What is Operational Risk ? Explain the various approaches for computation of operational risk capital under Basel Accord II.
Operational risk is the potential for loss resulting from inadequate or failed internal processes, systems, people, or external events. It encompasses a wide range of risks, including legal risks, fraud, human error, system failures, and external factors such as natural disasters or geopolitical events. Operational risks are inherent in every banking activity and can arise from various sources within a bank's operations.
Basel Accord II introduced specific methodologies for computing operational risk capital, recognizing the significance of addressing these risks in banking institutions. There are three primary approaches under Basel II for the computation of operational risk capital:
1. Basic Indicator Approach (BIA):
- The BIA is the simplest method for calculating operational risk capital. It uses a single indicator—usually the gross income—to determine the capital requirement. A fixed percentage, prescribed by regulators, is applied to this indicator to calculate the capital charge.
- The formula is straightforward: Operational Risk Capital = α
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