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Contrast the SMA with the AMA and other earlier capital methods for operational risk, noting what changed from one to the next.

FRM® Part II · Operational Risk and Resilience · Basel III: Finalising post-crisis reforms · FRM2.ORR.24.b

The idea

Earlier methods rose in sophistication. The basic indicator approach charges 15% of average positive annual gross income over three years, dropping negative or zero years from numerator and denominator. The standardized approach applies betas of 12%, 15% or 18% to gross income in eight business lines. Retail banking, asset management and retail brokerage carry 12%. Commercial banking and agency services carry 15%. Corporate finance, trading and sales, and payment and settlement carry 18%. The advanced measurement approach let approved banks use internal models built on internal losses, external data, scenario analysis and control factors, at a 99.9% one-year confidence level, with some diversification and insurance recognition. The SMA replaced all three because the AMA was complex and not comparable across banks, and the simple methods ignored loss history. The SMA is a regulatory formula with no model, no diversification and no insurance benefit. Past losses enter only through the multiplier.

Formulas

Basic indicator approach for operational risk

BIA = 0.15 × ΣGI ÷ n

GI
annual gross income in each of the previous three years that had positive gross income
n
the number of those positive years

The simplest predecessor of the SMA. Negative or zero years are dropped from both the sum and the count.

Standardised approach for operational risk

TSA = Σ max(Σ β × GI, 0) ÷ 3

β
the beta of each business line (12, 15 or 18 percent)
GI
the gross income of that business line in the year

Superseded by the SMA. Each line's own beta applies to its own gross income.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which statement best describes how the SMA relates to the earlier Basel operational risk capital methods?

  1. It replaced only the advanced measurement approach and kept the basic indicator and standardized approachesWhy not: Overlooks that the simple approaches were also withdrawn; the SMA is the single method for all banks.
  2. It replaced only the basic indicator and standardized approaches and kept the AMA for the largest banksWhy not: Wrong because the AMA was also removed in the final Basel III reforms.
  3. It replaced the basic indicator, standardized and advanced measurement approaches with one method - correct
  4. It is an optional alternative that banks may choose in place of any earlier approachWhy not: Treats the SMA as optional; it is the single required Pillar 1 method.

The finalised Basel III reforms replaced all earlier approaches (BIA, TSA and AMA) with the single SMA for Pillar 1 operational risk. The AMA was removed mainly for complexity and lack of comparability between banks.

A harder one

Under the basic indicator approach, a bank's annual gross income over the last three years was EUR 400 million, EUR 500 million and negative EUR 100 million. Its operational risk capital charge is closest to:

  1. EUR 40.0 millionWhy not: Includes the negative year in the numerator and divides by three (800 / 3) before applying 15 percent.
  2. EUR 45.0 millionWhy not: Includes the negative year as zero and divides the positive total by three.
  3. EUR 54.0 millionWhy not: Uses 12 percent, a standardized approach beta, instead of the 15 percent BIA factor.
  4. EUR 67.5 million - correct

BIA drops years with negative or zero gross income from both numerator and denominator: average = (400 + 500) / 2 = 450. Capital = 15% x 450 = EUR 67.5 million.

The hardest tier

A risk committee is comparing an existing advanced measurement approach (AMA) bank's treatment with what the SMA would require. Which statement is correct?

  1. The SMA keeps AMA-style insurance recognition but removes diversification benefitsWhy not: The SMA recognises neither; insurance and diversification benefits both disappear with the model.
  2. The SMA capital depends only on the business indicator, so the bank's own loss history has no effectWhy not: Ignores the internal loss multiplier, through which ten years of losses raise or lower capital above the business indicator component.
  3. Capital is set by a regulatory formula with no internal model, no recognition of insurance or diversification, and the bank's own losses entering through the multiplier - correct
  4. The SMA keeps the modelled 99.9 percent loss estimate but replaces scenario analysis with the business indicatorWhy not: The SMA contains no model or confidence level; the formula replaces all of the AMA elements.

The SMA is a standardized formula. Size comes from the business indicator component, bank-specific experience from the internal loss multiplier, and there is no internal modelling, no insurance mitigation and no diversification benefit, which is a main contrast with the AMA.

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