Operational Risk Capital Charge Calculation Methods– Basel – III

Operational Risk Capital Charge Calculation Methods– Basel – III

There are three methods to calculate the capital needed for operational risks in financial institutions. These are:

  • Basic Indicator Approach (BIA): This is the approach most financial institutions start with.
  • Standardized Approach (TSA): A more complex method.
  • Advanced Measurement Approaches (AMA): The most sophisticated and sensitive to risk.
  • Currently, financial institutions are required to use the Basic Indicator Approach.

Basic Indicator Approach Explained:

  • Capital for Operational Risk: This is calculated as an average of a fixed percentage of the institution’s positive annual gross income over the past three years. This fixed percentage is known as alpha (α), set at 15%.
  • Formula: KBIA = [Sum (GI1…n x α)]/n, where KBIA is the capital charge, GI is the annual gross income (when positive), and n is the number of years with positive gross income in the past three years.

Gross Income Definition and Components:

  • Gross income includes net interest income plus net non-interest income.
  • It should be:
  • Before any provisions or write-offs.
  • Exclusive of operating expenses and fees related to outsourcing.
  • Excluding reversals from previous years, disposal income from property, profits/losses from “held to maturity” securities, income from legal settlements, and other extraordinary items.
  • Not including income from insurance activities.

Calculation Steps:

  1. Calculate the average of Gross Income multiplied by alpha (15%) for the last three years, excluding years with negative or zero gross income.
  2. Determine Gross Income by adding net profit, provisions, contingencies, operating expenses, and then subtracting specific excluded items.
  3. Apply the alpha value of 15%.

Guidelines for Financial Institutions:

  1. While there are no specific criteria for using the Basic Indicator Approach, institutions should adhere to the Basel Committee’s guidance on managing operational risk and comply with risk management guidelines.
  2. After calculating the operational risk capital charge, this figure should be multiplied by 12.5 to arrive at the notional risk-weighted asset for operational risk.