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What are Minimum Capital Requirements for Operational Risk?

Reserve Bank of India (RBI) has released directions on minimum capital requirements for operational risk.

What is operational risk?

Operational risk means 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.

What is the objective of directions on minimum capital requirements for operational risk?

The directions require commercial banks to hold sufficient regulatory capital against its exposures arising from operational risk.

Which entities are covered under the directions?

The directions apply to all Commercial Banks (excluding Local Area Banks, Payments Banks, Regional Rural Banks, and Small Finance Banks).

What will be the changes in calculation of capital for operational risk?

The existing approaches for measuring minimum operational risk capital (ORC) requirements are as below –

  • Basic Indicator Approach (BIA)
  • Standardised Approach (TSA) / Alternative Standardised Approach (ASA) 
  • Advanced Measurement Approach (AMA).

All the existing approaches as mentioned above will be replaced by the new Standardised Approach (or Basel III Standardised Approach).

What are the components of Basel III Standardised Approach (Basel III SA)?

Basel III Standardised Approach (Basel III SA) calculation methodology is based on the following components –

  • Business Indicator (BI), which is a financial-statement-based proxy for operational risk. The constituents of BI include interest, lease and dividend, services and financial.
  • Business Indicator Component (BIC), which is calculated by multiplying the BI by a set of marginal coefficients (αi) (which increase with the size of the BI).
  • Internal Loss Multiplier (ILM), which is a scaling factor that is based on a bank’s average historical losses and the BIC.

The risk-weighted assets (RWA) for operational risk shall be calculated by multiplying the ORC by 12.5.

How shall ORC be calculated within a banking group? 

  • At the consolidated level, the ORC calculations shall be based on fully consolidated BI figures, which net all the intragroup income and expenses.
  • The ORC calculations at a sub-consolidated level shall be based on BI figures for the banks consolidated at that particular sub-level.
  • The ORC calculations at the subsidiary level shall be based on BI figures from the subsidiary.
  • A sub-consolidated bank or a subsidiary of the bank shall use only the losses it has incurred at that particular sub-consolidated or subsidiary level for the ORC calculations.

Which loss event shall be included in the loss data set?

RBI expects that a bank’s data collection and reporting procedures and processes capture all operational risk losses over the threshold of ₹1,00,000. 

However, if a bank excludes any eligible loss data event due to commission or omission errors or any other reason, it shall include such missed out data in the loss data set in the subsequent year by making necessary corrections for the relevant year. Such data shall be included in the loss data set from the year to which it pertains till 10 years from the year of detection of such missed out event.

What shall be the frequency of disclosures for operational risk?

Template Description of the template Frequency of disclosure
ORA General Qualitative information on a bank’s operational risk framework Annual
OR 1 Historical losses Annual
OR 2 Business Indicator and Sub components Quarterly
OR 3 Minimum required operational risk capital Quarterly

From when are the directions applicable?

The effective date of implementation of the directions will be separately communicated by RBI.


References

Reserve Bank of India. (2023, June 26). 'Master Direction on Minimum Capital Requirements for Operational Risk'. Retrieved from https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12520&Mode=0

Reserve Bank of India. (2023, June 26). 'Press Release - RBI releases ‘Master Direction on Minimum Capital Requirements for Operational Risk’'. Retrieved from https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=55922


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