Free Accounting Dissertations - G. Credit-linked Notes) Or Un-funded (e.g. Credit Default Swaps) Credit
g. credit-linked notes) or un-funded (e.g. credit default swaps) credit derivatives or guarantees that serve to hedge the credit risk of the portfolio.
This approach leaves the return to the investors in the hands of the performance of the underlying pool. Apparently, the risk associated is higher since the performance can be affected by numerous causes.
From the above-mentioned approaches the Basel II accord’s stand for evaluating the capital and minimum capital requirements are evident.
2.4.5: Operational Risk
The operational risk is defined by the Basel Committee as the risk associated with the loss resulting from inadequate or failed internal processes, people, systems or external events. This includes the legal risk with the exclusion of strategic and reputational risk.
The Basel II Accord has approved three methods for calculating the operational risk and risk sensitivity with the implications on minimum capital requirements. They are:
(i) The Basic indicator approach, (ii) the Standardised Approach and (iii) Advanced Measurement Approach.
Basic Indicator Approach:
In this case the banks should hold capital for the operational risk equal to the average over the past three years of a fixed percentage. This is expressed as a formula below
KBIA = [S (GI1n x a)]/n
Where
KBIA = the capital charge under the Basic Indicator Approach
GI = annual gross income, where positive, over the previous three years
n = number of the previous three years for which gross income is positive
a = 15%, which is set by the Committee, relating the industry wide level of required capital to the industry wide level of the indicator. This formula is obtained from the Basel II accord for the purpose of reader understanding.
Standardised Approach:
The standardised approach divides the bank’s activities into eight-business lines namely corporate finance, trading & sales, retail banking, commercial banking, payment & settlement, agency services, asset management, and retail brokerage.
The likelihood of operational risk exposure is calculated from the gross income associated with each business line that serves as an indicator for the scale of business operations by the bank in that specific area of business or business line.
This approach is very clumsy since the gross income associated with the business line varies due to numerous reasons both internal and external.
Advanced Measurement Approach:
The Advanced Measurement Approach equates the regulatory capital requirement with the risk measure generated by the bank’s internal operational risk measurement system using quantitative and qutative criteria. The banks can use this method only after the approval by the Committee.
