Work with the Basel operational risk taxonomy by applying and describing its Level 1, Level 2 and Level 3 categories.
The idea
The Basel operational risk taxonomy classifies loss events by event type in three levels. Level 1 has seven categories: internal fraud, external fraud, employment practices and workplace safety, clients, products and business practices, damage to physical assets, business disruption and system failures, and execution, delivery and process management. Level 2 divides each into sub-categories. For example, internal fraud splits into unauthorised activity and theft and fraud, and execution, delivery and process management into six groups including transaction capture and vendors and suppliers. Level 3 gives activity examples, such as intentional mismarking of positions under unauthorised activity. The key discriminators are intent and who is involved. Deliberate acts by an insider are internal fraud, deliberate acts by a third party are external fraud, and unintentional errors in processing usually fall in execution, delivery and process management. Strategic and reputational risk are excluded from the definition.
A practice question
How many Level 1 event-type categories are there in the Basel operational risk taxonomy?
- Five.Why not: Understates the list, dropping categories such as damage to physical assets and business disruption and system failures.
- Eight, matching the eight business lines.Why not: Confuses the event types with the eight business lines used elsewhere in the Basel framework.
- Seven. - correct
- Twenty.Why not: Gives the approximate number of Level 2 categories, not the Level 1 event types.
The Basel taxonomy has seven Level 1 event types: internal fraud, external fraud, employment practices and workplace safety, clients, products and business practices, damage to physical assets, business disruption and system failures, and execution, delivery and process management. Business lines number eight and Level 2 categories about twenty.
A harder one
A trader deliberately hides losses by marking positions at prices he knows are wrong. How is this classified at Levels 1 and 2 of the Basel taxonomy?
- Internal Fraud, Unauthorised Activity. - correct
- Execution, Delivery and Process Management, Monitoring and Reporting.Why not: Treats a deliberate act as a reporting error; intent places it in fraud rather than process management.
- Clients, Products and Business Practices, Improper Business or Market Practices.Why not: Mismarking positions is not a market-conduct failure towards clients or the market.
- External Fraud, Theft and Fraud.Why not: The act is by an employee, so it is internal rather than external fraud.
Deliberate mismarking of positions by an employee is an intentional act by an insider, so it falls under Internal Fraud, Level 2 Unauthorised Activity. Intent separates it from a processing or reporting error.
The hardest tier
Which statement about the structure of the Basel operational risk taxonomy is correct?
- Level 2 lists the eight business lines, and Level 3 lists the event types.Why not: Business lines are a separate dimension of the Basel framework and are not part of the event-type hierarchy.
- Level 1 gives seven event types, Level 2 subdivides them into categories such as Unauthorised Activity, and Level 3 lists activity examples of what falls within each Level 2 category. - correct
- Level 1 lists causes, Level 2 lists events and Level 3 lists effects.Why not: The hierarchy is by event type and increasing detail, not a cause-event-effect chain.
- The same Level 2 category sits under several Level 1 categories, so one event can be reported in more than one place.Why not: Theft and Fraud appears under both fraud types but as separate categories, distinguished by whether an insider is involved; each event maps to one.
The Basel hierarchy narrows from seven event types (Level 1) to sub-categories (Level 2) to concrete activity examples (Level 3). Repeated names such as Theft and Fraud sit in separate Level 1 categories for internal and external parties, and each loss maps to one place.
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