Expected vs. Unexpected Losses (EL/UL)
In line with other banking risks, conceptually a capital charge for operational risk should cover unexpected losses due to operational risk. Provisions should cover expected losses. However, accounting rules in many countries do not appear to allow a robust, comprehensive and clear approach to setting provisions, especially for operational risk. Rather, these rules appear to allow for provisions only for future obligations related to events that have already occurred. In particular, accounting standards generally require measurable estimation tests be met and losses be probable before provisions or contingencies are actually booked.
In general, provisions set up under such accounting standards bear only a very small relation to the concept of expected operational losses. Regulators are interested in a more forward-looking concept of provisions.
There are cases where contingent reserves may be provided that relate to operational risk matters. An example is costs related to lawsuits arising from a control breakdown. Also, there are certain types of high frequency/low severity losses, such as those related to credit card fraud, that appear to be deducted from income as they occur. However, provisions are generally not set up in advance for these.
Current practice for pricing for operational risk varies widely, and explicit pricing is not common. Regardless of actual practice, it is conceptually unclear that pricing alone is sufficient to deal with operational losses in the absence of effective reserving policies.
The situation may be somewhat different for banking activities that have a highly likely incidence of expected, regular operational risk losses that are deducted from reported income in the year. Fraud losses in credit card books are an example. In these limited cases, it might be appropriate to calibrate the capital charge to unexpected losses, or unexpected losses plus some cushion of imprecision. This approach assumes that the bank.s income stream for the year will be sufficient to cover expected losses and that the bank can be relied upon to regularly deduct losses.
Against this background, the Committee proposes to calibrate the capital charge for operational risk based on expected and unexpected losses, but to allow some recognition for provisioning and loss deduction. A portion of end-of-period balances for a specific list of identified types of provisions or contingencies could be deducted from the minimum capital requirement (or recognised as part of an available capital cushion to meet requirements) provided the bank discloses them as such. Since capital is a forward-looking concept, the Committee believes that only part of a provision/contingency should be recognised as reducing the capital requirement. The capital charge for a limited list of banking activities where the annual deduction of actual operational losses is prevalent (e.g. credit card fraud) could be based on unexpected losses only, plus a cushion for imprecision. The feasibility and desirability of recognising provisions and loss deduction depend on there being a reasonable degree of clarity and comparability of approaches to defining acceptable provisions and contingencies among countries. The industry is invited to comment on how such a regime might be implemented.
