most central banks perform the following functions; they serve as the government’s banker, act as the banker of the banking system, regulate the monetary system for both domestic and international policy goals, and issue the nation’s currency”. BOG (2006) has overall supervisory and regulatory authority in all matters relating to banking and non-banking businesses.

The purpose is to help achieve a sound, transparent, and efficient banking system in the interest of depositors, customers, institutions and the economy as a whole. The regulatory and supervisory frameworks within which banks, non-bank financial institutions, as well as forex bureaux operate in Ghana are guided by the following legal instruments: * Bank of Ghana Act 2002, Act 612, and Banking Act, 2004 (Act 673) * Banking Act 2007, Act 738 * Financial Institutions (Non-Bank) Law 1993, PNDC Law 328 * Companies Code Act 179, 1963 Mutual Funds Regulation 2001 L. I 1695 * Notices, Circulars, Regulation and Directives from BOG and other sub-sector regulators such as Ghana Stock Exchange, Securities and Exchange Commissions etc. Table 2 shows some notable key developments that occurred in the banking industry’s regulatory environment from 2003 to 2007. ————————————————- Table 2: Key developments in the banking industry 2003-2007 Year| Key Development| 2003| Universal Banking License was introduced; banks with ? 70 billion in apital permitted to carry out any form of banking. | 2003| Abolition of maintenance, transaction, and transfer fees charges by commercial banks. | 2004| The Banking Act 2004 (Act 673) which replaced the Banking Law 1989 (PNDCL 225). | 2006| Secondary deposits reserves requirement (15%) was abolished. | 2006| Foreign Exchange Act 2006 (Act 723) and Whistle Blowers Act 2006(Act 720). | 2007| Credit Reporting Act 2007 (Act 726) and Banking (Amendment) Act 2007 (Act 738). | 2007| Abolition of the National Reconstruction Levy. | 2007| Re-denomination of the cedi (? 0,000 = GH? 1)| Source: Ghana Banking Survey (2008) The Basel Accord The BCBS was established in 1974 as a sub-committee of the Bank for International Settlements (BIS). The main objective of the BCBS is the harmonisation of supervisory standards worldwide to strengthen the international banking sector. The 1988 Basel Capital Accord, or Basel I (BCBS 2001), which set minimum capital standards for internationally active banks, was really the first international accord of its kind. It succeeded at raising capital levels at a time when they were quite low.

Aside from defining what types of capital were eligible, Basel I set a capital ratio at 8% of risk-adjusted assets. It was the risk-adjustment of the assets which became the focus of concern and current regulatory reform resulting in the New Basel Capital Accord or Basel II (BCBS 2006). “Prior to 1988, bank regulators in different countries tended to regulate bank capital by setting minimum levels for the ratio of capital to total asset. However, definitions of capital and the ratios considered acceptable varied from country to country. Some countries enforce their regulations more diligently than others.

Banks were competing globally and a bank operating in a country where capital regulations were slack was considered to have a competitive edge over one operating in a country with a tighter more strictly enforced capital regulation. In addition the huge exposures of the major international banks to less developed countries such as Mexico, Brazil, and Argentina and the accounting games used to manage those exposures started raising questions about the adequacy of capital levels. Another problem was that the types of transactions entered into by banks were becoming more complicated.

The over-the-counter derivatives market for products such as interest rate swaps, currency swaps, and foreign exchange options was growing fast. These problems led supervisory authorities from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Sweden, Switzerland, the UK, and the US to form the Basel Committee on Banking Supervision. They met regularly in Basel, Switzerland, under the patronage of Bank for International Settlements. The first major result of these meetings was a document entitled “International Convergence of Capital Measurement and Capital Standards”.

This was referred to as “The 1988 BIS Accord” or just “The Accord”. More recently, it has come to be known as Basel I” (Hull 2007). Basel II, according to BCBS (2006), is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the BCBS. The purpose of Basel II, which was initially published in June 2004, is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and OpRisk that these banks face.

In practice, Basel II attempts to accomplish this by setting up rigorous risk and capital management requirements; designed to ensure that a bank holds capital reserves appropriate to risk exposure through its lending and investment practices (Gakpo, 2008). Schuermann (2006) as cited by Gakpo (2008) described Basel II as encouraging better and more systematic risk management practices and providing improved measures for capital adequacy for the benefit of supervisors and the marketplace as a whole.

