Basel III and Its Potential Effect on Operational Risk Management

UPDATE: In September 2024, the Federal Reserve outlined a set of proposed changes to the Basel III Endgame requirements, including raising tier 1 capital levels for globally systemically important banks by a smaller amount than was originally envisioned and increasing the asset threshold at which banks would be responsible for complying with the proposed rule changes. This article summarizes a panel convened in July of this year.   

The sweeping changes described in the Basel III Endgame proposal raised many questions within banking circles when they first were introduced in July 2023. Since then, calls for broad revisions to the plan have only grown louder. As uncertainty remains about the path to a final, workable version of the proposal, the industry will continue to evaluate Basel III’s possible impact and push alternatives that are less burdensome and costly for banks.    

“Generally, organizations have opposed the Basel III Endgame proposal because of the potential industry and broader economic implications,” said Ramy Farha, a partner in Oliver Wyman’s finance, risk, and public policy practice and a panelist on a recent Basel III-focused session at RMA’s Governance, Compliance and Operational Resiliency Conference.

Even Federal Reserve Chairman Jerome Powell has started to walk back some of his initial support for the plan.

In conceiving Basel III, the Basel Committee on Banking Supervision significantly increased both the quality and quantity of capital required for banks, in part to address many of the industry vulnerabilities highlighted by the 2007 banking crisis. The proposal revises international standards for banks’ capital adequacy, stress testing, and liquidity practices, requiring a greater sensitivity to operational, credit, and market-based risks. It also changes the calculation for risk-weighted assets (RWA), forcing banks to rethink business models and how they allocate capital.

New aspects of the proposal include:

• An expanded risk-based approach to the capital stack—an addition to the existing standardized approach.
• A new market risk rule and a new credit valuation adjustment (CVA) rule.
• Adjustments that make RWA calculations more granular and risk sensitive.
• A new standardized approach to operational risk capital that replaces the existing advanced approach.

Re-Factoring Operational Risk

Under Basel III Endgame, the RWA total banks must hold capital against is expected to increase 24% industrywide. For banking organizations, the operational risk component is viewed as the major driver of this increase—the RWA calculation also includes credit and market risk components—and the focus of industry scrutiny.

“This will have significant variation by banks of different sizes and business models, as well as significant shifts within businesses in light of the operational risk requirements moving from internal models to standardized models using business indicators based on volumes metrics rather than risk-based models,” said Eric Czervionke, a partner with the finance and corporate and institutional banking practices of Oliver Wyman.

There are several crucial factors to consider when it comes to the Basel III Endgame and operational risk. First, the operational risk capital requirement is essentially a combination of a business indicator component, which includes a scalar based on the range of the business, and an internal loss modifier (ILM). Multiplying the two gets you your capital requirement, Farha said.

“So, if you are doing a good job of managing your operational losses, you should expect to see the ILM go down,” Farha said.

The formula has some significant drawbacks. First, the business indicator is linked to income, which is likely to more heavily penalize businesses like wealth and asset management, investment banking, and credit cards. Second, the ILM has a 10-year look-back period, which would penalize firms for significant past losses until enough time elapses for improvements to the control environment can be realized. Finally, U.S. banks are at a competitive disadvantage as it relates to ILM. The European Union and the United Kingdom set ILM to one without regard to historical losses, while Canada has a floating ILM with no floor. One is the ILM floor for U.S. banks. “There’s obviously a lot of concerns with the flooring,” said Farha.

Another challenge for banks will be understanding their operational risks and aligning models for both internal risk management and regulatory purposes.  “You cannot manage risk without being able to measure it,” said Farha. “So, it is extremely important to have mechanisms to quantify the risk.”

Some important elements of operational risk models that help with internal risk management include:

• A stable and simple quantification approach.
• An exposure measure of risk that is dynamic and responsive to changes in the business.
• The ability to accurately estimate and test exposure.
• The ability to conduct stress testing to provide conditional and unconditional estimates of risk.
• The ability to recognize risk mitigation.
• An approach and a way of modeling operational risk that helps facilitate capital allocation to different business based on key risk drivers.

In an ideal world, Farha concluded, if the industry went back to the drawing board and considered a better way to measure operational risk, and therefore capitalize against it, he would suggest working with some of these elements, trying to converge the industry and the agencies around them, and then figuring out the best modeling technique to achieve them.

Endgame for Basel III Endgame?

There is still uncertainty about how the Basel III Endgame will play out in the months ahead, including whether the proposal will be finalized in 2024 and implemented in July 2025, as proposed.

Czervionke suggested it is increasingly unlikely that will happen, noting a palpable change in the rhetoric of the regulators as well as strong industry opposition to the rule in its current form. “I think a lot of the concerns that have been raised have been valid,” Czervionke said.

He added: “At this point, I think there’s almost certainly going to be either material adjustments to the rule as proposed, and a re-proposal looks to be increasingly likely. Given the backlash and lack of transparency around certain decisions, I think it’s increasingly unlikely that we’ll have a definitive answer prior to the election.”