Capital Requirements on Operational Risk

The 2004 New Basel Capital Accord introduced capital requirements to cover operational risk (OR). The purpose of this extension was to make mandatory capital requirements more sensitive to the actual risk profile of banks, bringing them closer to the risk measurement criteria adopted internally. The 1988 agreement recognized explicitly that the capital requirement of 8% of risk weighted assets, though related to credit risk, was also intended to cover indirectly the other kinds of risk. This coverage was not only indirect but also imprecise as a bank exposed to credit risk is not necessarily more vulnerable to market risk or operational risk. To make the correlation between risks and capital more precise, capital requirements on market risks were first introduced in 1996. As the requirement on credit risk became increasingly precise in 2004, an ad-hoc capital requirement for operational risk needed to be developed. This chapter discusses this capital requirement, its advantages and limitations, and its implications for banks. The capital requirement for OR was designed by the Basel Committee to provide coverage for both expected and unexpected losses. The capital requirement for OR became effective at the end of 2006. The system for measuring the OR capital requirement proposed by the Basel Committee is based on three alternative approaches of increasing complexity and precision: the Basic Indicator Approach, the Standardized Approach, and the Advanced Measurement Approaches.