At the outset of the process of developing the new Accord, the Basel Committee developed the three-pillar approach to capital adequacy. This involves the setting up of a minimum capital requirement, supervisory review of internal bank assessments of capital relative to risk, and an increased public disclosure of risk and capital information that is sufficient to provide meaningful market discipline. Although the Committee’s proposals have evolved considerably over the past several years, the fundamental objectives and the three-pillar approaches have been held constant

Pillars of Basel II Accord On July 4, 2006, BCBS released a comprehensive version of the Accord, incorporating the June 2004 Basel II Framework, the elements of the 1988 Basel 1 Accord that were not revised during the Basel II process, the 1996 Amendment to the Capital Accord to Incorporate Market Risks, and the November 2005 paper on Basel II (International Convergence of Capital Measurement and Capital Standards). No new elements have been introduced in this compilation. This version is now the most current version. The Basel 1 Accord dealt with only parts of each of three pillars.

For example: with respect to the pillar 1, only one risk, credit risk, was dealt with in a simple manner while market risk was an afterthought; operational risk was not dealt with at all (BIS, 2005). The three pillars of Basel II are as follows: (1) minimum capital requirements (addressing risk), (2) supervisory review and (3) market discipline to promote greater stability in the financial system. These pillars are illustrated in Figure 1 below. Pillar 1 MINIMAL CAPITAL REQUIREMENT Pillar 3 MARKET DISCIPLINE. Pillar 2 SUPERVISORY REVIEW PROCESS Figure 1: The 3 Pillars of Basel II The First Pillar

The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces. These are credit risk, operational risk, and market risk. Other risks are not considered fully quantifiable at this stage. The credit risk component can be calculated in three different ways of varying degree of sophistication, namely (1) standardized approach; (2) Foundation “Internal Rating-Based Approach” (IRB); and (3) Advanced IRB. For operational risk, there are three different approaches: (1) basic indicator approach (BIA); (2) standardized approach (TSA), and (3) advanced measurement approach (AMA).

For market risk, the preferred approach is value at risk (Hull, 2007; Schuermann, 2007). The Second Pillar The second pillar deals with the regulatory response to the first pillar, giving regulators much improved tools over those available to them under Basel I. It also provides a framework for dealing with all the other risks a bank may face, such as systemic risk, pension risk, concentration risk, strategic risk, reputation risk, liquidity risk and legal risk, which the accord combines under the title of residual risk.

The Third Pillar The third pillar greatly increases the disclosures that the bank must make. This is designed to allow the market to have a better picture of the overall risk position of the bank and to allow the counterparties of the bank to price and deal appropriately. Implementation of Basel II One of the most difficult aspects of implementing an international agreement is the need to accommodate differing cultures, varying structural models, and the complexities of public policy and existing regulations.

Most senior managers determine their own corporate strategy, as well as the country in which to base a particular type of business, based in part on how Basel II is ultimately interpreted by various countries’ legislature and regulators (Hull 2007). Hull (2007), Basel II capital requirements apply to “internationally active” banks. In the United States there are many small regional banks and the US regulatory authorities have decided that Basel II will not apply to them. These banks will be regulated under what is termed Basel IA, which is similar to Basel I.

The larger regional banks implement Basel II as a signal to their shareholders that they manage risk in a sophisticated way. Research has revealed that, on September 30 2005, four (4) US Federal banking agencies (the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of Thrift Supervision) announced their revised plans for the implementation of the Basel II Accord by the USA.

On July 16, 2008 the federal banking and thrift agencies (Board of Governors of the Federal Reserve System; the Federal Deposit Insurance Corporation; the Office of the Comptroller of the Currency, and the Office of Thrift Supervision) issued a final guidance outlining the supervisory review process for the banking institutions that are implementing the new advanced capital adequacy framework of Basel II. The final guidance, relating to the supervisory review, is aimed at helping banking institutions to meet certain qualification requirements in the advanced approaches rule, which took effect from April 1, 2008 (BIS, 2008; Gakpo, 2008).

BCBS (Report No. 15) on International Developments in Banking Supervision, Bank for International Settlement revealed the establishment of the Committee of Banking Supervisors of West and Central Africa (CBSWCA) in Accra, Ghana in April 1994, composed of Heads of Banking Supervisors of Central Banks of 11 countries (Burundi, DR Congo, Cape Verde, Ghana, Guinea, The Gambia, Nigeria, Sierra Leone, Sudan and Rwanda) and three Banking Commissions from Central Africa (COBAC), Madagascar (CSBF) and West African Monetary Union (WAMU).

The Committee is following a time table agenda for the adoption and implementation of Basel II. Criticisms of the Basel II Accord Hull (2007), Basel II Accord has been subjected to much criticism as being too simple and somewhat arbitrary. Some researchers argue that it has economically marginalized banks in developing countries by restricting their access to credits or by making their access to credits more expensive. It is also observed that the current financial crisis which began in August 2007 is a revelation of the inadequacies of the current international banking rules.

