CP16/22 – Implementation of the Basel 3.1 standards: Operational risk

Overview

8.1 This chapter sets out the Prudential Regulation Authority’s (PRA) proposals to implement the Basel 3.1 standards for operational risk. The operational risk capital framework aims to ensure that firms’ operational risk capital requirements adequately reflect the risks posed from inadequate or failed internal processes, people or systems, or from external events. Operational risk also includes legal risk.

8.2 The proposals in this chapter would:

• introduce the new requirements for operational risk in a new Operational Risk Part of the PRA Rulebook; and
• revoke the Operational Risk (CRR) Part of the PRA Rulebook, which replicated Article 316 of the CRR in PRA rules as part of PRA Policy Statement 17/21 – ‘Implementation of Basel standards’.

8.3 The proposals would also delete Supervisory Statement (SS) 14/13 ‘Operational risk’, which sets out the PRA’s expectations in relation to the advanced measurement approach, which would become obsolete.

8.4 The following policy proposals are set out in this chapter:

• to implement the new standardised approach (SA) for Pillar 1 operational risk capital requirements; and
• to exercise the national discretion to set the internal loss multiplier (ILM) equal to 1.

8.5 The Basel Committee on Banking Supervision (BCBS) concluded that the global financial crisis highlighted that operational risk capital requirements were not sufficient to cover the losses incurred by some firms. It also highlighted that sources of these losses – including those related to fines for misconduct or poor controls – were difficult to predict using internal models. This indicated that the existing set of simple approaches for operational risk – the basic indicator approach (BIA) and the standardised approach (SA), including its variant the alternative standardised approach (ASA) – and the advanced measurement approach (AMA), did not generate sufficiently accurate operational risk capital requirements relative to operational risks for a wide spectrum of firms.

8.6 In response, the BCBS designed a new operational risk framework that replaces all existing operational risk approaches for calculating Pillar 1 operational risk capital (ORC) requirements with a single standardised approach – the SA. The PRA considers that implementation of the SA would enhance the safety and soundness of firms. It would also facilitate a better comparison of risk-weighted assets (RWAs) between firms by removing the use of multiple concepts and methods, and removing the use of firms’ internal models for estimating operational risk.

8.7 The proposals in this chapter are relevant to PRA-authorised banks, building societies, PRA-designated investment firms, and PRA-approved or PRA-designated financial holding companies or mixed financial holding companies (‘firms’). The proposals would not apply to UK banks and building societies that meet the Simpler-regime criteria and choose to be subject to the Transitional Capital Regime proposals.^{footnote [1]}

Implementation of the standardised approach in PRA rules

8.8 The PRA proposes to implement the SA in the Basel 3.1 standards for Pillar 1 operational risk capital requirements in PRA rules. The PRA also proposes to retire the CRR Pillar 1 operational risk framework and SS14/13 - ‘Operational risk’.

8.9 Consistent with the Basel 3.1 standards, the PRA proposes to introduce a new calculation for Pillar 1 operational risk capital requirements calculated as follows:

8.10 The business indicator component (BIC) is a measure of firm size and economic activity, and is used as a proxy for operational risk on the basis that the larger and more active the firm, the greater the potential exposure to operational risk.

8.11 The ILM is intended to make a firm’s operational risk capital requirements sensitive to its operational loss history. The Basel 3.1 standards include a national discretion to neutralise the impact of historical internal operational risk losses by setting the ILM equal to 1. If this discretion is applied, then a firm’s operational risk capital requirements would not be mechanically linked to its past loss history. The PRA proposes exercising national discretion to set the ILM equal to 1 (see ‘Exercise national discretion to set the ILM equal to 1’ section later in this chapter). The PRA also proposes to continue to apply supervisory judgement regarding the relevance of past losses to future operational risk by using its more sophisticated approach in the Pillar 2A framework as set out in its Statement of Policy ‘The PRA’s methodologies for setting Pillar 2 capital’.

8.12 As a general principle, the PRA does not intend to require firms to calculate capital requirements for the same risk under both the Pillar 1 and Pillar 2 frameworks (see Chapter 10 – Interactions with the PRA’s Pillar 2 framework). To the extent that the proposals in this chapter improve operational risk capture in Pillar 1, the Pillar 2A operational risk capital requirements would adjust by an offsetting amount in line with the PRA’s existing approach to Pillar 2A. Therefore, the PRA considers that there would be no material impact on firms’ total Pillar 1 plus Pillar 2A operational risk capital requirements.

8.13 The PRA also proposes to maintain the requirements in relation to policies and processes set out in the CRR for a firm to evaluate and manage its exposure to operational risk.

