Wednesday 19 March 2025
The Basel Committee on Banking Supervision’s proposal for a new standardised approach to measuring operational risk has been met with criticism from experts in the field. The current simplified approach, known as SMA, is seen as flawed and prone to errors.
Operational risk refers to the likelihood of financial losses due to internal or external factors such as human error, system failures or natural disasters. Banks must set aside capital to cover these potential losses, but the SMA has been shown to be overly simplistic and fails to capture the complexity of operational risk.
The SMA uses a formula that aggregates data from different business lines and types of events to estimate the required capital. However, this approach has been found to be insensitive to changes in risk profiles and can lead to over-estimation or under-estimation of capital requirements.
Experts argue that a more advanced approach is needed, one that takes into account the specific characteristics of each bank’s operations and business lines. They point out that operational risk is highly dependent on factors such as internal controls, human resources and technology, which are unique to each institution.
One such approach is the Loss Distribution Approach (LDA), which has been shown to be more accurate in estimating operational risk. LDA models the distribution of losses using historical data and statistical techniques, allowing for a more nuanced understanding of the risk profile.
The Basel Committee’s proposal for a new standardised approach, known as AMA, is seen as a step in the right direction. However, experts argue that it still relies too heavily on aggregated data and fails to account for the complexity of operational risk.
A more flexible approach is needed, one that allows banks to incorporate their own unique characteristics and risk profiles into their calculations. This could involve using advanced statistical techniques such as generalized additive models (GAMLSS) to model the distribution of losses.
By adopting a more sophisticated approach to measuring operational risk, banks can better manage their capital requirements and reduce the likelihood of financial losses. It is clear that the Basel Committee’s proposal for AMA is a starting point, but further refinement is needed to create a robust system that accurately reflects the complexity of operational risk.
Cite this article: “Measuring Operational Risk: A Call for More Sophisticated Approaches”, The Science Archive, 2025.
Operational Risk, Basel Committee, Banking Supervision, Standardised Approach, Simplified Approach, Capital Requirements, Loss Distribution Approach, Generalized Additive Models, Gamlss, Statistical Techniques
