Under Basel II

Basel II

Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision...

, operational risk charges can be calculated by using one of the three methods (or approaches) that increase in sophistication and risk sensitivity: (i) the Basic Indicator Approach; (ii) the Standardised Approach; and (iii) Advanced Measurement Approaches (AMA).

Under AMA the banks are allowed to develop their own empirical model to quantify required capital for operational risk. Banks can use this approach only subject to approval from their local regulators. Once a bank has been approved to adopt AMA, it cannot revert to a simpler approach without supervisory approval.

Also, according to section 664 of original Basel Accord, In order to qualify for use of the AMA a bank must satisfy its supervisor that, at a minimum:

• Its board of directors and senior management, as appropriate, are actively involved in the oversight of the operational risk management
  Operational risk management
  The term Operational Risk Management is defined as a continual cyclic process which includes risk assessment, risk decision making, and implementation of risk controls, which results in acceptance, mitigation, or avoidance of risk...
  
   framework;
• It has an operational risk management system that is conceptually sound and is implemented with integrity; and
• It has sufficient resources in the use of the approach in the major business lines as well as the control and audit areas.

The Four Data Elements

According to the BCBS Supervisory Guidelines, an AMA framework must include the use of four data elements: (i) Internal loss data (ILD), (ii) External data (ED), (iii) Scenario analysis (SBA), and (iv) Business environment and internal control factors (BEICFs).

Loss Distribution Approach

While AMA does not specify the use of any particular modeling technique, one common approach taken in the banking industry is the Loss Distribution Approach (LDA). With LDA, a bank first segments operational losses into homogeneous segments, called unit of measure's (UoMs). For each unit of measure, the bank then construct a loss distribution that represents its expectation of total losses that can materialize in a one-year horizon. Given that data sufficiency is a major challenge for the industry, annual loss distribution cannot be built directly using annual loss figures. Instead, a bank will develop a frequency distribution that describes the number of loss events in a given year, and a severity distribution that describes the loss amount of a single loss event. The frequency and severity distributions are assumed to be independent. The convolution of these two distributions then give rise to the (annual) loss distribution.

See also

• Standardized approach (operational risk)
  Standardized approach (operational risk)
  In the context of operational risk, the standardized approach or standardised approach is a set of operational risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions....
  
  
• Basic indicator approach
  Basic indicator approach
  The basic approach or basic indicator approach is a set of operational risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions....
  
  
• Basel II
  Basel II
  Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision...
  
  
• Operational risk
  Operational risk
  An operational risk is, as the name suggests, a risk arising from execution of a company's business functions. It is a very broad concept which focuses on the risks arising from the people, systems and processes through which a company operates...