Operational risk is one of three major risks being faced by the banks in addition to those in credit and market. Data at end-December 2014 indicated that the share of Risk Weighted Asset (RWA) assigned to operational risk was 9.0 per cent of the total RWA of the banking system, which is 1.7 times higher against market risk in the same time period (Financial Stability Report 2014, published by the Bangladesh Bank (BB), issue-5, June- 2015).
Hallmark, Bismillah group and Basic Bank scams have caused banks and regulators to treat operational risk as one of the most significant ones that the banks face. Banking businesses are becoming more multifaceted, rapidly changing, operationally intensive, and technology reliant. Banks have to measure and manage operational risk to be less susceptible to systemic problems.
Operational risk, as defined by the Bangladesh Bank (BB) following the guidelines of the Basel Committee on Banking Supervision (BCBS), is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. It includes legal risks and excludes strategic risks and reputational risks.
Operational risk charges are calculated following the three distinct options which are Basic Indicator Approach, Standardised Approach, and Advanced Measurement Approaches, reflecting increasing levels of sophistication in measuring risk sensitivity.
Presently, most of banks in Bangladesh are using Basic Indicator Approach (BIA) to measure operational risks as prescribed by the BB in line with the Basel III Guidelines. However, banks are encouraged by the BB to move to more advanced approach as they develop more sophisticated operational risk measurement systems and practices meeting the supervisory qualifying criteria.
Even though it is not mandatory right now to use Advance Measurement Approaches (AMA) for quantification and management of operational risk, banks in Bangladesh can gradually build capacity to use AMA. They can create loss database for managing risk and calculating capital requirement.
From a regulatory viewpoint, a loss database is expected to be comprehensive and contain several years' worth of data before it can be approved for use in the risk estimation process. The Basel III specifically requires a minimum of 3 years' data initially and 5 years for the AMA.
The systematic capture of clean and comprehensive data on losses is the single most important aim of an operational risk management system. Capturing losses is a prerequisite to measuring them.
Creation of loss database by bank will provide following opportunities/benefits:
• n Loss database works as a platform for building capacity for graduation from BIA to AMA of operational risk management.
• n Facilitates mapping of business lines in accordance with the Basel -III guidelines;
• n Allows banks to identify source of operational losses;
• n Assists in tracking business 'risk event' in line with mapped business line;
• n Provides a framework for modelling extreme events;
• n Makes it possible for banks to compare their loss experience across business lines, and for supervisors to compare loss experience across banks;
• n Helps in identifying most risky business area the bank is operating in;
• n Delivers internal and external loss data to risk engine for modelling and capital calculation;
• n Mapped business line-wise loss data can be used to calculate risk weighted asset for measuring operational risk;
• n Allows banks to identify operational loss outcomes that they have exposure to, but have yet to experience;
• n Helps in taking corrective measures to prevent from happening of operational loss event;
• n Helps in assigning role and responsibilities to the business line manager to manage and control operational risk;
• n Keeps record of loss event that takes place in the bank;
• n Helps to recover amount of loss immediately once it happens;
• n Facilitates reporting of operational risk event to the proper authority;
• n Creates awareness among employees regarding operational risk event;
• n Helps to ensure better risk control;
• n Helps incorporate the quantification of "risk reduction" into the decision-making process and
• n A loss event can be linked to risks, controls, audit findings, regulations and policies.
For creating loss database, all the business activities of the banks have to be divided into following eight business lines as prescribed by the BB through the Basel III Guidelines: (i) Corporate Finance, (ii) Trading and Sales, (iii) Retail Banking, (iv) Commercial Banking, (v) Clearing, (vi) Agency Services, (vii) Asset Management, and (viii) Retail Brokerage. It is mentionable that the same aspects are also echoed in the DOS Circular Letter No. 13, dated September 09, 2015 (Annexure-1) where banking operations are being divided into nine business lines. It is to be mentioned here that private banking is separated from retail banking in the circular which was combined earlier.
Side by side, operational loss events should be segregated in seven operational risk events, i.e. (i) Internal Fraud, (ii) External Fraud, (iii) Clients, Products, and Business Practices, (iv) Employment Practices and Workplace Safety, (v) Damage to Physical Assets, (vi) Business Disruption and System Failure, and (vii) Execution, Delivery, and Process Management. Within each business line, gross income is a broad indicator that serves as a proxy for the scale of business operations and thus the likely scale of operational risk exposure within each of these business lines. The capital charge for each business line is calculated by multiplying gross income by a factor (denoted Beta) assigned to that business line.
If business lines mapping and operational risk event types are defined as mentioned above, banks will be able to collect loss data from each business line and report the same to the central bank. Consequently, the business line-wise loss data will help to identify control weakness and risk mitigation activities, evaluate risk events and outcomes, make understandable the current operational risk exposures and areas of excessive risks and embed the operational risk disciplines. Finally, operational loss database would provide a valuable insight into the current operational risk exposure of the banks.
The writer, a banker and financial analyst, works in the risk management division of a commercial bank.