Committee clarify expected loss treatment for Basel II Operational Risk AMA

Paragraph 669(b) states: "Supervisors will require the bank to calculate its regulatory capital requirement as the sum of expected loss (EL) and unexpected loss (UL), unless the bank can demonstrate that it is adequately capturing EL in its internal business practices. That is, to base the minimum regulatory capital requirement on UL alone, the bank must be able to demonstrate to the satisfaction of its national supervisor that it has measured and accounted for its EL exposure." The paragraph forms part of a set of detailed criteria through which the BCBS describe the quantitative standards that will apply to internally generated operational risk measures for the purposes of calculating the regulatory minimum capital charge within the Advanced Measurement Approach.

The Operational Risk Subgroup of the Basel Committee Accord Implementation Group (AIGOR) has now issued a newsletter in which they try to provide some clarity on this and also provide greater consistency in the implementation of the AMA.

AIGOR highlight several issues which have been raised regarding the measurement and treatment of EL:

• Banks developing very different methods for determining operational risk capital with varying emphasis given to the calculation of expected losses relative to total capital.
• The limitation of establishing accounting reserves in respect of expected future operational risk losses in many jurisdictions.
• Data issues resulting from many banks only collecting historical operational risk losses exceeding a specified threshold.
• Limitations on the quality of data due to its being based on short time periods and including very few, if any, high severity losses (which can also dominate banks' historical loss experience).

To address these issues AIGOR has outlined four principles which they believe may facilitate consistent implementation and still leave sufficient room for appropriate discretion by national supervisors. These are:

1. For operational risk EL to be "measured" to the satisfaction of national supervisors, the bank’s measure of EL must be consistent with the EL-plus-UL capital charge calculated using the AMA model approved by supervisors. For operational risk EL to be "accounted for" to the satisfaction of national supervisors by means other than holding capital or establishing provisions, the bank must be able to demonstrate that the corresponding losses are highly predictable and reasonably stable, and that the estimation process is consistent over time.
2. The maximum offset for operational risk EL should be bounded by the EL exposure calculated by the bank's AMA model approved by supervisors. While many supervisors may interpret this maximum offset as a statistical measure of expected loss over the entire loss distribution, some supervisors may choose a more restrictive maximum offset.
3. Allowable offsets for operational risk EL must be clear capital substitutes or otherwise available to cover EL with a high degree of certainty over a one-year time horizon. Where the offset is something other than provisions, its availability should be limited to those business lines and event types with highly predictable, routine losses. Because exceptional operational risk losses do not fall within EL, specific reserves for any such events that have already occurred will not qualify as allowable EL offsets.
4. The bank is expected to clearly document how its operational risk EL is measured and accounted for, including how any EL offsets meet the conditions outlined above.

Full details are available in the document, "The treatment of expected losses by banks using the AMA under the Basel II Framework", available on the BIS website.