Fed paper stirs debate on new operational risk charge

Researchers offer academic justification for Basel's standardised measurement approach

Federal Reserve paper seeks to provide intellectual backing for SMA

A recent paper by two US Federal Reserve economists has sought to provide intellectual backing for the Basel Committee on Banking Supervision's proposed new operational risk capital charge, but industry practitioners dispute its findings.

The research tests certain features of the Basel Committee's standardised measurement approach (SMA), which was put forward in March as a replacement to all existing approaches to op risk. It is thought likely to proceed and is due to be finalised by the end of the year.

Op risk practitioners are largely unimpressed by the proposal. Compared with the advanced measurement approach (AMA), the own-models approach currently used by more sophisticated banks, the SMA would be less sensitive to risk and could encourage banks to game the rules, they argue.

The SMA is also expected to lead to higher capital charges. A recent study by the UK-based Operational Riskdata eXchange Association (ORX) found aggregate op risk capital requirements at 54 banks would have been €115 billion ($430 billion) greater in 2015 under the charge.

The authors of the recent research are Filippo Curti, an economist at the Federal Reserve Bank of Richmond, and Marco Migueis, principal economist at the Federal Reserve Board in Washington, DC. Migueis is the Fed's representative on the Basel Committee working group on operational risk and served as deputy lead on the SMA project.

Their paper, Predicting operational loss exposure using past losses, appeared on SSRN on April 8. In it, Curti and Migueis seek to provide evidence that historical losses are good predictors of op risk tail events. They conclude that combining historical losses with a measure of bank size is the best way of predicting future losses. "The results of this paper support the combination of size and loss metrics in the calculation of operational risk capital and can inform revisions to the SMA," the paper said.

Specifically, the economists found that each additional historical loss above $100,000 increased the ninety-fifth percentile of future annual op risk losses by around $4.6 million.

The assumptions that prior losses can help determine future losses, and that operational risk increases with bank size, are central to the SMA.

The SMA uses a revenue-based proxy of bank size called the 'business indicator' and combines this with a multiplier based on 10-year internal losses. The Basel Committee says the formula would make capital more comparable between different jurisdictions and institutions, but would also ensure it remains sensitive to risk through the inclusion of past losses.

Blaming gaming

Though the research homes in on loss frequency as the best predictor of tail events, the SMA uses average losses. The paper justifies the Basel Committee's choice by saying that using loss frequency could have led to the wrong incentives. "Requiring the use of frequency metrics to measure exposure can lead to undesirable incentives, as breaking loss events into smaller loss events or aggregating them into larger loss events would have capital implications," the paper said.

This suggests that the Basel Committee opted to use average losses to discourage banks from gaming the capital charge. But discarding a superior method due to such fears would be a mistake, says Luke Carrivick, head of research and analytics at ORX.

"It seems to be assuming the worst of banks, saying this would be the best solution, but we're not going to do it because we think that banks would manipulate the data," he says. "Who knows? They might do, but there might be other ways of enforcing that people do it properly rather than throwing away a good method."

The paper also examined whether or not size-based proxies were useful predictors of future operational losses. The existing simpler approaches to op risk capital use balance sheet-based proxies for size to estimate op risk capital. Under the Basel Committee's proposed SMA, the business indicator would perform a similar role.

Saying that the losses in the US are similar to the losses in Europe or in Brazil, at least for the largest exposure, is fallacious and misleading
Bertrand Hassani, Santander

The research did not test the business indicator directly, owing to a lack of available data, but instead tested some of its component parts. It found a significant correlation between net interest income and future op risk losses. This positive correlation between tail events and measures of size or income backs the SMA formula, the authors said.

The authors drew upon data collected from all 31 banks subject to the 2015 Fed stress test, also known as the Comprehensive Capital Analysis and Review (CCAR), as well as loss data collected by supervisors from 2000 to the present day.

Regional variations

Some practitioners reject the analysis. Bertrand Hassani, global head of research and innovation at Santander in London, says there is a limited relationship between historical and future op risk losses. But he says that using data from US banks to draw conclusions for other firms worldwide is wrong.

"Saying that the losses in the US are similar to the losses in Europe or in Brazil, at least for the largest exposure, is fallacious and misleading, as the [risk] generating processes are different," says Hassani.

He argues that the risks banks are exposed to differ greatly between jurisdictions, and says this isn't recognised by the SMA formula. "You cannot say that the conduct risk you have in the UK or the US is the same as what you could have in Spain. That's not true. You cannot generate universal rules. You need to have at least rules per risk category and per jurisdiction, because otherwise it's a one-size-fits-all and it's just inappropriate."

While ORX's Carrivick says the results for different jurisdictions could be similar, this may not necessarily be the case. "You would probably see something similar if you did this with other data, but that's not guaranteed," he says.

Alongside other op risk practitioners, Hassani co-wrote a piece of research in response to the Basel Committee's consultation that appeared on SSRN on June 2. The paper, co-authored by Ariane Chapelle and Gareth Peters of University College London, along with Pavel Shevchenko of the Commonwealth Scientific and Industrial Research Organisation of Australia, heavily criticises the Basel Committee's proposal.

Among other things, Hassani and his co-authors argue that the SMA could lead to capital instability, a reduction in risk sensitivity, an increase in risk-taking by banks and a sharp rise in op risk capital.