The Reserve Bank of India (RBI) has recently issued a set of directions called the "Minimum Capital Requirements for Operational Risk" to ensure that commercial banks maintain sufficient regulatory capital against their operational risk exposures. These directions replace the existing approaches with a new standardized approach known as the Basel III Standardized Approach. In this article, we will break down the key points of these directions in an easy-to-understand manner.
Applicability
The
directions apply to all commercial banks, excluding Local Area Banks,
Payments Banks, Regional Rural Banks, and Small Finance Banks. The provisions
contained in Part A of these directions are mandatory, while the guidelines
listed in Part B are encouraged to be followed. Part C and Part D contain
Frequently Asked Questions (FAQs) and Illustrations, respectively, for general
guidance.
Understanding Operational Risk
Operational risk
refers to the risk of loss resulting from inadequate or failed internal
processes, people, and systems, or from external events. This includes legal
risk but excludes strategic and reputational risk. Operational risk can arise
from various sources, such as human error, fraud, technology failures, and
legal or regulatory non-compliance.
Components of Basel III Standardized
Approach
The Basel III
Standardized Approach calculates the operational risk capital requirements
based on three components: Business Indicator (BI), Business Indicator
Component (BIC), and Internal Loss Multiplier (ILM).
Business Indicator (BI): The BI is a
financial-statement-based proxy for operational risk. It consists of three
constituents: Interest, Lease, and Dividend Component (ILDC), Services
Component (SC), and Financial Component (FC).
Business Indicator Component (BIC): The
BIC is calculated by multiplying the BI with marginal coefficients (αi) that
increase with the size of the BI. The coefficients are specified in Table 1 of
the directions.
Internal Loss Multiplier (ILM): The ILM
is a scaling factor based on a bank's average historical losses and the BIC. It
reflects a bank's internal operational risk loss experience. The ILM is
calculated based on the Loss Component (LC), which is 15 times the average
annual operational risk losses.
Calculating Operational Risk Capital (ORC)
The ORC requirements are determined based
on the BIC and ILM:
Banks in Bucket
1 and Buckets 2 and 3 without sufficient historical loss data: The ORC
requirements are equal to the BIC.
Banks in Buckets
2 and 3 with 5 years or more of high-quality operational risk annual loss data:
The ORC requirements are calculated by multiplying the BIC with the ILM.
Risk-Weighted Assets (RWA)
The
risk-weighted assets for operational risk are calculated by multiplying the ORC
by 12.5. This reflects the amount of capital a bank needs to hold against its
operational risk exposures.
Consolidated Level Calculation
At the
consolidated level, ORC calculations are based on fully consolidated BI
figures. Sub-consolidated banks and subsidiaries use BI figures specific to
their level for the calculations. Loss experiences are considered based on the
appropriate level and criteria.
Inclusion and Exclusion of BI Items and
Losses
BI items related
to acquisitions and mergers are included in the calculation of BI components
for ORC. Divested activities can be excluded with the approval of the RBI's
Department of Supervision.
Identification, Collection, and Treatment
of Loss Data
Banks in Buckets
2 and 3 must follow specific criteria for the identification, collection, and
treatment of operational risk loss data. Losses related to acquisitions,
mergers, and divested activities must be appropriately included or excluded
based on the RBI's guidelines.
Conclusion
The Reserve Bank
of India's Master Direction on Minimum Capital Requirements for Operational
Risk provides a framework for commercial banks to maintain sufficient
regulatory capital against operational risk. By implementing the Basel III
Standardized Approach, banks can calculate their operational risk capital
requirements based on specific components and factors. Compliance with these
directions ensures a sound risk management framework and helps protect the
stability and integrity of the banking system in India.