Settling this matter will stay on the agenda of researchers in the field for years to come with the hope that a Basel II Accord (if any) might eventually emerge to the address the current challenges of Basel II. The table 4 contains 14 Regional Regulators of Basel II Accord. Each of the regional regulators consists of Heads of Banking Supervisors of Central Banks of member countries that operate within their own national boundaries. Table 4: Regional Regulators of Basel II 1.

Association of Financial Supervisors of Pacific Countries (AFSPC) 2. Group of French-Speaking Banking Supervisors| 3. The Association of Supervisors of Banks of the Americas 4. The Islamic Financial Services Board| 5. The Banking Supervision Committee of the ESCB 6. Offshore Group of Banking Supervisors (OGBS)| 7. Caribbean Group of Banking Supervisors 8. Regional Group on Banking Supervision of Transcaucasia| 9. Committee of European Banking Supervisors 10. Central Asia and the Russian Federation| 11.

Committee of Banking Supervisors of West and Central Africa 12. SADC Subcommittee of Bank Supervisors (SSBS)| 13. EMEAP Working Group on Banking Supervision 14. SEANZA Forum of Banking Supervisors| Source: BCBS (Report No 15). Defining Operational Risk Management Chorafas (2003) described operational risk management (ORM) in the banking sector as a key issue linked to the stability of the financial system. Unsound ORM practices governing bank lending played a central role in recent episodes of financial turmoil.

Sparrow (1999) defined the term ORM as “the systematic assessment and management of the trade-offs made between risk and opportunity to run an efficient and effective organisation”. The U. S Department of Transportation, Coastal Guard define the term ORM as: “a continuous, systematic process of identifying and controlling risks in all activities according to a set of pre-conceived parameters by applying appropriate management policies and procedures. This process includes detecting hazards, assessing risks, and implementing and monitoring risk controls to support effective, risk-based decision-making (Chorafas, 2003; Doerig, 2003; Hull, 2007; Sparrow, 1999). According to Moscadelli (2004), OpRisk has become an area of growing concern in banking. The increase in the sophistication and complexity of banking practices has raised both regulatory and industry awareness of the need for an effective operational risk management and measurement systems.

From the time of the release of the second consultative document on the New Capital Accord in 2001, BCBS has established a specific treatment for operational risk; as a basic component of the new framework represented by Pillar 1, which explicitly calls for a minimum capital charge for this category of risk. According to Muermann (2003), risk managers usually have a large set of management methods available, out of which the optimal combination is selected with the aim of maximising business value. Those methods include loss reduction, insurance within and outside of the company, or hedging.

Risk prevention and reduction seems to be the most appropriate management device with respect to OpRisk. The implementation of such internal management mechanisms is immensely powerful, particularly during times in which underlying risk patterns have not been thoroughly understood, sound risk models have not been developed, and large databases and control systems have not been constructed yet. Capital Regulation of Operational Risk In response to the problems related to risk management in the financial system, the banking industry called for regulatory bodies to address the overwhelming issues relating to OpRisk.

Therefore, regulators set out a framework on capital requirements involving methods of risk quantification (BCBS, 2003). However, the peculiarity of OpRisk not only questions the point of the regulatory objective to prevent systemic crises but also causes any quantification framework outlined by regulators to be extremely vague; disregarding the difficulties mentioned in risk measurement. As the amount of capital to be allocated relies on the validity of those quantification methods, any capital determination from outside may fail to address the specific risk causes and effects of different banks.

Regulatory capital requirement may have an adverse impact on risk taking behavior to provide a certain return on investors’ capital and thus cause additional operational losses. There is no evidence yet that capital allocation has avoided famous bankruptcies due to rogue trading or other OpRisk events (BCBS, 2003; Fountnouvelle, 2003; Hull, 2007; Moscadelli, 2004; Sundmacher, 2006). Baud, Frachot and Roncalli (2002) described Basel II Accord as bank capital regulation, specifically designed to better align regulatory capital to better manage OpRisk.

Measuring Operational Risk Muermann (2003), the accuracy of risk measurement methods crucially depends on the soundness of the risk model and the availability of data. Proper risk modeling requires a thorough understanding of recurrent patterns that underlie the risk under consideration. The appropriateness of those risk models is inherently linked to data availability and thus the occurrence of events. Incidents help to better understand underlying risk structures and also provide the ground for statistical testing of risk models.

Furthermore, the accuracy of risk models depends on the measurability of outcomes and thus goes hand in hand with a sound definition and understanding of effects. Calculating Operational Risk Moscadelli (2004), Basel II requires banks to meet a capital requirement for operational risk as part of an overall risk-based capital framework. The three distinct options for calculating OpRisk Capital charges are the Basic Indicator Approach (BIA), The Standardised Approach (TSA), and the Advanced Measurement Approach (AMA), reflecting increasing levels of risk sensitivity.

