Managing uncertainty with the Standardised Measurement Approach (SMA)

Compromise is not easy, as the Basel Committee found when they published the final Standardised Measurement Approach (SMA) for calculating operational risk Pillar 1 capital in December. As the name suggests, a fundamental intention of the SMA was to provide a global framework to further standardise the management of operational risk capital. Instead, following a period of industry consultation, the SMA appears to have created more uncertainty for financial institutions and will further hinder the comparability of cross-industry operational risk capital data following its implementation in 2022.

One of the most significant sources of uncertainty, and the biggest challenge to data comparability, has been the discretion provided to national regulators to:

1. exclude loss history from the SMA calculations, although historical operational risk losses must be disclosed; or to
2. include historical losses in the SMA calculations, but have certain losses excluded based on lobbying by institutions

While these elements of the SMA were an attempt to address concerns about the backward-looking nature of the new approach, not only have they created ambiguity regarding how historical operational losses may be treated, but they have also given local regulators extraordinary influence over the calculation of operational risk capital. This will lead to differences in how SMA calculations are managed by different institutions and could well open new avenues for regulatory arbitrage across jurisdictions.

This has all been compounded by the vastly different estimated impacts of the SMA across the globe. For example a recent European Banking Authority (EBA) impact study estimated an average increase of 28% in Tier 1 Minimum Capital Requirements (MCR) for operational risk for Europe’s largest lenders migrating from the Advanced Management Approach (AMA). Similarly, some of China’s largest banks who have vast amounts of interest-generating business are expected to have significantly raised requirements on the basis that the new SMA regime uses an absolute value for interest income. On the other hand, an average reduction in MCR is anticipated for banks in the United States, driven by the way AMA has been implemented and by the number of Globally Systemically Important Banks (G-SIBs) located there; estimates in a Quantitative Impact Study (QIS) by the Basel Committee have suggested that G-SIBs could benefit from the greatest potential reductions in operational risk capital.

In the context of the divergent impacts of SMA across the globe, some local regulators have already signalled a willingness to create additional national operational risk capital requirements. For example, in the U.S., a complex series of regulatory floors has been considered, that may offset potential decreases in operational risk capital requirements from the introduction of the SMA. Alternatively, in the U.K, the PRA has indicated it may include scenario analysis of forward-looking conduct risk in Pillar 2A capital as part of a broader focus on Pillar 2. While national regulators refine their response, institutions will continue to experience ongoing uncertainty as to how to approach the calculation, analysis and disclosure of operational risk capital. In my opinion, these responses also highlight the fundamental tension between local capital management and the Basel Committee’s goal of creating a more standardised, comparable global approach.

A final key feature of the introduction of the SMA is the move away from the use of sophisticated scenario modelling techniques under the AMA and the use of more readily obtainable data. This has caused debate as to whether changes to the structure of operational risk modelling teams may be required. The outcome will depend on the degree to which further detailed scenario analysis could be required for Pillar 2 reporting, stress testing or other internal risk management activity. For many institutions, the answer will continue to evolve as local regulators consider their response to the final release of the SMA and may seek to update their Pillar 2 modelling requirements.

As with all changes to regulatory reporting requirements, implementing the SMA will require institutions to adapt whilst managing considerable uncertainty. Clearly the role that local regulators will play in determining the impact of the SMA on individual institutions will be key. From my experience, supporting the implementation of enterprise wide regulatory reporting regimes in universal banks, I know that managing regulatory interactions across an institution through centralised communication and governance processes will be crucial to implementation.

Embedding sound change management practices will also allow firms to better manage specific areas of uncertainty, including: whether to reduce modelling resources; how to leverage useful elements of existing scenario models; how to work with regulators to report operational risk losses; or any potential changes to Pillar 2 requirements.

Ultimately, the SMA is a case study in the tension between a more standardised, transparent approach to calculating operational risk capital and the need for local regulators to have the flexibility to influence local capital requirements.

In my opinion, the current SMA still does not have the balance right, as it opens up the possibility for banks to focus on lobbying regulators instead of improving global standards for issues such as reporting on emerging scenarios. As 2022 approaches, local regulators and institutions will have to work closely to ensure there is a reasonable balance between the backward-looking focus of the SMA and the ongoing analysis of emerging risks.