The regulatory framework and capital requirements for operational risk
Regulatory capital for operational risk is a favourite exam area because the rules are precise and the arithmetic is checkable. You need the Basel definition and approaches, the post-reform Standardised Approach, and how the UK and EU regimes apply them.
Basel history in one paragraph
Basel II (2004) created three approaches: Basic Indicator (BIA), Standardised (TSA) and Advanced Measurement (AMA). Basel III's final reforms replaced all three with a single Standardised Approach based on a Business Indicator (BI), implemented in the EU through CRR3 from 1 January 2025, with the UK delaying Basel 3.1 to 1 January 2027.
The arithmetic
BIA: capital = 15% × the three-year average of positive gross income. Negative years are excluded from both numerator and denominator.
Old TSA: gross income per business line × beta: corporate finance 18%, trading and sales 18%, payment and settlement 18%, commercial banking 15%, agency services 15%, retail banking 12%, asset management 12%, retail brokerage 12%.
New SA: the BI is built from interest, lease and dividend income, services income and financial income. The Business Indicator Component (BIC) uses marginal coefficients: 12% up to €1bn, 15% between €1bn and €30bn, 18% above €30bn. Banks also apply an Internal Loss Multiplier based on ten-year average losses relative to the BIC.
Wider framework
Capital sits in Pillar 1; Pillar 2 (ICAAP/ICARA and SREP) covers risks not fully captured; Pillar 3 requires disclosure. UK firms also face operational resilience rules (impact tolerances for important business services, in force 31 March 2025), SM&CR accountability and the FCA/PRA outsourcing rules.
Worked example
Gross income: Year 1 £120m, Year 2 £140m, Year 3 −£20m. BIA: exclude Year 3, average of 120 and 140 = 130; capital = 15% × 130 = £19.5m. Reasoning: including the negative year would understate the charge and is expressly not permitted. Note that the exclusion changes the denominator to two years.
Traps that cost marks
- Averaging over three years but including zero or negative income.
- Mixing up the retail banking beta (12%) with corporate finance (18%).
- Quoting AMA as a current Basel option.
- Forgetting Pillar 2 and the internal capital adequacy process.