3 approaches to measure operational risk

In this article, we explain the different approaches to measuring operational risk in an organization. See what they are!

According to the Basel Committee, there are three ways to measure operational risk: the basic indicator approach (BIA), the standard approach (SA) and the advanced measurement approach (AMA). Here we explain each of them.

Basic indicator approach for measuring operational risk

The basic indicator approach is much simpler than the other techniques for measuringoperational risk and is therefore recommended for small financial entities whose operations are not very complex.

This method calculates the operational risk for the entire organization and then assigns the result to the operational lines. The basic indicator is measured as a percentage of gross income over that of the preceding three years.

There are several reasons why this indicator is calculated through gross income. Firstly, it is verifiable. Secondly, because it is immediately available and also because it is a counter-cyclical measure that helps to reliably measure the size of activities.

Standard approach to measuring operational risk (SA)

According to this method for measuring operating risk, banks' activities are divided into eight lines of business: corporate finance, sales and trading, retail banking, commercial banking, payments and settlements, agency services, asset management and retail brokerage.

Within each line of business, gross revenue serves as an indicator to measure the scale of commercial operations and, therefore, to calculate the possible exposure to operational risk in each line.

It is calculated by taking the three-year average of the sum of the regulatory capital charges for each operating line in each year.

To use the standard approach, a bank must meet certain requirements:

• Both the board of directors and senior management must be involved in overseeing the operational risk management framework.
• It must have a solid operational risk management system that is implemented throughout the company.
•  It must have sufficient resources to use this approach in the main lines of business, as well as in the areas of control and auditing.

Advanced measurement approach (AMA)

Out of the three approaches to measuring operational risk, this is the most sophisticated method. With the AMA model, banks can create their own empirical model to quantify the capital required for operational risk.

An AMA framework should include the use of four quantitative elements for its development: internal loss data, external data, scenario and business environment analysis, or internal control factors.

Among the AMA models, there are three different types of methodologies: internal measurement approach (IMA), loss distribution approach (LDA) and scorecards.

At Pirani, the advanced measurement approach (AMA) is the one we use to estimate operational risk capital based on the loss distribution approach (LDA). This approach allows us to establish continuous improvement systems, predict expected losses for the organization over a period of time, define loss indicators and thresholds, and create scenarios to simulate catastrophic events.

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