The battle for control over the op risk regulatory capital agenda has been fascinating to watch, rather like a game of chess. So, what happened on the regulatory chessboard? Here’s a summary:

The banks played white and opened with the ‘regulatory capture’ gambit. In a sequence of carefully planned and expertly coordinated moves, white took control of the chessboard.

White’s strong opening position should have led to an easy win, but a few careless moves handed positional advantage to black. With black now on top, white lost key pieces, including its queen. Black continued to press its positional and material advantage and succeeded in promoting one of its pawns to a queen. With white’s position now completely hopeless, it tipped over its king and resigned.

So, what does our op risk chess metaphor represent?
1. The ‘regulatory capture’ gambit played by white resulted in the regulators accepting each qualifying bank’s own internal calculation of op risk regulatory capital, the so-called Advanced Measurement Approach or AMA. Given the non-standardization of banks’ internal AMA models and the consequent non-comparability of the outputs, the banks effectively took initial control of the op risk regulatory capital framework.
2. The ‘careless moves’ were the extreme losses suffered by banks in the period leading up to the global financial crisis of 2007/8, primarily the misguided and/or fraudulent activities of rogue traders and the subprime fiasco.
3. White’s ‘loss of key pieces’ refers to the post-crisis introduction of Basel III which restricted banks’ risk-taking and freedom to operate.
4. The ‘loss of white’s queen’ is the removal by the regulators of the banks’ flagship AMA from the op risk regulatory capital framework.
5. Black’s ‘pawn promoted to a queen’ was the implementation of the Basel Committee’s Standardized Approach (SA) and the US Fed’s Stress Capital Buffer (SCB).

In effect, the SA and SCB have given regulators free rein to unilaterally demand whatever amount of op risk capital they believe will guarantee the safety and stability of the banking sector. Their effect is to oblige banks to hold inert, unproductive and costly capital reserves well in excess of their operating requirements.

To correct this punitive disconnect between the capital reserves mandated by regulators and banks’ true risk profiles, a solution is required that combines both financial and non-financial exposures within a common accounting framework. Here’s how it can be done:

Accounting involves the identification of all contractual obligations a firm enters into and the registration, in accounting systems, of all past and expected receipts and payments that emanate from them. This takes care of accounting for financial exposures.

We’ve demonstrated on our website and through numerous published academic papers, articles and presentations that the non-financial risks triggered by these same contractual obligations can also be quantified and registered in accounting systems. The pairing of financial and non-financial risk values within a common accounting framework provides an audit trail between the identification and quantification of non-financial exposures at the transaction level and op risk capital valuation at the holding company level.

Achieving a common financial and non-financial risk reporting and accounting framework isn’t as difficult as people might imagine because the financial accounting infrastructure already exists. But you don’t have to take my word for it. If you allow us to run a proof-of-concept in your organization, you’ll see for yourself.

I’ll finish on this thought from our new board member, Colin Lawrence: “…critical operational risks such as conduct, climate, and supply chain risk must be quantitatively embedded in accounting metrics to avoid the catastrophes of the past.”

Best wishes,

Peter

Peter J. Hughes

Chairman of the Risk Accounting Standards Board, RASB