The Standardised Measurement Approach (SMA) replaces all four approaches currently available under Pillar 1. The objective is to provide stable, comparable and risk-sensitive estimates for the operational risk exposure.
The formula calculates the minimum capital requirement based on:
- The size and activity of the bank based on financial statement data (business indicator, BI),
- A marginal coefficient (12, 15 or 18%) based on the size of the business indicator (with thresholds at EUR 1bn and 30bn) and
- A multiplier based on the bank’s large losses incurred during the previous 10 years (internal loss multiplier, ILM4
The business indicator component (BIC) is the product of the first two components, the BI and the marginal coefficient. The minimum operational risk capital requirement is the product of the BIC and the ILM. The corresponding RWA is 12.5 times that.
The Business Indicator intends to measure the size of the operation based on income, expense and profitability measures, assuming that the larger the institution, the higher its operational risk exposure. This non-linearity is introduced using the 3-bucket approach based on the BI and the increasing marginal coefficients in them.
The Business Indicator is calculated as the sum of three sub-components:
- The interest, leases and dividend component (ILDC),
- The services component (SC), and
- The financial component (FC).
Each component is based on several other components: interest income, interest expense, interest earning assets and dividend income for the ILDC; other operating income or other operating expense, and fee income or fee expense for the SC; and the absolute value of the net P&L of the banking book and trading book for the FC. Each of these is calculated as the average of the latest three years’ data.
The objective of the ILM is to adjust the BIC, with the actual loss experience of the bank relative to the BIC. If the BIC represents the usual operational risk exposure of banks, the ILM adjusts this upwards or downwards based on the actual large loss experience of the specific institution. The large loss experience is consolidated as the sum of all individual losses above EUR 20,000 for each of the previous 10 years. The average of these yearly sums is multiplied by 15 to give the Loss Component (LC), which is then compared to the value of the BIC. If the Loss Component is 1% of the BIC, the value of the ILM is 0.55. If the LC is half, twice or five times the BIC, the ILM will be 0.83, 1.24 and 1.67, respectively.
“Supervisors are provided the flexibility to set the ILM to one for all institutions, or to increase the individual loss floor up to EUR 100,000 for large institutions (BI > EUR 1 BN) in their jurisdiction. The observation period may also be shorter than 10 years for currently non-AMA banks if certain criteria are met and if the supervisor approves.”
With such a standardized approach to Pillar 1 (minimum) capital requirements, the BIC will be an indicator that is comparable across institutions. The ILM provides an opportunity to adjust this to the institution’s own loss experience. As the past 10-year loss experience (sum of individual losses above the floor in each year) will need to be disclosed, external stakeholders may also gain a better understanding of the drivers of the minimum capital requirement.