The regulation of operational risk was globally founded on Basel II and later refined in Basel III. This chapter discusses the regulatory response to the Basel Capital Accords (commonly known as Basel I, Basel II, and Basel III) that were presented by the Basel Banking Committee of the Bank of International Settlements in 1988, 2004, and 2010 and that were intended to provide a robust capital framework and risk management approach for internationally active banks.

The focus of this chapter is on (1) the history of the Basel Accords; (2) the rules of the Basel Accords; (3) the adoption of Basel II in Europe and (4) in the United States; (5) the impact of the financial crisis and resulting European and U.S. regulatory changes, including the Dodd-Frank regulation in the United States; and, finally, (6) the introduction of Basel III and its impact on operational risk management.

HISTORY OF THE BASEL ACCORDS

The Basel Accords were developed by the Bank of International Settlements (BIS), which is headquartered in Basel, Switzerland. The BIS describes its mission and activities as follows:

Our mission is to support central banks' pursuit of monetary and financial stability through international cooperation, and to act as a bank for central banks. To pursue our mission we provide central banks with:

• a forum for dialogue and broad international cooperation
• a platform for responsible innovation and knowledge-sharing
• in-depth analysis and insights on core policy issues
• sound and competitive financial services¹

The BIS was originally established in 1930 to assist with the management of reparation loans post World War I, but it soon transitioned into a body that addressed monetary and financial stability through statistical analysis, economic research, and regular meetings between central bank governors and other global financial experts. The BIS has successfully expanded its global reach in recent decades and between 1995 and 2020 grew its membership from 33 member central banks or monetary authorities to 63.

At the time of this writing, the global representation at the BIS accounts for about 95 percent of world GDP and includes the following members:

• Bank of Algeria
• Central Bank of Argentina
• Reserve Bank of Australia
• Central Bank of the Republic of Austria
• National Bank of Belgium
• Central Bank of Bosnia and Herzegovina
• Central Bank of Brazil
• Bulgarian National Bank
• Bank of Canada
• Central Bank of Chile
• People's Bank of China
• Central Bank of Colombia
• Croatian National Bank
• Czech National Bank
• Danmarks Nationalbank (Denmark)
• Bank of Estonia
• European Central Bank
• Bank of Finland
• Bank of France
• Deutsche Bundesbank (Germany)
• Bank of Greece
• Hong Kong Monetary Authority
• Magyar Nemzeti Bank (Hungary)
• Central Bank of Iceland
• Reserve Bank of India
• Bank Indonesia
• Central Bank of Ireland
• Bank of Israel
• Bank of Italy
• Bank of Japan
• Bank of Korea
• Central Bank of Kuwait
• Bank of Latvia
• Bank of Lithuania
• Central Bank of Luxembourg
• Central Bank of Malaysia
• Bank of Mexico
• Bank Al-Maghrib (Central Bank of Morocco)
• Netherlands Bank
• Reserve Bank of New Zealand
• Central Bank of Norway
• National Bank of the Republic of North Macedonia
• Central Reserve Bank of Peru
• Bangko Sentral ng Pilipinas (Philippines)
• Narodowy Bank Polski (Poland)
• Banco de Portugal
• National Bank of Romania
• Central Bank of the Russian Federation
• Saudi Central Bank
• National Bank of Serbia
• Monetary Authority of Singapore
• National Bank of Slovakia
• Bank of Slovenia
• South African Reserve Bank
• Bank of Spain
• Sveriges Riksbank (Sweden)
• Swiss National Bank
• Bank of Thailand
• Central Bank of the Republic of Turkey
• Central Bank of the United Arab Emirates
• Bank of England (United Kingdom)
• Board of Governors of the Federal Reserve System (United States)
• State Bank of Vietnam²

Over the years, the BIS has established several standing committees to take on the important financial topics of the day. It was heavily involved in supporting the Bretton Woods System in the early 1970s, and tackled the challenges of cross-border capital flows and the importance of financial regulation in the late 1970s and 1980s. In 1974, the G10 nations³ formed the BIS Basel Committee on Banking Supervision (BCBS) to address shortcomings in the regulation of internationally active banks:

The Basel Committee comprises 45 members from 28 jurisdictions, consisting of central banks and authorities with formal responsibility for the supervision of banking business. Additionally, the Committee has nine observers including central banks, supervisory groups, international organisations and other bodies. The Committee expanded its membership in 2009 and again in 2014.⁴

Institutions represented on the Basel Committee on Banking Supervision

In 1988, the BCBS published the Basel Capital Accord⁵ (commonly known today as Basel I) to provide a framework for the consistent and appropriate regulation of capital adequacy and risk management in internationally active banks. In 2004, the Basel Committee published a revised framework, which came to be known as Basel II.⁶ Today, the Basel Committee is made up of five groups: the Policy Development Group, the Supervision and Implementation Group, the Macroprudential Supervision Group, the Accounting Experts Group, and the Basel Consultative Group; each of these groups has task forces and working groups that are formed as needed.

