Capital impact of the SMA ORX benchmark of the proposed Standardised Measurement Approach

Association Research Information

www.orx.org +44 (0)1225 430 390© Operational Riskdata eXchange (ORX) 2016

1

1 Executive Summary

This note summarises the ORX benchmark of the SMA capital requirements based on data submitted by 54 banks during March 2016.1

Within the sample of banks surveyed we found:

• The SMA is not capital neutral in comparison to current regulatory approved capital

• 75% of banks would see an increase in capital, equating to an additional €115 BN Pillar I capital

• European banks see the biggest increase under the SMA, experiencing on average a 63% higher capital charge in comparison with current regulatory approved capital

• In relation to gross revenue, US banks would continue to hold higher capital than other regions, at around 32% of gross revenue compared to 20% for their European counterparts

• Larger banks would hold proportionally more SMA capital, face the biggest increase beyond current regulatory approved capital, and experience the largest impact from the loss history

• For the smallest banks the implied SMA capital requirement can be below the current standardised approach.

The SMA Formula The SMA is based on two components: the Business Indicator (BI) Component, a balance sheet metric, and the Loss Component, derived from 10 years of internal losses. It allocates banks into one of 5 BI buckets which require proportionally higher capital as BI increases.

The BI Component is calibrated as the SMA’s capital baseline, chosen to reflect a capital level appropriate for a bank with an “average” loss profile. This Component is adjusted up or down according to the bank’s loss history. The maximal decrease, corresponding to zero loss within the previous 10 years, is 45%.

There are a number of outstanding questions concerning the calculation of the SMA. All data reported here is based in submitting banks’ current understanding of BCBS’ proposals 4 March 2016. Information is only presented where four or more responses are available.

Our report uses box plots to summarise the range of participant responses. Please see Annex 1 for a guide on how to read box plots.

1 For a full list of participants see http://www.orx.org/Pages/ORXResearch.aspx

The Operational Riskdata eXchange Association (ORX) is a not-for-profit industry association dedicated to advancing the measurement and management of operational risk in the global financial services industry.

Copyright & Disclaimer NoticeORX has prepared this document with care and attention. ORX does not accept responsibility for any errors or omissions. ORX does not warrant the accuracy of the comments, statement or recommendations in this document. ORX shall not be liable for any loss, expense, damage or claim arising from this document. The content of this document does not itself constitute a contractual agreement, ORX accepts no obligation associated with this document except as expressly agreed in writing.© Copyright 2016 ORX. All rights reserved. ORX and its associated logo are trademarks. All other trademarks are the property of their respective owners. All ORX products and services are subject to continuous development. We reserve the right to alter technical specifications without prior notice.

For further details please contact the authors:

Simon Wills Executive Director simon.wills@orx.org

Luke Carrivick Head of Analytics and Research luke.carrivick@orx.org

Paul Minter Senior Analytics Manager paul.minter@orx.org

2

2 ORX Introduction

On 4 March 2016 the Basel Committee on Banking Supervision (BCBS) proposed a new Standardised Measurement Approach (SMA) for Pillar I operational risk capital. It proposed the SMA replaces all existing Basic, Standardised and Advanced approaches for calculating operational risk capital requirements.

The BCBS’ stated aim is to achieve an appropriate balance between simplicity, comparability, and risk sensitivity for operational risk capital calculations.2

It expects the revisions to have a relatively neutral impact on capital.3

2 http://www.bis.org/publ/bcbs258.pdf 3 https://www.bis.org/press/p160304.htm

3 Capital Impact

Pillar I operational risk capital requirements increase under the SMA for the majority of banks.

Of the banks surveyed 75% would see an increase in Pillar I operational risk capital under the SMA compared to current regulatory approved4 capital for 2013-15.

The median change is a capital increase of 33%, the mean change an increase of 61%, and a quarter of banks would see an increase of 70% or more.

Taken together the surveyed banks would have been required to hold 55% more capital in 2015, equivalent to €115 BN additional capital or 20% of total annual income.

2 Banks supplied their capital according to their regulatory approved method of calculation, the AMA, TSA or BIA.

75% of banks face a capital increase

25% of banks face a capital reduction

Figure 1: Capital Impact of SMA on current approved capital requirements.

