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own funds
, and debt. Bank debts are essentially
made of retail deposits – the current and savings accounts familiar to most people.
As with every economic agent, revenues generated on the asset side repay debts. If
the activity slows down, revenues dry up, or if losses incurred are too large, assets
are not enough to repay the debts. In the case of a bank, it is unable to repay people’s
deposits. Banks need own funds, or capital, to make sure that they can absorb whatever
losses they may face without defaulting on their debt obligations on the liability side
and disrupting the loan market and the financial market on the asset side, with terrible
systemic consequences for the economy.
Since the Great Depression, which led to an estimated 15% drop in the US gross
domestic product (GDP) between 1929 and 1932, government and public regulatory
authorities have developed rules and regulations to restrict and monitor the activities of
banks. The most important measure was the Glass-Steagall Act, separating commercial
and investment banking. In particular, banks were forbidden to simultaneously lend and
hold shares in the same company, in order to avoid conflict of interest and over-lending.
In 1974, following serious disturbances in the banking market, notably the failure of the
German bank Herstatt, a further supervisory step was taken when the Basel Committee
was established by the central bank governors of the Group of Ten countries. Its first
measures laid the principles for supervision of foreign banks by host countries and
cooperation between banking authorities (Basel Concordat, 1975). In 1988, Basel I
recommended a minimum level of capital to cover losses due to credit risk (the Cooke
ratio at 8% of the risk-weighted assets). This was widened in 1996 to include market
risk, followed in 2002 by operational risk.
Regulatory capital for operational risks therefore appeared for the first time in
2002, under the terms of Basel II. The reform introduced a three-pillars approach to
banking regulation, going beyond the simple need for capital. Basel II became law
77
Operational Risk Management: Best Practices in the Financial Services Industry, First Edition.
Ariane Chapelle.
© 2019 John Wiley & Sons Ltd. Published 2019 by John Wiley & Sons Ltd.
78
RISK ASSESSMENT
in the European Community in 2007 and applies to all financial institutions. In the
U.S., Basel II was mandatory for internationally active banks only, later on to be called
systemically important financial institutions (SIFIs). The three pillars of the Basel reg-
ulation are as follows:
■
Pillar 1: Regulatory capital: mandatory minimum level of capital to cover credit,
market and operational risks.
■
For operational risk, additional managerial recommendations come in the form
of the “Sound Principles for the Management of Operational Risk” (2003,
updated in 2011 and 2014).
■
Pillar 2: Supervisory review process (known currently as SREP): adjustments to
the pillar 1 requirements based on the specific risk profile of an institution, its
activities and the quality of its risk management, as assessed by the regulator and
by the firm itself.
■
Over the years and especially since the crisis, this has resulted in capital add-ons,
sometimes substantial.
■
Pillar 3: Market discipline: body of rules on mandatory information disclosures
yearly or quarterly by financial institutions regarding the financial situation and
risk information.
■
The initial idea of pillar 3 was that the publication of certain financial and risk
information would encourage market discipline, whereby shareholders of firms
more exposed to risk would require the firms to hold more capital to compensate
for the increased level of risk. It never quite worked as intended.
In the early 2000s the rule of thumb was that operational risk capital should rep-
resent 12% of the total capital held by the bank, the remaining 88% being covered by
credit and market risk capital. Why 12%? Cynics like me will note that this percentage
corresponds roughly to the expected drop in the credit risk capital introduced by the
Basel II reform with the new diversification effect allowed in credit risk portfolio (a
similar diversification effect was applied to subprime portfolios a few years later . . . ).
With the market risk rules remaining unchanged, this led to a simple substitution effect
between credit risk capital (down 12%) and operational risk capital (up 12%), but no
increase in the solvency level of the sector. It made sense because according to some
pressure groups, the Basel Committee at the time committed not to increase the regu-
latory capital requirements.
Although the rules for capital were strictly observed when implemented in the
early 1990s, they weakened over time. Coverage became stretched and exceptions more
common. Because the rules were not legally binding, each country applied them as it
saw fit in its own jurisdiction.
The financial crisis of 2007/2008 was a painful reminder of what bank failures
were like during the Great Depression. Several macroeconomic factors led to the
recent financial crisis, such as the repeal of the Glass-Steagall Act in 1999 followed
by a wave of other deregulations; the proliferation of new and misunderstood financial
Regulatory Capital and Modeling
79
products, especially credit derivatives and synthetic derivatives linked to depleted
underlying assets (the subprime loans); and, finally, the development of new and
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