#operational risk – Federal Financial Analytics

14 08, 2023

Karen Petrou: Why The Operational-Risk Capital Rules Make No Sense

Eliza Allen2023-08-14T10:41:30-04:00August 14th, 2023|The Vault|

While there are many risks for which regulatory capital is a vital panacea, operational risk is not among them. The proposed approach to these capital standards makes it still more clear that regulators don’t trust themselves or banks and thus deploy the only tool they seem to know – ever-higher capital – no matter the cost and, more important, the risk. In fact, the best way to address operational risk is to spend money, not put it in a capital piggybank regulators can shake to hear coins rattle when they worry even though getting the coins out in a hurry will prove devilishly difficult.

The reason why regulatory capital doesn’t do diddly for operational-risk absorption is self-evident when one understands what constitutes operational risk. It’s essentially what God does to banks (natural disasters), what people do to banks (fraud), and what banks do to themselves (fragile systems) and to others (endangering consumers or markets at ultimate legal cost).

None of these risks is meaningfully reduced with more capital and, even if it were, the way the new rules work frustrates the way it might. As our in-depth analysis of the proposed operational risk-based capital (ORBC) rules makes clear, regulators want banks to look back as long as ten years to see how many operational losses they booked, measure business volume over the past three years, ramp up these sums via mysterious “scaling factors,” and then somehow discern what operational risk will be in coming years and how much shareholder …

FedFin on: Operational Risk-Based Capital Standards

Arezou Rafikian2023-08-11T16:25:34-04:00August 10th, 2023|The Vault|

Noting that operational risk is present at all banks due to most activities, the U.S. regulatory-capital rewrite would end the current approach to operational risk-based capital (ORBC). This now subjects only categories I and II banks to ORBC and then only to the advanced measurement approach (AMA) premised on each bank’s internal models. Consistent with the overall decision to end internal-model reliance, this section of the proposal subjects categories I, II, III, and IV banks to a new operational-risk standardized approach (SA). This would result in very steep capital requirements based on a bank’s experience over the past ten years compared to various sources of revenue over the past three years, perhaps taking business-model changes over the course of the last three years into account if regulatory standards are met for doing so….

The full report is available to retainer clients. To find out how you can sign up for the service, click here and here.…

Karen Petrou: Two Tenets of the Capital Proposal That Make No Sense No Matter How Much One Might Want to Love The Rest of It

Eliza Allen2023-07-31T10:40:41-04:00July 31st, 2023|The Vault|

In the wake of the 1,089-page capital proposal, debate is waging on well-trod battlegrounds such as whether the new approach will dry up credit and thus stifle growth. I’ve my own view on this, but my initial read of the proposal points to a still more fundamental issue: some of it makes absolutely no sense even if one agrees with the agencies’ goals. Here, I lay out two bedrock assumptions that contradict the rule’s express intent and will have adverse unintended consequences to boot. God knows what lurks in the details.

The first “say what” in the sweeping rules results from the new “higher-of” construct. Credit and operational -risk models are entirely gone and market-risk models are largely eviscerated. Instead, big banks must hold the higher of the old, “general” standardized approach (SA) or the new, “expanded” SA. Each of these requirements is set by the agencies – models mostly never allowed. Further, a new “output floor” – different from Basel’s approach to this model’s constraint – is also mandated as yet another safety net preventing anyone gaining any advantage from any possible regulatory-capital arbitrage.

Why then not just demand that big banks use a standardized weighting the agencies think suffices? Must banks be put through the burden of calculating two ratios when they have no ability to arbitrage requisite capital weights? Do the agencies not even trust themselves to set capital standards that are now sometimes higher, sometimes lower as God gives them to know probability of default …