3

4 Regional Differences

The average increase in capital under the SMA from current approved levels differs by region. Banks headquartered in different regions face different implied increases when calculating capital under the SMA. Figure 2 shows the ratio of SMA capital to current approved regulatory capital, where 100% on the Y axis equates to no capital change needed to meet SMA requirements. We see the median bank in all regions experiences a capital increase with the European median bank experiencing the highest increase of 63%. The mean increase for European banks is 79% with a quarter of European banks facing an increase of 88% or more.

Whilst the relative increase is highest for European banks (+63.5% Table 1), those banks headquartered in the USA still hold the greatest proportion of income as operational risk capital (Figure 3). Under the SMA the median proportion of gross income US institutions would hold in capital is 31%, compared to 20% for European banks (Table 2). Figure 3 also shows the spread of capital outcomes to income is broader for the SMA than for 2015 regulatory approved capital in all jurisdictions except Australia. The spread of current capital requirements may appear narrower due to the association of current requirements and income.

Figure 2: SMA as a % of 2015 regulatory approved capital by region.

Our sample of US banks are on average larger than the sample of European banks (Annex 1, Table 5), so naturally have a larger BI Component and SMA requirement. We explore the effect of size in more detail in the next section.

Figure 3: Regional comparisons of SMA and 2015 regulatory approved capital as a % of income.

Table 1: Median and mean increases from current regulatory approved capital to the SMA by region.

Median

Mean

33.2

61.3

8.9

12.0

24.6

22.9

63.5

79.6

26.3

33.2

2.9

1.3

% capital increase to SMA All Australia Canada Europe South Africa USA

Table 2: Capital to Income % for regulatory approved and SMA levels.

2015 Regulatory Approved

SMA

20.7

32.2

14.8

15.7

12.5

16.4

13.7

20.0

12.0

14.6

31.7

31.7

Capital / Income % All* Australia Canada Europe South Africa USA

SM

A C

apit

al /

Cur

rent

Ap

pro

ved

Cap

ital

%

Australia

300%

250%

200%

150%

100%

50%

0%Canada Europe South

AfricaUSA

REGION

Current Capital SMA Capital

SM

A a

nd R

egul

ato

ry A

pp

rove

d C

apit

al /

Inco

me

%

Australia

60%

50%

40%

30%

20%

10%

0%Canada Europe South

AfricaUSA

REGION

* The “All” numbers represent an overall sample ratio i.e. Total Sample Capital / Total Sample Income. The equivalent median ratios for “All” when treating banks individually are SMA 19.4% and Regulatory Approved 13.7%.

4

Figure 4: SMA to income ratio for increasing bank size grouped by assets.

Figure 6: Implied multiplier by BI bucket. BI bucket 1 does not include losses to calculate the SMA.

Figure 5: SMA to current approved capital ratio for banks grouped by assets.

5 Size Impacts

Under the SMA larger banks receive proportionally higher capital charges. Larger institutions receive a proportionally higher capital charge under the SMA compared to their smaller peers. As illustrated by the medians in Figure 4, the largest banks by assets will hold more than 36% of gross revenues in Pillar I capital, compared to 15% for the smallest banks. Accordingly, to achieve higher SMA capital levels larger banks will on average face a larger increase in capital requirements than smaller banks. Figure 5 shows that for the largest banks the median increase in capital is more than 100%, while for the smallest the SMA appears capital neutral.

Additionally, larger banks experience the largest impact from the loss component. Figure 6 demonstrates the median multiplier increases steadily from 0.88 in BI bucket 2 to 1.35 in bucket 5. We explore the loss component in more detail in section 7.

Taken together, bank size appears the biggest determinant of capital levels under the SMA. Larger banks hold proportionally more SMA capital, have the biggest increase beyond current regulatory approved capital, and experience the largest impact from the loss component.

SM

A C

apit

al /

Inco

me

%

< 250 Bn

60%

50%

40%

30%

20%

10%

0%250 – 500 Bn 500 Bn – 1 Tn > 1 Tn

ASSET SIZE €

SM

A C

apit

al /

ICur

rent

Ap

pro

ved

Cap

ital

%

< 250 Bn

350%

300%

250%

200%

150%

100%

50%

0%250 – 500 Bn 500 Bn – 1 Tn > 1 Tn

ASSET SIZE €

Mul

tip

lier

< 1 Bn

2.25

2.0

1.75

1.5

1.25

1.0

0.75

0.51-3 Bn 3-10 Bn 10-30 Bn

BI BUCKET

> 30 Bn

6 The Business Indicator

During 2013-15 the Business Indicator performs very similarly to gross income.

