The calculation for operational risk capital requirements under Basel three is full of acronyms and complex terminology, but we'll try to get to the heart of what it's all about.
It is calculated by multiply what is referred to as the business indicator components by the internal loss multiplier.
The business indicator component, or BIC, is a measure of the size of a firm and its level of economic activity, and it is this factor which is used as the main proxy for operational risk.
This is on the basis that the larger and more active the firm, the greater the potential exposure to operational risk losses.
To calculate the business indicator components, you need to multiply the business indicator by the marginal coefficient.
The implementation of Basel three by different national regulators results in some differences in the specifics of how the business indicator is calculated, but on a simplified basis, it is the average gross income over the last three years.
Where gross income is interest income, less interest paid, plus non-interest income, such as advisory fees, the marginal coefficient is either 12%, 15%, or 18% depending on the size of the firm.
With larger firms being subject to a larger marginal coefficient, the internal loss multiplier is intended to make a firm's operational risk. Capital requirements sensitive to its operational loss history, and is determined by a bank's regulator.
For banks with higher historical losses, the internal loss multiplier would be above one, and it would be lower than one.
For banks with lower historical losses, the aim is to reward a bank, which is potentially better controls in place leading to lower losses historically with lower regulatory capital requirements.
However, in implementing Basel three, many regulators, including those in the US and the uk, have decided to set the internal loss multiplier to one.
This has been done with the aim of reducing fluctuations and uncertainty in the operational risk capital requirements over time as new operational risk losses are incurred by the bank or historical losses drop out of dataset being used, where this is the case, it means an organization's historical loss Has no impact on their operational risk capital requirements, removing the incentive to improve operational risk controls through reduced capital requirements.
