Advanced Measurement Approach

The purpose of the Basel II Accord is to provide the foundation for a sound operational risk framework, while allowing organizations to identify the most appropriate means to meet the requirements. Each organization will need to consider its complexity, range of products and services, organizational structure, and risk management culture as it decides which approach to use to calculate its minimum capital requirements. To encourage banks to improve their operational risk management frameworks, the new Basel Accord has also set criteria for implementing more advanced approaches to operational risk. Such approaches are based on banks’ internal calculations of the probabilities of operational risk events occurring and the average losses from those events. Of the three approaches available for calculating operational risk, the advanced measurement approach (AMA) is likely to have the most appeal because of its flexibility and the amount of self-discipline it provides. Using an AMA allows banks to develop their own methodologies in measuring operational risk and

the capital they will set aside in accordance with certain guidelines proposed in Basel II. With an AMA, banks may use their own method for assessing their exposure to operational risk, as long as it is sufficiently comprehensive and systematic. Moving beyond the averaging of the other methods, the bank is allowed to collect the history of its losses, analyze that history, and use multiple risk factors to derive a probability of loss. The use of these approaches will reduce the operational risk capital requirement, as is currently done for market risk capital requirements and is proposed for credit risk capital requirements. These approaches, however, will be subjected to audit and regulatory oversight. The result should be that banks that invest to reduce their risks would ultimately get the financial return of lower capital requirements. More importantly, banks will achieve operational risk management that will warranty better business operational stability and performances. Under the AMA, if a bank invests in improved contingency procedures and systems, the investment will be reflected in a reduction in the need for operational risk capital, which is inevitably higher in the less advanced approaches. As a result, there is an incentive for organizations to use the more advanced and sophisticated approaches.