To compare the behaviour of gross income and the Business Indicator a scatter plot is given in Figure 7, showing that within this period they are highly correlated. Statistical analysis implies gross income determines 96% of the BI’s behaviour in our sample, indicating a strong relationship.5

This suggests that the business indicator and gross income have a similar capacity to capture the risk profile of an institution in these years.

7 The Loss Multiplier

On average the loss multiplier increases SMA capital requirements by 11% from the BI Component.

Loss experience adjusts a bank’s BI Component to determine its SMA capital requirement. Looking at the loss multiplier shows differences in SMA capital requirements independently of bank size. Figure 8 provides a comparison of the loss multiplier by region. The median effect on SMA capital requirements due to internal losses differs by region. It reduces SMA requirements from the baseline BI capital for the median bank in Australia, Canada and South Africa, and increases it in Europe and the US (Table 3). The average increase in SMA capital requirements determined by the loss multiplier is an increase of 11% from the BI Component.

Table 3: Average Loss Component adjustment by region.

Median Mean

1.00

0.93

0.67

1.09

0.83

1.16

1.11

0.98

0.73

1.19

0.84

1.21

Average Loss Multiplier

All

Australia

Canada

Europe

South Africa

USA

5 R2 = 0.9604

Figure 8: Loss Component adjustment (the multiplier) by region for 2015. A multiplier of 0.9 equates to a 10% reduction in SMA capital requirements from the BI baseline.

Figure 7: Relationship between the business indicator and gross income.

Differences in the reported loss multiplier exist between regions and within BI buckets (Annex 1,Table 6), particularly for European and US banks. For example, US banks in BI bucket 5 reported a mean impact of the loss component of 1.54, compared to 1.35 for banks headquartered in Europe. This difference contributes to the higher SMA requirement in the US.

Mul

tip

lier

Australia

1.8

1.6

1.4

1.2

1.0

0.8

0.6Canada Europe South

AfricaUSA

REGION

5

Gross Income (Log Scale)

Bus

ines

s In

dic

ato

r (L

og

Sca

le)

Given the concentration of banks within BI buckets 3-5 (Table 4) there is potential for the results of our survey to be more representative of larger banks as they make up the majority of participants.

Furthermore a breakdown of the banks in BI buckets by region demonstrates the distribution of larger banks.

There are a number of outstanding questions concerning the calculation of the SMA. All data reported here is based on submitting banks’ current understanding of BCBS’ proposal 4 March 2016.

Table 5: Survey participants by BI bucket and Region.

Table 6: Mean loss multiplier of participants by BI bucket and Region.

Australia

Canada

Europe

Europe

Rest of the World

South Africa

USA

USA

–

4%

–

25%

–

–

–

–

33%

4%

–

–

–

33%

–

–

33%

33%

1.00

75%

20%

–

25%

1.00

33%

33%

1.33 1.35

–

80%

67%

42%

1.46 1.54

–

25%

–

–

–

33%

% of participants in region by BI Bucket

Mean loss multiplier in region by BI Bucket

One

One

Two

Two

Three

Three

Four

Four Five

Five

www.orx.org +44 (0)1225 430 390© Operational Riskdata eXchange (ORX) 2016

Reading the box plotsThis report uses box plots to summarise the range of participant responses. The central horizontal line indicates the median response, and the box indicates the spread of answers for the central half the number of respondents known as the inter quartile range (IQR). The top of the box shows the upper 75% point of all respondents and the bottom of the box the lower 25% point. The whiskers indicate the min and max observations within 1.5 of the IQR of the top and bottom of the box.

Information is only presented where four or more responses are available.

Figure 9: Location of participating institutions. Table 4: Number of banks participating within each BI bucket.

< 1 Bn

1 – 3 Bn

3 – 10 Bn

10 – 30 Bn

> 30 Bn

2

4

17

21

10

BI Bucket Number of Banks

8 Annex 1: Survey Inputs

54 internationally active banks, including 16 of the world’s G-SIBs, submitted their current regulatory approved Pillar I operational risk capital requirements and their estimated SMA capital requirement.

The location of the participants is given in Figure 9, showing a strong representation by European (44%) and US (22%) banks.

Ho

me

Reg

ion

Australia

Canada

Europe

SouthAfrica

RoW

USA

0 5 10 15 20 25

Number of Banks Participating