By its own admission, the Basel Committee has no legal authority over member central banks, but it relies on them to commit voluntarily to the standards that it sets:

The BCBS does not possess any formal supranational authority. Its decisions do not have legal force. Rather, the BCBS relies on its members' commitments, as described in Section 5, to achieve its mandate.

Section 5. BCBS members’ responsibilities

BCBS members are committed to:

1. work together to achieve the mandate of the BCBS;
2. promote financial stability;
3. continuously enhance their quality of banking regulation and supervision;
4. actively contribute to the development of BCBS standards, guidelines and sound practices;
5. implement and apply BCBS standards in their domestic jurisdictions within the pre-defined timeframe established by the Committee;
6. undergo and participate in BCBS reviews to assess the consistency and effectiveness of domestic rules and supervisory practices in relation to BCBS standards; and
7. promote the interests of global financial stability and not solely national interests, while participating in BCBS work and decision-making.⁷

However, the U.S. Federal Reserve, along with the majority of member central banks, moved forward with national regulatory implementation of most of the Basel Committee recommendations such that they became mandatory for the banks in their jurisdictions.

As a result of the global economic crisis of 2008, the BCBS implemented further standards focusing on credit and liquidity risk management and further bolstering the capital requirements of global financial institutions. These additional standards are known as Basel III.

RULES OF THE ACCORDS

The Basel Accords outline rules for financial institutions and for the national regulators who supervise those institutions.

Basel II

As pressure mounted for a revised approach, the Basel Committee responded by proposing a revised Capital Adequacy Framework in June 1999. They described the new proposed capital framework as consisting of three pillars: “minimum capital requirements; … supervisory review of an institution's internal assessment process and capital adequacy; and effective use of disclosure to strengthen market discipline as a complement to supervisory efforts.”⁹

Comments and discussions were held over the next few years, with the newly broadened membership of the Committee providing a global perspective on the proposed changes. The “International Convergence of Capital Measurement and Capital Standards: A Revised Framework” was issued on June 26, 2004, and served as a basis for national rule-making to reflect the Basel II approaches. The Basel Committee outlined the goal of the revised framework as follows:

The Basel II Framework describes a more comprehensive measure and minimum standard for capital adequacy that national supervisory authorities are now working to implement through domestic rule-making and adoption procedures. It seeks to improve on the existing rules by aligning regulatory capital requirements more closely to the underlying risks that banks face. In addition, the Basel II Framework is intended to promote a more forward-looking approach to capital supervision, one that encourages banks to identify the risks they may face, today and in the future, and to develop or improve their ability to manage those risks. As a result, it is intended to be more flexible and better able to evolve with advances in markets and risk management practices.¹⁰

On July 4, 2006, the Committee issued an updated version of the revised framework incorporating additional guidance and including those sections of Basel I that had not been revised. The revised framework is almost 10 times the length of Basel I, running to more than 300 pages. For the first time, operational risk management and measurement were required.

Basel II consists of three pillars: Pillar 1—Minimum Capital Requirements, Pillar 2—Supervisory Review Process, and Pillar 3—Market Discipline.

Pillar 1

The major changes to the capital adequacy rules were outlined in detail in Pillar 1. Basel II required banks to hold capital for assets in the holding company, so as to prevent banks from avoiding capital by moving assets around within its corporate structure.

Credit Risk Pillar 1 offered three possible approaches to calculating credit risk: the standardized approach, the foundation internal ratings based (F-IRB) approach, and, finally, the advanced IRB approach.

Under the standardized approach a bank could use “authorized” rating institution ratings in order to assign risk weightings and to calculate capital.

