Why operational risk measurement remains important despite SMA

  • 28 September 2020

From their beginnings in 2001 and through Basel II, models to measure operational risk, such as those mandated by the advanced measurement approach (AMA), were positioned as both an effective method to calculate regulatory capital, and an incentive to operate good operational risk management practice.

SMA seemed to signal the end for capital models

By 2014, the Basel committee had proposed revisions to the standard approaches for calculating operational risk regulatory capital which also signalled an intent to end use of the AMA. An alternative approach based on a simple formula, and titled the standardised measurement approach (SMA), was published for consultation in 2016 to widespread criticism. By 2017 a final formula was published shifting the onus towards regional supervisors to decide on final implementations.

We are now more than four years on from the SMA proposal and the industry still lacks clarity on the final implementations in most jurisdictions and the final implementation date has been postponed until 2023.

Yet studies focused on capital as popular as ever

Despite this apparent death of the operational risk capital model, ORX has continued to see widespread interest in our capital benchmarking and methodology exercises with more than 80 firms participating in a study during the past four years.

Indeed, it seems increasing clear that models are not going away. The delay and uncertainty in SMA implementations has meant that firms still need to maintain and update their Pillar I models.

Furthermore, economic capital models appear to have increased in importance. This is in part because of their role in Pillar II in some jurisdictions, but also because of the myriad of other potential business uses of economic capital. The modelling team often have fewer constraints to contend with when developing their economic capital model – whether that be the chosen target percentile, the inclusion of insurance mitigation or the relevance of certain data points. More appropriate modelling assumptions means greater business buy in to the measure.

Firms moving away from the LDA, but to what?

ORX research has previously indicated that the loss distribution approach (LDA) approach is the accepted standard for modelling operational risk capital with scenarios playing a significant and an increasingly important role alongside. That said our most recent most recent CCAR study indicated that firms had moved away entirely from the approach for stress testing.

Challenges certainly remain with the approach (beyond the clear statistical problems resulting from the 99.9 requirement), such as selecting units of measure, selecting and filtering loss data, how to approach risk areas with little loss data, justifying correlation assumptions, adapting the model to legal entities.

There is a desire in the industry to understand how firms are meeting these challenges. Furthermore, there is an appetite to explore new ideas such as factor-based methods and scenario-based models and potentially lots more besides.

Given the known and accepted weaknesses of the AMA approach it makes sense to explore both current practices and new ideas and our upcoming capital methodology study provides an opportunity for firms to share ideas with their peers and validate their approaches. Now is the time for the industry to come together to agree on approaches that will satisfy regulators and work for the business.

Will the coronavirus pandemic impact capital?

Coronavirus has brought many challenges to the industry and the impact on losses and operational risk capital remains to be seen. Through the use of the ORX guidance for capturing losses resulting from the pandemic we will soon have an indication of the industry costs.

Whether this translates to a significant increase in operational risk capital is uncertain. Indeed as we observe an industry (and supervisory) shift from financial to operational resilience and if the operational risk losses do not turn out to be significant, the industry will potentially be questioning the benefit in holding operational risk capital for such events.