The Evolution of Risk Accounting
The Business Indicator: A Proxy for Operational Risk or a Missed Opportunity?
As banks have evolved to become more complex and interconnected, the methods used to measure and manage risks have also needed to adapt.
One such method introduced by the Basel Committee on Banking Supervision is the Business Indicator—a key component of the standardized approach to calculating operational risk capital under Basel III. This approach, however, has sparked significant debate within the industry. Critics argue that the Business Indicator is an oversimplified proxy for operational risk that fails to capture the true nature of a bank’s risk profile.
In this article, we’ll examine the Business Indicator, its intended role in operational risk management, and why it might fall short of its goals. We will also explore how risk accounting could provide a more accurate and comprehensive alternative.
What is the Business Indicator?
The Business Indicator (BI) is a metric introduced under the Basel III regulatory framework as part of the standardized approach to calculating operational risk capital requirements. The BI is designed to act as a proxy for a bank’s overall exposure to operational risks by using financial statement items that reflect the scale and complexity of the bank’s business activities.
It is calculated based on three main components: the Interest, Leases, and Dividend Component; the Services Component; and the Financial Component, all of which are averaged over three years.
The BI simplifies the process of determining how much capital a bank should hold to cover potential operational losses. However, the BI has been criticized for its lack of sensitivity to the specific risk profiles of individual institutions, potentially leading to inaccurate capital requirements that do not fully reflect the actual risks faced by banks.
What is the Business Indicator
The Business Indicator was introduced as part of Basel III’s standardized approach to operational risk capital calculation. It is designed to serve as a proxy for the size and complexity of a bank’s operational risk exposure, based on financial statement items. Specifically, the Business Indicator is calculated using three components averaged over three years:
- The Interest, Leases, and Dividend Component
- The Services Component
- The Financial Component
These components are intended to reflect the bank’s overall business activity, with the assumption that higher business activity correlates with higher operational risk. The result of this calculation is then used to determine the amount of capital that a bank must hold to cover potential operational losses.
The Logic Behind the Business Indicator
The Basel Committee’s rationale for using the Business Indicator is rooted in the desire to simplify the process of calculating operational risk capital. The Committee recognized the complexity and inconsistency of previous approaches, such as the Advanced Measurement Approach (AMA), and sought to create a more standardized method that could be applied across institutions.
By basing the Business Indicator on financial statement items, the Basel Committee aimed to create a transparent and straightforward proxy for operational risk. This approach was intended to be easy to implement, reducing the burden on banks while still ensuring that they hold sufficient capital to cover potential losses.
Criticisms of the Business Indicator
Despite its simplicity, the Business Indicator has been met with significant criticism from industry professionals and academics alike. One of the primary concerns is that the Business Indicator is a blunt tool that oversimplifies the complex nature of operational risk. As Peter Hughes noted, “The imposition of a non-measurement non-model capital calculation method has drawn severe criticism from the banks.” Critics argue that this approach fails to capture the nuances of operational risk, leading to potential underestimation or overestimation of a bank’s true risk exposure.
Some of the key criticisms include:
- Lack of Risk Sensitivity: The Business Indicator does not account for the specific risk profile of individual banks. Instead, it assumes that operational risk is directly correlated with the size of a bank’s business activities, which is not always the case. This lack of sensitivity to actual risk factors can lead to capital requirements that do not accurately reflect the bank’s true risk exposure.
- Oversimplification: By relying on broad financial statement items, the Business Indicator oversimplifies the complexities of operational risk. Operational risks can arise from a wide range of factors, including internal processes, systems, people, and external events, which are not necessarily captured by the components of the Business Indicator.
- Potential for Misalignment: The use of the Business Indicator can create a misalignment between the capital held for operational risk and the actual risk profile of the bank. This misalignment can lead to either excessive capital requirements, which tie up resources unnecessarily, or insufficient capital, which leaves the bank vulnerable to operational losses.
- Impact on Smaller Institutions: Smaller banks, in particular, may find the Business Indicator to be a poor fit for their operational risk profile. The one-size-fits-all nature of the Business Indicator does not take into account the specific characteristics of smaller institutions, potentially leading to disproportionate capital requirements.
The JPMorgan Critique
One of the most vocal critics of the Business Indicator has been Jamie Dimon, CEO of JPMorgan Chase. In a 2023 interview with CNBC, Dimon expressed his frustration with the Basel Committee’s approach, stating, “Operational risk capital is based on a model that makes no sense.” Dimon’s critique highlights the broader concerns within the industry that the Business Indicator is an inadequate proxy for the true risks faced by banks.