Under the IRB approaches, the banks were able to take advantage of capital improvements on the standardized approach by applying their own internal credit rating models. Under F-IRB, a bank could develop its own model to estimate the probability of default (PD) for individual clients or groups of clients, subject to approval from their local regulators. F-IRB banks were required to use their regulator's prescribed loss given default (LGD) and to calculate the risk-weighted asset (RWA) and the final required capital.

Under advanced IRB (A-IRB), banks could use their own estimates for PD, LGD, and exposure at default (EAD) to calculate RWA and the final required capital.

Market Risk Pillar 1 also provided market risk capital requirements, based mainly on a value at risk (VaR) approach.

Operational Risk Finally, Pillar 1 introduced a new risk category: operational risk. As discussed in Chapter 1, operational risk is defined in Basel II as the “risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk.”¹¹

Pillar 1 offered three possible methods to calculate capital for operational risk: the basic indicator approach (BIA), the standardized approach (TSA), or the advanced measurement approach (AMA).¹²

Under BIA, capital was simply calculated from a percentage (set at 15 percent) of the average of the previous three years' revenue. TSA offered different percentage weightings depending on the business line—ranging from 12 percent for retail banking to 18 percent for sales and trading. AMA offered banks the opportunity to develop their own risk-based model for calculating operational risk capital. AMA required that the model include four elements: internal loss data, external loss data, scenario analysis, and business environment and internal control factors. These three methods are summarized in Figure 2.1.

While Pillar 1 offered three possible methods to calculate operational risk capital, most large banks found that their local regulator required them to pursue an AMA approach. In addition, even where a bank was not required to take an AMA approach to calculating capital, their regulator often advised them that they should adopt best practices and that best practices require them to ensure they have fully developed all four elements of AMA.

Therefore, the standard for a strong operational risk framework is based on the effective development of internal and external loss data systems, appropriate use of scenario analysis, and effective development of business environment and internal control factors.

Recent Basel guidance requires banks to adopt a more simplified standardized approach to capital calculation that is driven only by the business activities of the bank and the internal loss history of the bank. However, whether or not the AMA elements are still used as direct inputs into a capital model, they are still considered vital elements of a sound operational risk management framework.

Capital Reserves Finally, under Pillar 1, a bank had to hold capital reserves of at least 8 percent of their total credit, market, and operational risk-weighted assets:

Pillar 2

Basel II introduced Pillar 2 requirements as follows:

This section discusses the key principles of supervisory review, risk management guidance and supervisory transparency and accountability produced by the Committee with respect to banking risks, including guidance relating to, among other things, the treatment of interest rate risk in the banking book, credit risk (stress testing, definition of default, residual risk, and credit concentration risk), operational risk, enhanced cross-border communication and cooperation, and securitization.¹³

Pillar 2 outlined how the regulators were expected to enforce soundness standards and provided a mechanism for additional capital requirements to cover any material risks that had not been effectively captured in Pillar 1.

Pillar 3

Pillar 3 provided methods for disclosure of risk management practices and capital calculation methods to the public. The purpose of Pillar 3 was to increase transparency and to allow investors and shareholders a view into the inner risk practices of the bank.

ADOPTION OF BASEL II IN EUROPE

In the European Union, Basel II was codified through the European Parliament through the Capital Requirements Directive,¹⁴ which required member states to enact appropriate local regulations by January 1, 2007, with advanced approaches available by January 1, 2008.

ADOPTION OF BASEL II IN THE UNITED STATES

In the United States, the plethora of regulators added to the complexities of implementation.

IMPACT OF THE FINANCIAL CRISIS

The global economic crisis that began in 2007 led to much soul-searching by governments, regulators, and the BIS as they sought to understand how the Basel frameworks had failed to protect the global economy.

BASEL III

The Basel Accords have resulted in global regulatory changes that have reached beyond G10, beyond G20, and into the far reaches of the global financial regulatory environment. Basel I introduced credit risk capital measures, and Basel II provided enhanced risk capital calculation for credit, market, and operational risk. The United States has played a key role on the Basel Committee for Banking Supervision, which designed these accords, and so it is not surprising to find that U.S. regulators have consistently adopted these measures.

The economic crisis highlighted the need for further refinements in the way that banks calculate and hold capital for all risk types, and the importance of sound operational risk management and measurement. In addition, it drew close scrutiny of the methods used to ensure there is robust risk management and healthy liquidity in the bank.

