Forward-looking and Incentive-compatible Operational Risk Capital Framework

Abstract

The Advanced Measurement Approach (AMA) to operational risk capital is vulnerable to gaming, complex, and lacks comparability. The Standardized Measurement Approach (SMA) to operational risk capital lacks risk sensitivity and is unlikely to be appropriately conservative for US banks. An alternative framework is proposed that addresses the weaknesses of these approaches by relying on an incentive-compatible mechanism to elicit forward-looking projections of loss exposure. JEL Classification: G21, G28, G32Keywords: Banking Regulation, Operational Risk, Regulatory Capital, Incentive Compatibility -IntroductionOperational risk comprises a large portion of US banks' capital requirements, accounting for 27% of risk-weighted assets (RWA) in December 2015. However, designing an operational risk capital framework has proved challenging for the Basel Committee on Banking Supervision (BCBS) and US banking regulators. Basel II's Advanced Measurement Approach (AMA) is now seen by many regulators and industry practitioners as unnecessarily complex and not providing enough value to business decisions. Also, regulators worry that AMA capital lacks comparability across banks and countries. Thus, to improve simplicity and comparability, the BCBS proposed an alternative framework, the Standardized Measurement Approach (SMA), wherein operational risk capital calculation would be fully standardized according to a regulatory formula. However, industry practitioners have criticized the SMA for lack of risk sensitivity and excessive calibration. This paper puts forward a set of properties that an ideal capital framework should meet: appropriate conservatism, robustness to gaming, risk sensitivity, comparability, stability, simplicity, and usefulness to risk management and advancement of risk quantification. The AMA and the SMA are evaluated relative to these properties, and both are deemed to have significant flaws. The AMA's main flaws are its vulnerability to gaming, lack of comparability, and complexity. The SMA's main flaws are its lack of risk sensitivity, particularly due to its lack of forward-looking perspective, and its possible lack of appropriate conservativeness, as a watering down of the previous SMA proposal may be needed to reach an international agreement.An alternative framework is proposed, the Forward-looking and Incentive-compatible Approach (FIA), which uses an incentive-compatible capital calculation mechanism to meet the seven desired properties. The FIA combines a backward-looking component, aimed to guarantee a minimum level of conservatism and comparability, with a forward-looking component based on banks loss projections, aimed to enhance risk sensitivity. The incentive-compatibility of the mechanism guarantees the framework is robust to gaming, thus allowing appropriate conservatism and risk sensitivity to be combined. The proposal is kept as simple as possible to achieve the other desired properties.The remainder of the paper is organized as follows: Section 2 describes the properties of an ideal ca...