Calculation of the business indicator component (BIC)

8.14 The BIC is calculated by multiplying the business indicator (BI) – as defined below – by defined marginal coefficients (α_i). The BI is a financial statement-based proxy for operational risk and includes three components, all comprising of specific combinations of profit and loss items:

• the interest, leases, and dividend component (ILDC);
• the services component (SC); and
• the financial component (FC).

8.15 The PRA proposes to explicitly set out, in PRA rules, the items to be included in each of the three BI components (see the table set out in ‘Annex 1 – Business Indicator Components’ of the Operational Risk Part of the PRA Rulebook). The PRA expects that the majority of firms already collect and store these data items.

8.16 The BI is calculated as a three-year simple average of ILDC + SC + FC, taking those components as at a firm’s financial year end. Where a firm has been in operation for less than three years, in the existing framework, the PRA permits the use of forward-looking estimates in calculating the BI, provided that the firm begins using historical data as soon as it is available. The PRA considers it would be prudent and proportionate to maintain this flexibility in the PRA rules.

8.17 The Basel 3.1 standards require that the BI includes items that result from acquisitions of relevant businesses and mergers. Where a firm can prove that, due to a disposal of entities or activities, using a three-year average to calculate the BI would lead to a biased estimation of the operational risk capital requirements, it may request supervisory approval to exclude divested activities from the calculation of the BI. The PRA proposes to implement an approval process for such cases in line with the existing approval process for CRR Articles 315(3) and 317(4).^{footnote [2]}

8.18 The marginal coefficients (α_i) set out in the Basel 3.1 standards increase with the size of the BI, as shown in the table below. The BI places firms in different ‘buckets’ according to their income; the higher the BI, the higher the marginal coefficient. For example, for firms in the first bucket (ie BI less than or equal to £0.88 billion),^{footnote [3]} the BIC would be equal to BI x 12%. For firms in the second bucket (ie BI above £0.88 billion and below or equal to £26 billion), the marginal coefficient for every unit of BI above £0.88 billion would increase to 15%, so the BIC would be equal to (0.88 x 12%) + ((BI - 0.88) x 15%). Finally, firms in the third bucket (ie BI above £26 billion) would apply a marginal coefficient of 18% for every unit of BI above £26 billion.^{footnote [4]} This approach is intended to reflect that larger firms are more complex and therefore proportionately more exposed to operational risk.

BI ranges and marginal coefficients

8.19 The PRA proposes to adopt the marginal coefficients as set out in the Basel 3.1 standards. The BIC contrasts with the proxy indicators currently used under the CRR in that it introduces the size of a firm’s business as a risk driver, as opposed to just relying on gross income.

PRA objectives analysis

8.20 The PRA considers that the SA would enhance risk-sensitivity relative to the CRR. The PRA considers this is particularly the case for the calculation of the BIC, as the size and complexity of firms is a relevant factor in considering operational risk. The approach would also help achieve consistency across firms while maintaining an appropriate level of capital. As such, the approach would advance the PRA’s primary safety and soundness objective.

8.21 In adjusting coefficients for the size of firms, the PRA considers the approach would also advance its secondary competition objective as operational risk capital requirements would be relatively higher for larger firms in buckets 2 and 3.

‘Have regards’ analysis

8.22 In developing these proposals, the PRA has had regard to the FSMA regulatory principles, the aspects of the Government’s economic policy set out in the HMT recommendation letter from 2021 and the supplementary recommendation letter sent April 2022. Where the proposed new rules are CRR rules (as defined in section 144A of FSMA), the PRA has also taken into consideration the matters to which it is required to have regard when proposing changes to CRR rules. The following factors, to which the PRA is required to have regard, were significant in the PRA’s analysis of the proposals:

1. Proportionality (FSMA regulatory principles and Legislative and Regulatory Reform Act 2006):

• The PRA considers that the SA would be proportionate, both through its simplicity of calculation based on financial statement information, and through its differentiation based on a firm’s size and complexity. The introduction of a single SA, rather than three alternative approaches as under the CRR, would incur some small costs for firms. However, the PRA considers these would be initial one-off costs, and notes that there would be a reduction in the regulatory burden on firms in terms of the complexity and difficulty in understanding multiple approaches and which approach is most appropriate for the firm.

2. Sustainable growth (FSMA regulatory principles):

• Operational risk exposures accrue differently from credit risk and market risk. A firm could have low credit exposures but still run substantial operational risks (eg custodian banking activities). The BIC would aim to ensure firms calculate adequate capital requirements against operational risk. This, in turn, would enable firms to continue to provide banking services to the real economy when operational risks crystallise, therefore supporting sustainable growth.

Question 47: Do you have any comments on the PRA’s proposed implementation of the SA in the Basel 3.1 standards for operational risk capital requirements?