In 2010, the BCBS introduced enhanced capital requirements under Basel III so that banks had to maintain more capital of higher quality to cover unexpected losses. They were clear as to the purpose of the Basel III reforms:

The Basel III framework is a central element of the Basel Committee's response to the global financial crisis. It addresses a number of shortcomings in the pre-crisis regulatory framework and provides a foundation for a resilient banking system that will help avoid the build-up of systemic vulnerabilities. The framework will allow the banking system to support the real economy through the economic cycle.³¹

Minimum Tier 1 capital rose from 4 percent to 6 percent, and at least three-quarters of it had to be of the highest quality (common shares and retained earnings). Global systemically important banks (G-SIBs) were subjected to even higher capital requirements. In other words, the initial approach to the crisis was “hold more capital.”

Basel III was originally scheduled for adoption in January 2013, but that deadline was missed by both the EU and the United States, and a delayed and phased implementation was crafted for implementation over the next few years.

Meanwhile, the writing and implementation of rules under Dodd-Frank and similar nation specific rules across the globe continued at a fast pace. While the operational risk framework remained mostly unchanged since Basel II, the plethora of new regulatory requirements and governance enhancements led to increasing complexity in managing the operational risks faced by a bank on a day-to-day basis.

The 2010 focus of Basel III did not address systemic concerns regarding the variability in methods used by the banks to calculate their overall risk-weighted assets (RWAs) nor the apparent disparity between the riskiness of a bank's portfolio and the calculation of its required capital. This remained an area of concern for the BCBS, and they sought to rebuild the credibility of RWAs as an appropriate risk measure and to bring about greater predictability and consistency across the financial system in the calculation of required capital.

In 2017, the BCBS addressed these issues and released finalized Basel III rules regarding standardized approaches for calculating credit risk, market risk, Credit Valuation Adjustment, and operational risk. These guidelines included a simplified approach to calculating operational risk capital. The BCBS sought to ensure greater risk sensitivity and clearer comparisons between banks with these new standards. In addition, new constraints were introduced on the use of internal models, and floor limits were set in order to limit the benefit that a bank could receive from its preferred capital calculation methods. All of these changes meant that the much-maligned Basel II AMA approach was retired, and all four methods of operational risk capital calculation were replaced by a simpler single standardized method that combines a refined measure of gross income with a bank's own internal loss history over 10 years.

In December 2019, BCBS issued new guidance on this simplified standardized calculation of operational risk capital³² and a final version is due for implementation in January 2023.

In November 2020, BCBS issued a report³³ on the progress of its member nations in the implementation of all of the Basel requirements. In it they acknowledged that implementation had been inconsistent and not all deadlines had been met by all nations. In March 2021 they issued “Revisions to the Principles for the Sound Management of Operational Risk.”³⁴

These documents now form the basis for the future regulatory expectations for operational risk and provide additional clarity on the management and measurement of this risk.

BCBS recognized the impact of the global COVID-19 pandemic and confirmed that they would extend the deadline for the adoption of the new operational risk capital standard to January 2023.

Both the Basel II and Basel III capital calculation methods are discussed in Chapter 12 and the revised principles will be discussed throughout this book.

KEY POINTS

• The Basel Accords were developed by the Bank of International Settlements (BIS) to ensure capital adequacy.
• Basel II was first published in 2004, and its full title is “International Convergence of Capital Measurement and Capital Standards: A Revised Framework.”
• Basel II required operational risk management and measurement for the first time.
• There are three approaches to calculating capital for operational risk under Basel II: the basic approach, the standardized approach, and the advanced measurement approach.
• In 2008, the Federal Reserve, OCC, FDIC, and OTS issued a joint requirement for mandatory Basel II rules for large United States banks and opt-in provisions for noncore banks.
• In 2009 and 2010, the CEBS issued guidance on operational risk management and measurement.
• In 2011, U.S. regulators issued the “Interagency Guidance on the Advanced Measurement Approaches for Operational Risk.”
• The United States enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act in July 2010.
• The Act addressed the following areas:
  • Consumer Protections with Authority and Independence
  • Ends Too Big to Fail
  • Advanced Warning System
  • Transparency and Accountability for Exotic Instruments
  • Federal Bank Supervision
  • Executive Compensation and Corporate Governance
  • Protects Investors
  • Enforces Regulations on the Books
• BCBS issued final Basel II rules in 2017 and further guidance on operational risk capital calculation methods in 2019 and revised sound practices for operational risk management in 2021.
• The global pandemic has delayed the full adoption of Basel III.

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