Operational Risk

The idea behind the advanced IRB approach is that investors should strive to acquire risk the current risk management and modeling skills, as this will be the prerequisite for using the advanced IRB approach. The investor can therefore calculate the probability of default and loss of given default. In addition, they would also be able to work out the exposure to default and maturity [18]. With regards to retail portfolios, only calculations of probability of default, loss of given default and exposure to default are needed.

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Since one of the aims of Basel II is mainly to improve risk management, it is therefore imperative for investors to take advantage of the IRB approach [18]. The bank of international settlements defines operational risk as the potential of loss resulting from failed internal processes, people and systems or from external events [1, 2, 4, 5, 9, and 10]. Mistakes committed because of weak internal systems may lead to losses. Frauds may be committed on the bank by some customers, outsiders and even by employees [10].

The purpose of the second pillar was to spot risk factors not spotted in pillar 1, and allowing the regulators exercise their discretion to fine-tune the regulatory capital requirement. But Under Basel 1, this was pre-calculated. The expectations investors expect from pillar 2 are much higher with regards to regulatory capital. Under pillar 2, financial institutions are required to take into account a wide range of risks they expect to face especially those not addressed under pillar 1 e.g. interest rate risk [11].

Pillar 2 therefore deals with key principles of supervisory review, risk management guidance, supervisory transparency, accountability with respect to banking risks, guidance relating to the treatment of interest rate risk in the banking book, credit risk, operational risk, enhanced cross border communication and co-operation and securitisation [11, 18, 22, 23,]. There are four key principles of supervisory review, which I have summarized below.

Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels [18]. The five main features of a rigorous process are as follows: (1) Board and senior management oversight; (2) Sound capital assessment; (3) Comprehensive assessment of risks; (4) Monitoring and reporting; and (5) Internal control review [18].

Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios [18]. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process [18]. The objective of the third pillar was to add to the transparency of lenders risk profile by compelling them to give details of their risk management, profile and risk distributions [18].

This will help the market participants to assess the information on capital, risk exposures, risk assessment processes and capital adequacy of the bank [18]. Such disclosures are more important in the case of banks, which are permitted to rely on internal methodologies giving them more discretion in assessing capital requirements. Market discipline supplements regulation as sharing of information facilitates assessment of the bank by others including investors, analysts, customers, other banks and rating agencies.

A transparent organization may create more confidence in the investors, customers and counter parties with whom the bank has dealings. It would also be easier for such banks to attract more capital [18]. Although much of Basel risk categories have largely been shaped in the context of financial institutions, however, other non-financial institutions can utilize the operational risk approach. In a service-based economy, both retail and business customers are becoming ever more intolerant of delays and errors in the service they receive.