Advanced Measurement Approach for Operational Risk: Scenario Based Approaches

Banks complying with BASEL II guidelines can enjoy reduced capital requirements if they follow the advanced measurement approach (AMA) for Operational Risk. As per BASEL II guidelines, banks using the AMA approach can use the Scenario Based Approach (SBA) to overcome the limitations of the traditional Loss Distribution Approach (LDA). SBA is a process by which banks consider the impact of extreme but plausible events resulting in Operational Loss that the bank may or may not have experienced. Scenarios need to be tailored to the business environment of the bank and to capture changes in the bank's internal or external situations.

Approach:

It broadly comprises of the following steps:

1. Understanding the Business and Operational risk profile of the Organization: The business profile of the company can be understood by reviewing the business plan, strategy documents, annual reports etc. of the company. The understanding of the operational risk profile can be derived from the RCSA (Risk & Control Self Assessments), KRIs (Key Risk Indicators), Internal & External Operational Loss experience. This view is important while creating the operational risk scenarios relevant to the entity.
2. Scenario Workshops or Interviews with Business Experts: For the effective capture of the likelihood and impact of potential scenarios affecting the organization, the input of business experts within the entity is essential. Workshops are conducted, where business experts and the risk management team brainstorm on the relevant scenarios and decide on frequency and severity parameters for the same.
3. Developing Loss Distributions using Statistical Methods: Based on the frequency and severity parameters obtained for each scenario, a statistical simulation is generated using Monte Carlo methodology. The correlation factors between the losses also considerably impact the capital charge and are included in the form of a correlation matrix.
4. Arriving at Operational Risk Capital Charge: The overall distribution of operational losses is derived from the frequency and severity distribution over a given future horizon (generally, one year). The capital charge (VAR) resulting under this approach is based on a high percentile of the loss distribution (99.9th percentile).

Benefits:

• It is an ideal approach to use when there is a lack of historic Op Loss Data.
• Forward looking, as it also covers scenarios which the entity may not have experienced earlier.
• Incorporates a top down approach to develop loss parameters by engaging the high level Business Experts

Limitations:

• This approach assumes that the business experts have an in-depth understanding of the risks that the organization faces.
• This approach would only be effective in the presence of a robust operational risk framework (RCSA, KRIs, Loss Data Capture etc.)