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Operational Risk

Prof. b.p.mishra
XIMB
XUB

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Operational Risk Indicators
Employee sick days
Employee review & Grading for promotion
Staff Turnover
Failed background checks on employees
Above market returns
Transaction volume
Amount of Overtime worked
Investment in technology
System Downtime
Age of Hardware
Capacity to Usage ratio
Margin on Product
Level of training
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Definition

Operational risk is defined as the risk of loss resulting from


inadequacy or failure of a commercial banks internal control
processes, people, and systems or from external events, including
legal risk (e.g. prosecutorial or litigation risk or authority-imposed
fine as well as any loss stemming from out of court settlement
agreement, etc.) .

However, this type of risk excludes strategic risk and reputational


risk.

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Gross income

Gross income is defined as an income


from normal business operations of a
commercial bank, combining of two elements -
net interest income and net non-interest
income.

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Value equivalent to operational risk-
weighted asset
Value equivalent to operational risk-weighted asset
is defined as an amount that indicates a level of
operational risk which is calculated according to the
RBI guideline.

Such value is calculated with risk-weighted assets for


credit risk and market risk to derive at a minimum
capital charge which a commercial bank must maintain
to meet statutory requirements

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Three alternative calculation
approaches
Three alternative calculation approaches, that is :

The Basic Indicator Approach (BIA)


The Standardized Approach (TSA)
Advanced measurement approach (AMA)

whereby a commercial bank must choose a suitable approach


that is commensurate with its business complexity, risk exposure,
and operational risk management system.

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All approaches use gross income as a proxy in the
calculation of value equivalent to operational risk-weighted
asset, implying that a commercial bank with high gross
income shall have high operational risk.

Thus, a commercial bank shall have high value equivalent to


operational risk-weighted asset and shall thereby maintain
high capital charge for minimum requirement against high
operational risk.

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Basic Indicator Approach (BIA)
A commercial bank shall calculate minimum
capital base for operational risk equal to the
average over the previous three years of a fixed
percentage (a constant risk value at 15 percent) of
positive annual gross income.

Then, a commercial bank shall calculate value


equivalent to operational risk-weighted asset by
multiplying 12.5 with minimum capital base for
operational risk according to the formula below:

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ERWABIA 12.5 K BIA

K BIA
(GI i ..... n )
n
Where,
ERWABIA = Value Equivalent to operational risk-weighted asset under
BIA
KBIA = Minimum capital base for operational risk under BIA
GI1n = Annual gross income, (where positive), over the previous
three years
= Constant risk value, under BIA, equals to 15%
N= Number of years for which gross income is positive

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Banks are advised to compute capital charge for
operational risk Under the basic indicator approach:

a)Average of { Gross income* alpha} for each year


of the last three Financial year,
excluding years for negative or zero gross income.

b)Gross Income = Net profit (+)


Provisions and Contingencies (+)
Operating Expenses ()
certain items like
profit from revaluation of FA.

c) = 15%
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If the annual gross income for any given year is
negative or equal to zero, such income must be
excluded from the numerator and such year must be
subtracted from the total number of years in the
denominator.

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Calculation of Capital with respect to
Operationally Risk weighted Assets
For XYZ bank , The gross income for last three years are given as under
Rs 9000. crores March, 2014
Rs11000 crores March, 2015
Rs 4000crores March, 2016. Find out what is its
operationally risk weighted asset And what is the capital requirement
under BIA.

Answer- a) 15%* {(9000 +11000 +4000)/3}


= 1200 crore is the Operational Risk weighted Asset
b) Capital Requirement =
Rs 1200 crore x 12.5%
Rs 150 crores
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The Standardized approach
A commercial bank shall allocate gross income into
each business line .

- Business line classification based on attributes of


business activity comprises eight types of
business.

- Allocate gross income into the aforesaid eight


business lines. To ensure suitable and consistent
allocation of gross income in each business line .

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ERWASAOR 12.5 K SAOR
max (GI
year13
18 18 ),0
K SAOR
3
Where,

ERWA SA-OR= Value equivalent to operation risk-weighted asset


under TSA
KSA-OR= Minimum capital base for operational risk under TSA
GI1-8 = Annual gross income for each of eight business lines
1-8 = Constant risk value under TSA-which is assigned
a different value for each type of eight business lines

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Business line Type of business
1. Corporate Finance I. Corporate and government financing 18%
management
II. Merchant banking
III. Financial advisory services
2. Trading & Sales I. Sales 18%
II. Market making
III. Proprietary positions
IV. Treasury
3. Retail Banking I. Retail banking 12%
II. Private banking
III. Card services
4. Commercial Banking I. Commercial Banking 15%
5. Payment and I. Payment and Settlement 18%
Settlement
6. Agency Services I. Custody and trust 15%
II. Corporate Agency
7. Asset management I. Asset management 12%
8. Retail brokerage I. Retail brokerage 12%
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Business line Type of business Rs in
crores
1. Corporate Finance I. Corporate and government financing 18% 32
management
II. Merchant banking 53
III. Financial advisory services 8
2. Trading & Sales I. Sales 18% 76
II. Market making 9
III. Proprietary positions 41
IV. Treasury 321
3. Retail Banking I. Retail banking 12% 870
II. Private banking 65
III. Card services 15
4. Commercial Banking I. Commercial Banking 15% 984
5. Payment and I. Payment and Settlement 18% 142
Settlement
6. Agency Services I. Custody and trust 15% 7
II. Corporate Agency 63
7. Asset management I. Asset management 12% 532
8. Retail brokerage I. Retail brokerage 12% 31
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Type of business Rs in crores amount = 15%