Sundmacher (2007) described Pillar I of the Basel II framework developed by the BCBS as dealing with the calculation of minimum capital requirements for operational, credit and market risk exposures in banks. The OpRisk capital charge under the BIA and the TSA is dependent on a bank’s GI level and distribution. Banks that wish to use the TSA or the AMA are required to fulfill a set of qualifying criteria, resulting in compliance costs for the bank. Both the Basic Indicator Approach (BIA) and the Standardised Approach (TSA) rely on the financial institution’s gross income (GI).

The BCBS (2006: 145) defines Gross Income as “the net interest income plus net non-interest income”. It is intended that this income figure is gross of operating expenses, provisions; income from insurance, realised profits or losses from the sale of securities in an institution’s banking book, and any irregular item. The BIA is the simplest approach and can be applied by all banks that either do not qualify for or are 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 institution’s annual three year average positive GI using the formula: KBIA = [? (GI1… n * ? )] / n, whereby GI1…. n denominates the amount of GI in those years over the three year horizon, in which the financial institution’s GI was positive and ? denominates the scaling factor, which is currently set at 15% (BCBS 2006: 145). The TSA is a more sophisticated approach compared to the BIA. In order to be eligible to use the TSA, a financial institution needs to fulfill a set of qualifying criteria.

A financial institution that uses the TSA is required to map its overall annual GI into eight business lines, which are predetermined by the BCBS. The GI of each business line is scaled by a fixed scaling factor, beta. Beta is determined by BCBS, and the value is contingent upon a business line’s riskiness. The BCBS identifies the following business lines and their respective betas (BCBS 2006:147-149) as shown on table 5. Table 5: Eight Business Lines and Beta Factors BUSINESS LINE| BETA FACTOR| Corporate Finance| 18%| Trading and Sales| 18%| Retail Banking| 12%| Commercial Banking| 15%|

Payment and Settlement| 18%| Agency Services| 15%| Asset Management| 12%| Retail Brokerage| 12%| Source: Hull (2007) A financial institution’s total operational risk capital is calculated as the sum of OpRisk capital calculation for each business line. The formula is mathematically represented as: KTSA = {? years1-3 max [? (GI1-8 * ? 1-8), 0]} / 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 retail banking and commercial banking.

The principles of the Alternative Standardised Approach are outlined in (BCBS 2006: 136), but are not relevant for further discussion in this paper. In contrast to the BIA, negative GI in one business line can be used to offset positive GI in other business 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 institution’s credit or market risk capital level. The most sophisticated approach is the Advanced Measurement Approach (AMA).

The AMA requires financial institutions to develop and implement their own measurement methodologies based on internal loss data and risk measurement systems. According to the BCBS (2001: 5-6), the rationale of providing institutions with such a high degree of flexibility is to allow the development of innovation. Connell (2006) summarily enumerated six stringent “qualitative standards” that a bank must meet to qualify it to use the AMA approach to calculate operational risk under Basel II, (Basel 2004, Section 666): 1. An independent operational risk management functions. 2.

An operational risk measurement system that is closely integrated into the day-to-day risk management processes of the bank. 3. Regular reporting of operational risk exposures to business units, senior management, and the Board, with procedures for appropriate action. 4. The operational risk management system must be well documented. 5. Regular reviews of the operational risk management processes/systems by internal and/or external auditors. 6. Validation of the operational risk measurement system by external auditors and/or supervisory authorities, in particular, making sure that data flows and processes are transparent and accessible.

The Basel Committee’s ‘Revised Framework for the International Convergence of Capital Measurement and Capital Standards’ on capital charges for Operational Risk under Basel II (Basel 2004) allowing “internationally active” banks to calculate regulatory capital using their own internal models under the Advanced Measurement Approaches (AMA) was to backed away from dictating explicit methodologies for calculating operational risk capital charges towards a more qualitative approach to the management of Operational Risk under the AMA approach (Connell, 2006).

Analysing Operational Risk Risk and Control Self Assessment (RCSA) is one important way in which banks try to achieve a better understanding of their OpRisk exposures. This involves the managers of those business units to identify OpRisk hazards based on questionnaires designed by senior management. In addition, a program for measuring and understanding OpRisk must be based on internally developed key risk indicators (KRIs). KRI is primarily, a selection of key performance indicators (KPIs) and key control indicators (KCIs).

KRI is very useful for the purpose of risk tracking. A forward looking approach also helps risk managers to become proactive in preventing OpRisk losses by observing and monitoring events happening to other banks. ORM process is a comprehensive system that includes creating an appropriate risk management environment, maintaining an efficient risk measurement, mitigating, and monitoring processes, and establishing adequate internal control arrangements and reporting frameworks (Doerig, 2003; Garcia, Laviada and Rodriguez, 2005; Hull, 2007).


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