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Describe the general and specific Basel Committee criteria for how operational loss data should be identified, collected and treated.

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

The idea

The Basel Committee sets criteria so that loss data feeding the SMA is reliable. The general criteria come first. The database must be comprehensive, capturing all material activities and exposures from all sub-systems and geographic locations. Procedures for identifying, collecting and treating losses must be documented. Losses must be mappable to the Level 1 event types for supervisors. The specific criteria cover the data itself. A bank needs ten years of high-quality data, and five years are allowed at first adoption. For each loss it records the gross amount, recoveries and the dates of occurrence, discovery and accounting. Losses from a common or related event are grouped as one. Credit-risk-related losses stay in the credit framework, while market-risk-related operational losses stay operational. General maintenance contracts, business enhancement spending after a loss and insurance premiums are not operational losses. Exam questions usually test an exclusion or the grouping rule.

Formulas

Loss component

LC = 15 × L

L
the average annual net operational loss over the previous ten years

Ten years of data, or at least five at first adoption: divide total losses by the years actually used, not by ten.

A practice question

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

Which of the following is a general Basel Committee criterion for a bank's internal operational loss data?

  1. The database must capture all material activities and exposures from all appropriate sub-systems and geographic locations, under documented procedures - correct
  2. The database must hold only losses above EUR 1 billionWhy not: Sets an absurdly high threshold; the criteria call for comprehensive capture, with only a modest collection threshold.
  3. The database may be limited to the bank's home jurisdiction because foreign losses are reported elsewhereWhy not: Contradicts the requirement to capture material exposures from all geographic locations.
  4. The database may omit event-type classification as long as losses are classified by business lineWhy not: Contradicts the requirement that losses be mappable to Level 1 event types.

General criteria require comprehensive coverage across activities, sub-systems and locations, documented identification, collection and treatment procedures, and the ability to map losses to Level 1 event types on request.

A harder one

Over three years, an employee in a bank's payments unit repeatedly bypassed a control and caused many separate losses, each from the same fraud scheme. How should the bank record these losses in its operational loss data?

  1. Record each loss separately in the year it occurred, because each is a distinct paymentWhy not: Splits a single related event; Basel requires losses from a common or related event to be grouped.
  2. Record the group as a single loss, because losses from related events over time must be grouped - correct
  3. Record only the first loss, because later losses are consequences of the same eventWhy not: Discards the later losses; they must be included, grouped into one total, not dropped.
  4. Exclude all of them from the loss data, because fraud is covered by internal auditWhy not: Fraud is an event type within operational losses and is not excluded.

Basel requires losses caused by a common operational risk event, or related events over time, to be grouped and entered as a single loss, so the true size of the event is visible.

The hardest tier

A bank adopting the SMA has only seven years of high-quality loss data, totalling EUR 84 million of net losses, and the supervisor permits it to use the data it has (at least five years) rather than the full ten. Its loss component is closest to:

  1. EUR 12 millionWhy not: Computes the average annual loss but omits the multiplier of 15.
  2. EUR 180 million - correct
  3. EUR 126 millionWhy not: Divides the total by ten, counting three missing years as zero losses.
  4. EUR 1,260 millionWhy not: Multiplies the seven-year total by 15 without averaging.

With at least five years of data allowed at first adoption, LC = 15 x average annual losses = 15 x (84 / 7) = 15 x 12 = EUR 180 million. Dividing by ten would understate losses.

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