1. Aon Risk Solutions
Global Risk Consulting
Risk. Reinsurance. Human Resources.
The future of operational risk capital modeling
After a year of uncertainty and rumors, the Basel Committee’s latest publications on the new
“simplified approach” to operational risk capital and capital floors shed light on the future
regulatory framework for operational risk capital requirements.
Is it time for Basel IV?
In his recent speech in Barcelona, Andrea Enria – chairman of the European Banking Authority – highlighted
regulators’ concerns related to internal models:
“The poor performance of these models during the crisis, and the perception of unfairness and gaming of the
rules that accompanied reports of wild differences in risk weighted assets at banks with supposedly similar
portfolios have seriously dented the credibility of current regulatory approaches.”
In order to restore credibility and comparability of RWA, and to create a level playing field that avoids capital
arbitrage, the Basel Committee is working to change the rules for Pillar I capital calculation, defining the next
iteration of the Basel regulatory framework.
For many European banks these new standards will result in significantly increased operational risk capital
requirements. The effect if adopted in the US would be much more modest, as US regulators have worked with
Advanced Approaches banks to ensure that the significant losses incurred between 2007 and 2010 are
represented in capital models.
We’re here to
empower results:
Aon supports financial
institutions with all aspects of
their operational risk
management and modeling.
To share your views about
the future of operational risk
regulation please contact:
Evan Sekeris
+1.310.490.0243
evangelos.sekeris@aon.com
Giorgio Aprile
+39.02.4543.4092
giorgio.aprile@aon.it
Derrick Oracki
+1.202.429.8539
derrick.oracki@aon.com
AMA
STDorBIA
STDorBIA
NewSA
NewSANewSANewSANewSA
MinimumCapitalRequirement
MinimumCapitalRequirement
AMA
Many AMA
models in
Europe are
implicitly
benchmarked
against simpler
approaches.
The revised
simplified
approaches will
increase the
regulatory
capital levels.
The capital
floor framework
will impose an
explicit cap on
the potential
regulatory
capital benefit
achievable
using an AMA
model.
AMA models
will be
squeezed and
banks will be
forced to
increase their
regulatory
capital.

2. Aon Risk Solutions
Global Risk Consulting
The future of operational risk capital modeling 2
Revisions to the simpler approaches
In October 2014 the Basel Committee published a
consultative document entitled “Operational Risk –
Revisions to the Simpler Approaches”, addressing
weaknesses identified in the Basic Indicator
Approach (“BIA”), the Standardized Approach (“SA”),
and the Alternative Standardized Approach (“ASA”).
In their executive summary, the Committee criticizes
the fact that, in general, levels of operational risk
capital have not increased “despite an increase in
the number and severity of operational risk events
during and after the financial crisis”.
The largest losses incurred by many European
banks over the last ten years were close (or even
exceeded) the operational risk capital calculated
using either AMA models or the simplified methods.
Unless we believe that such events represent
realistic 1 in 1,000 year events (the target for capital
introduced under Basel II), we must accept that
previous levels of operational risk capital were
insufficient.
Ultimately, the goal of the revised simpler
approaches is to increase the overall level of
operational risk capital held by the industry.
A survey of our clients revealed that the potential
capital increase under the revised simpler
approaches ranges from 20% to more than 70%.
The original simpler approaches are, by definition,
not sensitive to the unique operational risk
exposures of each institution. While it recalibrates
the level and distribution of capital in the industry,
the new approach has no significant improvement in
risk sensitivity.
The capital floor framework
In addition, the Basel Committee also recently
published a consultative document entitled “Capital
floors: the design of a framework based on
standardised approaches”.
In this document the Committee declare that “the
objectives of a capital floor are to: ensure that the
level of capital across the banking system does not
fall below a certain level; mitigate model risk and
measurement error stemming from internally
modelled approaches; address incentive-
compatibility issues; and enhance the comparability
of capital outcomes across banks.”
The document does not address the calibration of
the floor. However, if the experience with the floor
introduced under Basel I is anything to go by, the
minimum capital requirement is likely to be set at
80% to 90% of the capital implied by the standard
approaches.
It is also not yet clear whether a single floor will be
applied to total RWA (across all risk types) or
whether separate floors will be required for
operational risk, market risk and credit risk. Since
the Committee is proposing revised simplified
approaches for each of the risk types individually,
which we think it likely that the latter approach will
prevail.
What does this mean for AMA banks?
In regions where the regulators have adopted the
Basel accords in full, it is possible that these two
proposals will require banks to increase their
operational risk capital.
For example, in Europe many banks will be forced to
increase their operational risk capital through capital
buffers. The level of capital at these banks may well
become detached from their internal models, or
force a recalibration to meet the new minimums.
The proposals will likely have less impact in the US.
The large losses recorded by US banks in recent
years have led to capital figures that are well above
those required under the pro-forma basic method.
However, the individual capital floors that the
regulators have imposed on a number of institutions
will have a similar effect on how AMA models are
viewed.
The experience in the US has been that banks have
continued to develop and implement AMA models
and systems. Our expectation is for this to be
repeated in Europe as there is still much value to be
gained by the superior understanding of operational
risk that an AMA system provides.

3. Aon Risk Solutions
Global Risk Consulting
The future of operational risk capital modeling 3
The future of AMA models
The Basel Committee is not yet ready to relegate
internal models to Pillar 2 only. However, that may
still be under consideration.
In his speech, Enria noted that: “Restoring credibility
and comparability of RWAs will be an extremely
challenging task: if successful, it will enable banks
and regulators to restore confidence in the
methodologies for measuring and managing risks; if
not successful, it will probably lead to more radical
changes in the regulatory framework.”
The committee is reserving the right to make more
significant changes to Pillar 1. This may be the
industry’s last chance to prove the value of internal,
and risk sensitive, models for operational risk capital.
Why work with Aon?
Leading institutions know that the key to an effective and successful enterprise risk management framework lies
in ensuring compliance with evolving regulatory expectations whilst simultaneously adding tangible value to the
business. We understand this too. Our team has experience of being on both sides of regulatory conversations,
and of developing risk management tools and processes both as consultants and in the industry.
A “one size fits all” is often counterproductive when working with complex financial institutions. We believe that
the key to successfully supporting our clients is for us to understand their unique issues and approach to risk
management. Our clients see us as trusted advisors who provide in-depth advice blending regulatory insights
with practical recommendations and support.
About Aon
Aon plc (NYSE:AON) is the leading global provider of risk management, insurance and reinsurance brokerage,
and human resources solutions and outsourcing services. Through its more than 66,000 colleagues worldwide,
Aon unites to empower results for clients in over 120 countries via innovative and effective risk and people
solutions and through industry-leading global resources and technical expertise. Aon has been named repeatedly
as the world’s best broker, best insurance intermediary, reinsurance intermediary, captives manager and best
employee benefits consulting firm by multiple industry sources. Visit www.aon.com for more information on Aon
and www.aon.com/manchesterunited to learn about Aon’s global and principle partnership with Manchester
United.