I. Corporate and government financing 18% 32 5.76


management
II. Merchant banking 53 9.54
III. Financial advisory services 8 1.44
I. Sales 18% 76 13.68
II. Market making 9 1.62
III. Proprietary positions 41 7.38
IV. Treasury 321 57.78
I. Retail banking 12% 870 104.4
II. Private banking 65 11.70
III. Card services 15 2.70
I. Commercial Banking 15% 984 147.6
I. Payment and Settlement 18% 142 25.56
I. Custody and trust 15% 7 1.05
II. Corporate Agency 63 9.45
I. Asset management 12% 532 63.84
I. Retail brokerage 12% 31 3.72
I. TOTAL 467.22 70.08
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Basel III

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Shortcomings of Basel II
The main charge against Basel II is that it is precise risk
sensitivity that made it blatantly Procyclical.
In good times, when Market is doing well, Bank provides
more lending to borrowers
Since, borrowers are doing well, Basel II complied banks do
not require additional capital.as unexpected loss is not
severe.
On the other hand, in stressed times, when banks require
additional capital( high UL) and markets are averse to buy
shares issued by Banks
Where as Bank needs more capital in stress scenario
During the crisis, it was the failure to bring in capital when
under pressure that forced major international banks
insolvency, thereby triggering the world into recession

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Basel III is an enhancement of Basel II

Basel III represents an effort to fix the gaps in


Basel II

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Improving the Quality, Consistency
and
Transparency of the Capital Base

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BASEL III Capital Conservation Buffer
The capital conservation buffer
(CCB) is designed to ensure that banks
build up capital buffers during normal
times (i.e. outside periods of stress)
which can be drawn down as losses are
incurred during a stressed period.

Carry out the business in downturn

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BASEL II & III

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Additional Capital Requirement:
Basel III (India)

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Implementation

The Bassel III capital regulation has been implemented


from April,1, 2013 in India in phases
And it will be fully implemented as on March, 31, 2019.
Components of Capital
Total Regulatory Capital will consist of
the sum of the following categories:

(I) Tier 1 Capital

(a) Common Equity Tier 1 ( CET- 1)


(b)Additional Tier 1 (AT 1 )

(II ) Tier - 2 Capital (T 2)


Limits and Minima
REGULATORY CAPITAL As % of RWAs
I Minimum Common Equity Tier 1 Ratio 5.5
ii Capital conservation Buffer ( Compromising of Common Equity) 2.5
iii Minimum Common Equity Tier 1 plus CCB { I + ii } 8.0
iv Additional Tier 1 1.5
v Minimum Tier 1 capital Ratio [ i + iv ] 7.0
vi Tier 2 Capital 2.0
vii Minimum Total capital ratio ( MTC) [ v + vi) 9.0
viii Minimum Total capital Ratio plus Capital conservation Buffer 11.5
[ vii + ii ]

Banks should not issue Additional Tier 1 Capital to Retail Investors


Transitional Arrangement
MINIMUM APRIL MARCH MARCH MARCH MARCH MARCH MARCH
Capital 1 31 31 31 31 31 31
ratios 2013 2014 2015 2016 2017 2018 2019

CET 1 4.5 5 5.5 5.5 5.5 5.5 5.5


CCB - - - 0.625 1.25 1.875 2.5
MIN CET 1 + CCB 4.5 5 5.5 6.125 6.75 7.375 8
MIN TIER 1 6 6.5 7 7 7 7 7
CAPITAL
MINIMUM TOTAL 9 9 9 9 9 9 9
CAPITAL * (MMTC)
MMTC + CCB 9 9 9 9.625 10.25 10.875 11.5

*Phase in of all 20 40 60 80 100 100 100


deductions from
CET 1 in %
Capital Conservation Buffer -CCB

CCB is designed to ensure that banks build up


capital buffers ( Outside period of stress)
Which can be drawn down in losses are incurred during
A stressed period.
BASEL III: Countercyclical Capital Buffer
The purpose of countercyclical capital buffer is to achieve the
broader macro-prudential goal of protecting the banking
sector from periods of excess aggregate credit growth.

For any given country, this buffer will only be in effect when
there is excess credit growth that results in a system-wide
build up of risk. The countercyclical capital buffer, when in
effect, would be introduced as an extension of the capital
conservation buffer range
Additional 2.5% other T I Cap Ratio..2019

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When buffers have been drawn down,
One way banks should look to rebuild them
is through
Reducing Discretionary distributions of Earning.
Discretionary distributions of Earning

This could include:

Reducing dividend payments


Share Buybacks
Staff bonus payments.
Counter Cyclical Capital Buffer-CCB

CCB can be drawn only when a Bank faces a


SYSTEMIC or IDIOSYNCRATIC RISK.

A bank should not choose in normal times to operate


in the buffer range
to gain market share by adding Risk weighted asset.

It will help pro-cyclicality.


Minimum Capital conservation
standard for banks
CET 1 ratio after including the Minimum Capital conservation
current period Retain earnings Ratios ( Expressed as % of earnings)
5.5% - 6.125% 100%
> 6.125 - 6.75% 80%
>6.75 - 7.375% 60%
> 7.375 - 8.00% 40%
> 8. 00 0%

A bank with CET 1 capital ratio in the range of 6.125% - 6.75 % is required
to conserve 80% of its Earning in the subsequent Financial Year.
( Pay out not more than 20% in terms of Dividend, Buy-back, discretionary
Bonus payment is allowed)
Thanks

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