Exercise national discretion to set the Internal Loss Multiplier (ILM) equal to 1

8.23 The PRA proposes to exercise the national discretion in the Basel 3.1 standards to set the ILM equal to 1.^{footnote [5]} The ILM takes into account past operational risk losses via the loss component (LC), which is equal to 15 times average annual operational risk losses incurred by the firm over the previous 10 years. Where the LC is greater than the BIC (ie actual losses exceed the proxy for losses), the ILM is greater than 1; and where the LC is lower than the BIC, the ILM is less than 1. The Basel 3.1 standards include a national discretion to neutralise the impact of historical internal operational risk losses by setting the ILM equal to 1.

8.24 The PRA considers a mechanical link to past losses to be inappropriate for the following reasons:

• The calculation of the ILM is non-linear – operational risk capital requirements increase more slowly as historical losses increase. The PRA considers that, particularly for situations of large historical losses, more flexible and risk-sensitive approaches are appropriate, including the PRA’s Pillar 2A methodology.^{footnote [6]}
• Calculating capital requirements for operational risk is a significant challenge. The loss distribution is unusually ‘fat-tailed’, characterised by infrequent but very large losses, and there is a paucity of data. The PRA considers that low-probability high-impact events, given their heterogeneity, are generally not good predictors of other unlikely events and therefore future losses. In these situations, the ILM may not be sufficiently risk-sensitive.
• The PRA considers that the information value of operational risk losses generally diminishes over time as business models and lending activities change. The SA’s use of a 10-year window of unweighted past losses in the ILM could result in it being inappropriately affected by large historical operational risk losses near the start of the 10-year period that might be weak predictors of future losses.

8.25 However, the PRA recognises that historical losses can provide important information when considering operational risk. It is important to monitor and assess the magnitude of operational risk events as part of the Pillar 2 review of firms’ capital adequacy. The PRA already has a sophisticated approach to calculating Pillar 2A operational risk capital requirements, which includes using loss estimates based on a firm’s forecast, historical losses, scenario analysis, and supervisory judgement to inform the setting of a firm’s operational risk add-on. The PRA proposes to continue to use that approach, which applies supervisory judgement regarding the relevance of past losses to future exposure to operational risk.

8.26 As a general principle, the PRA framework does not intend to double count capital requirements for the same risks in Pillar 1 and Pillar 2A. To the extent that the proposals in this CP improve operational risk-capture in Pillar 1, under the PRA’s existing policy, the Pillar 2A operational risk capital requirements would adjust accordingly (Chapter 10).

PRA objectives analysis

8.27 The PRA considers that by continuing to apply supervisory judgement regarding the relevance of past losses to future operational risk using its more sophisticated approach in the Pillar 2A framework, this proposal would maintain the safety and soundness of firms by ensuring operational risk capital requirements are risk-sensitive.

8.28 The PRA considers that the proposals set out in this section should not have any significant implications for facilitating effective competition. The proposal to set the ILM equal to 1 would mean Pillar 1 operational risk capital requirements would be solely dependent on a proxy of a firm’s gross income and size. As a result, the SA would be based on the BIC and have a different impact on different firms reflecting their size and complexity. The PRA considers this would be a suitable outcome as evidence suggests that the size of a firm is the dominant differentiator of operational risk.^{footnote [7]} In addition, the PRA considers that no particular business model is likely to be disproportionally affected by setting the ILM equal to 1. In contrast, applying a variable ILM could have different, and possibly material, impacts on different firms with different business models, which could have unintended consequences for competition.

‘Have regards’ analysis

8.29 In developing these proposals, the PRA has had regard to the FSMA regulatory principles, the aspects of the Government’s economic policy set out in the HMT recommendation letter from 2021 and the supplementary recommendation letter sent April 2022. Where the proposed new rules are CRR rules (as defined in section 144A of FSMA), the PRA has also taken into consideration the matters to which it is required to have regard when proposing changes to CRR rules. The following factors, to which the PRA is required to have regard, were significant in the PRA’s analysis of the proposals:

1. Finance for the real economy (FSMA CRR rules):

• The PRA considers the proposal to set the ILM equal to 1 would help ensure that there would be no material impact on firms’ total Pillar 1 plus Pillar 2A operational risk capital requirements – notably due to the flexibility the PRA has under its existing Pillar 2A methodology. As a result, the proposals should not have an impact on finance for the real economy.

2. Relevant international standards (FSMA CRR rules):

• The PRA’s proposals would align with the Basel 3.1 standards by exercising the national discretion to set the ILM equal to 1.

Question 48: Do you support the PRA’s proposal to set the ILM equal to 1?