Causal Capital

It was only a matter of time before the effects of regulations such as SMA would have iatrogenic effects and the writing is on the wall on this on.  The is going to be a backlash and a terribly cycle of decline here.

In the domain of banking, operational risk is not the only risk management discipline taking a beating at the moment. The BCBS have similar aspirations to dumb down credit risk modelling too, in an attempt to revert back to thinking back in the world of Basel I.  Oh yes, credit risk is also going through a retrograde battle at the moment and one which is probably going to finish up with an unhappy ending.

This document is all food for thought and a useful artefact that could potentially tell another story of Basel and another side to the narrative needs to be told. Perhaps operational risk modelling was doomed from the outset, this white paper explores why OpVaR was destined for failure.

Way back in 2014 the new methods for a redesign Standarized Approach for measuring Operational Risk capital emerged. No one would expect that AMA was under threat but a year or so on, we are in a very different place. If you want to really understand the calculation under SMA, this is a good article to read.

Recently the world was amazed by the instruments , built by scientists searching for Einstein's gravity waves,  which measured changes in the length of a 4 kilometer long bar to 1/10,000 the width of a proton.  By contrast, the Basel Committee of the Bank for International Settlements (BCBS) has appeared to resort to the age-old practice of examining chicken entrails to divine the future.

Pat clearly outlines three reasons why the new SMA is a fail in this wonderfully insightful text.

In its proposal to replace the Advanced Measurement Approach (AMA) with a simpler Standardised Measurement Approach (SMA), the Basel Committee on Banking Standards (BCBS) bemoaned that fact that, on the AMA, the Committee’s “expectations failed to materialise” and as one expert noted in a child-like tantrum, threw the ” toys out of the pram”.

Another wonderful article that looks at the history of operational risk in the Basel domain and why the BCBS have failed.

The much awaited consultative document on the future of AMA and the Operational Risk Regulatory Capital was published on 4th March 2016. And the initial reactions, going by the newspaper headlines and online commentary is, understandably, one of shock and aghast.

Ravi Gupta highlights four major issues with the new SMA technique.

A recent paper (in a series) published by Azamat Abdymomunov and Ibrahim Ergen of the Federal Reserve Board of Richmond, titled “Correlations and Systemic Risk in Operational Losses of the U.S. Banking Industry”. Since Operational Risk has been shown to have a systemic component, in addition to a firm-specific (idiosyncratic) component, a thorough review of the capital regime for Operational Risk is called for.

PWC publishes a first take and notes banks with a loss history above or below the industry average will have capital above or below the BI component, respectively. Additionally, the ILM weighs tail events (i.e., large events above 10m euro) heavier than others – an indication that regulators believe that banks should carry a larger capital penalty for particularly high past losses.

The inherent complexity of the AMA and the lack of comparability arising from a wide range of internal modelling practices have exacerbated variability in risk-weighted asset calculations.

Is it really a good idea to remove the AMA and have the same SMA for each institute? Do we not increase the Model Risk in the whole system? In my opinion it was a good idea to have incentives to think about the individual risk profile of an institution.