No place for historical losses in APRA's plans for op risk capital
- 6 June 2019
In an industry consultation today, the Australian Prudential Regulatory Authority (APRA) set out its plans for adoption of the Standardised Measurement Approach (SMA) to Pillar I operational risk capital.
It is the first major regulatory body to clearly articulate its intentions on the SMA and may prompt other jurisdictions to follow suit.
No use of historical loss data or insurance
As was widely expected, APRA has chosen to not include historical losses within the SMA formula, meaning the capital levels are entirely based on the Business Indicator (BI). However, a recent Basel paper clarified the period over which “good quality” loss data can be used, suggesting there may still be appetite in some jurisdictions to use the loss component within the SMA calculation. By removing losses, the sole inclusion of insurance as an offset of historical losses has also been removed from the framework.
BI elements clarified
Much of the consultation provides welcome clarification on what is included and excluded from the calculation of the interest, leases and dividend component (ILDC), the services component (SC), and the financial component (FC) which are summed to provide the BI.
In the event of a merger or acquisition the paper states that aggregated components of the BI are used, and that subject to APRA’s approval, divested activities may correspondingly be excluded when calculating the BI. The recent Basel paper also clarified wording in the area of acquired businesses.
Implementation as early as 2021
Within the consultation a clear implementation timeframe of 1 January 2021 for AMA banks, and 1 January 2022 for non-AMA banks is given. Part of the reasoning for an early adoption by AMA banks is the concern that due to falling resources which are needed to maintain AMA models, the quality of the capital forecasts may be dropping.
Adapted for use in Australian Dollars
In a practical move, APRA has adapted the SMA to its native currency by translating the thresholds from Euros to Australian dollars. Thus, providing a stable calculation which is not influenced by fluctuating exchange rates. It did so by using a fixed exchange rate of 1.5, which is around 10% under the current levels of 1.63 AUD to 1 EUR. Due to the construction of the SMA, which assumes that relative risk increases with bank size, the lower than current rate will give comparatively conservative levels of capital for an equivalent bank working in EUR. A higher proportion of the BI will be subject to the increased percentages as dictated by the three BI buckets. At current exchange rates this effect is minimal, with a typical increase of around 1 per cent (figure 1). However future changes in the exchange rate of AUD to EUR can increase or decrease the effect.
Figure 1: Additional capital due to calculation using APRA (AUD based) thresholds in comparison to BCBS (EUR based) thresholds. The jump in the % is due to the bucket 3 thresholds not aligning due to the simplified rate of 1.5 used.
ORX is actively monitoring future regulatory developments as the intended implementation deadline of the SMA approaches.