Dimon’s comments also reflect a broader industry sentiment that the regulatory approach to operational risk capital needs to be more aligned with the realities of risk management. The criticism from one of the world’s largest financial institutions underscores the need for a more accurate and responsive method of calculating operational risk capital.
Risk Accounting: A Better Alternative?
The limitations of the Business Indicator highlight the need for a more sophisticated and nuanced approach to measuring operational risk. Risk accounting offers a compelling alternative by providing a more accurate, forward-looking, and integrated method for assessing risk.
- Risk Sensitivity: Unlike the Business Indicator, risk accounting allows for a more precise measurement of a bank’s risk exposure. By quantifying risks based on current exposures and potential future events, risk accounting provides a clearer picture of the true level of operational risk.
- Comprehensive Risk Measurement: Risk accounting takes into account a wide range of risk factors, including internal processes, systems, people, and external events. This comprehensive approach ensures that all relevant risks are captured and accounted for, reducing the likelihood of underestimating or overlooking significant risks.
- Alignment with Financial Statements: Risk accounting integrates risk measures directly into financial statements, providing a more holistic view of a bank’s financial health. This integration allows for better alignment between capital requirements and the actual risk profile of the bank.
- Scalability for All Institutions: Risk accounting is adaptable and scalable, making it suitable for institutions of all sizes. Unlike the Business Indicator, which may disproportionately impact smaller banks, risk accounting can be tailored to reflect the specific characteristics of different institutions.
A Brief Introduction to Risk Accounting
Risk accounting is an innovative approach that combines traditional accounting practices with advanced risk management techniques. It involves identifying, quantifying, and aggregating risks across an organization and integrating these risk measures into financial statements. This provides a more comprehensive and transparent view of a company’s financial health, enabling better decision-making and more effective risk management.
Conclusion
The Business Indicator, while designed to simplify the calculation of operational risk capital, has significant limitations that can undermine its effectiveness. Its reliance on broad financial statement items and lack of sensitivity to actual risk factors make it an inadequate proxy for the complexities of operational risk. Risk accounting offers a more accurate and comprehensive alternative, providing a standardized, detailed, and forward-looking approach to managing risks.
As we continue this series, we’ll explore further how risk accounting can be applied to address other critical issues in the financial industry. For those interested in learning more about risk accounting, additional resources are available to help deepen your understanding of this essential innovation.
More Articles in the Series
Risk Accounting: The Key to Restoring Confidence in Global Banking
Trust in global banking is fragile, but risk accounting could be the key to restoring confidence. Explore how this innovative approach can enhance transparency, accountability, and financial stability.
Building the Infrastructure for Risk Accounting: A Roadmap for the Future
Implementing risk accounting requires more than a change in mindset — it demands a robust infrastructure. Learn what’s needed to build this infrastructure and why it’s essential for the future of risk management.
Jamie Dimon vs. Basel III: The Impact of Operational Risk Capital Requirements on Banking
The Basel III framework, introduced in the wake of the 2008 financial crisis, was designed to strengthen the regulation, supervision, and risk management of banks. One of its key components is the operational risk capital requirement, which mandates that banks hold...
Risk Accounting in Practice: How It Could Have Prevented the Collapse of Silicon Valley Bank
Could risk accounting have saved Silicon Valley Bank? Explore how this forward-looking approach to risk management might have prevented one of the most shocking bank failures in recent years.
Professor Tom Butler’s Call for a Paradigm Change: The Case for Risk Accounting
Professor Tom Butler advocates for a paradigm change in how the financial industry manages operational risks. Explore his case for adopting risk accounting as the future of risk management.
Operational Risk Management Today: Insights from the McKinsey & Co. and ORX Report
Current operational risk management practices are often backward-looking and inconsistent. Learn how risk accounting can address these challenges and lead to a more resilient financial system.
Risk & Control Self-Assessment (RCSA): Why the Banking Sector Needs More Than Just Traffic Lights
Risk & Control Self-Assessment (RCSA) is a popular tool in risk management, but is it enough? Discover why the banking sector needs more than just color-coded assessments and how risk accounting offers a more robust solution.
The Rise and Fall of the Advanced Measurement Approach (AMA) in Operational Risk Management
The Advanced Measurement Approach (AMA) promised to revolutionize operational risk management, but complexity led to its downfall. Could risk accounting be the solution the AMA failed to provide?
Understanding Basel II: The Basel Committee’s Challenge to Banks on Operational Risk
Basel II set the stage for operational risk management, but did it meet its goals? Learn how its shortcomings highlight the need for a more comprehensive approach like risk accounting.
The Call for Risk Accounting: Lessons from Professor Andrew Lo
Discover how Professor Andrew Lo’s insights into the limitations of GAAP led to the development of risk accounting, a forward-looking approach that could redefine how financial risks are managed.