Methodological Flaws in the Basel III Endgame Operational Risk Capital Requirements

Introduction

Proposed new bank capital standards, collectively referred to as the Basel III Endgame (B3E), impose an entirely new approach to computing capital charges and risk-weighted assets associated with operational risk for the largest banking organizations in the United States. Under current capital standards, the largest U.S. banking organizations, designated Category I and II institutions, have the option to use internal models to determine the amount of required operational risk capital (ORC). Smaller and less complex banks (Category III and IV and all others not otherwise designated) under current regulatory capital standards follow a standardized approach that does not include an assessment of operational risk capital.

Under the proposed B3E framework, Category I-IV banking organizations would be required to follow a standardized approach that would include an operational risk capital component. For Category I and II firms, this replaces the model-based advanced measurement approach and for Category III and IV, and makes them subject to operational capital requirements for the first time.

Official estimates suggest that these new capital standards on operational risk will increase risk-weighted assets (RWA) for Category I and II banks by $1.4 trillion and by $550 billion for Category III and IV institutions, and the new operational risk requirements will represent a substantial portion of the increase in RWA under B3E. Such changes would lower key risk-based capital ratios calculated for these banks from current levels, thus requiring them to increase capital. These banks would subsequently face higher capital costs, with the result of eroded profitability, higher raising costs or constrained credit to bank customers—or a combination of all three—with a negative impact on economic growth.

These changes in operational risk capital requirements are riddled with shortcomings and relate ORC to bank income, expense and revenue from various banking activities. The standardized approach is inherently flawed methodologically, unsupported by a welldeveloped theoretical foundation for the drivers of operational loss and not empirically supported. Moreover, the ORC charge grossly overestimates the amount of tail operational losses given actual historical loss experience.

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