Quantitative techniques measurements for operational risk faced by banks licensed under the Malta Financial Services Authority

Abstract

Operational Risk refers to the risk of losses resulting from inadequate or failed internal processes, people and systems, or external events. Quantitative Measurement Techniques refers to the tools and mathematical methodologies required to facilitate the quantification of operational risk. The Basic Indicator Approach, the Standardised Approach and the Advanced Measurement Approaches as the Internal Measurement Approach, the Scorecard-Based Approach, Scenario Analysis and the Loss Distribution Approach are the techniques permitted for the capital allocation to cover the operational risk of a bank. The objective of the study is to analyse the procedures developed to quantify operational risk and assess their application in practice. Questionnaires were mailed to banks licensed under the Malta Financial Services Authority (MFSA). Face-to-face interviews were also conducted with three banks' representatives and a representative of the Banking Unit of the MFSA. The study has concluded that banks are restricted to utilise the simplest approach (i.e Basic Indicator Approach) for regulatory capital allocation to operational risk due the limited resources available on the market such as the necessary staff expertise and the adequate IT systems, and also due to the structure of local banks (mainly traditional banks without any complex products and services). As a result of growth expectation in the Maltese Banking Sector, the implementation of the Standardised Approach will be more beneficial since it permits better risk controls. For instance, both an increase in market participants (especially the establishment of credit institutions owned by a foreign parent company) and the introduction of new products enhance faster improvements in such measurement technique. The main factors which inhibit the utilisation of advance measurement approaches by local banks are the cost-benefit analysis and the limited number of operational loss events occurring in Malta. The advanced approaches provide efficient results only when methodologies are backed by a huge amount of data that comprises of internal and external data. The study has concluded that no external data exist for local banks. Therefore the development of sound and comprehensive data collection practices encourages banks to move to more quantitative methods since such methods ensure that their internal risk profile is represented by the regulatory capital. Although the development of risk measurement techniques are continuously being developed and practised by large banks, it needs not necessarily to be adopted by smaller deposit money banks. Since in Malta the measurement of operational risk is at its infancy stage, the Maltese Regulatory Authorities have no intentions to impose any stringent measures in relation to which tool or technique the bank should adopt. Hence the choice of measurement technique is at the discretion of the bank which depends on the different levels of risk sensitivity.