Operational Risk

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Application Provision

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1

Application and Definitions

1.1

This Part applies to:

  1. (1) a firm that is a CRR firm; and
  2. (2) a CRR consolidation entity.

1.2

In this Part, the following definitions shall apply:

Business Indicator

has the meaning given in 5.2.

Business Indicator Component

has the meaning given in 5.7.

financial component

means the items specified in the table C in Annex 1 of this Part, excluding any items specified in table D in Annex 1 of this Part.

gross loss

means loss before recoveries of any type.

interest, leases and dividend component

means the items specified in table A in Annex 1 of this Part, excluding any items specified in table D in Annex 1 of this Part.

Internal Loss Multiplier

has the meaning given in 5.9.

Level 1 supervisory categories

means the event types specified in the first column of the table in Annex 2 of this Part.

recoveries

means an independent occurrence which is related to the original loss event and separate in time in which funds or inflows of economic benefits are received from a third party (excluding receivables).

services component

means the items specified in the table B in Annex 1 of this Part, excluding any items specified in table D in Annex 1 of this Part.

standardised approach

means the approach to calculating operational risk which is set out in Chapter 5.

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2

Level of Application

2.1

A firm must comply with this Part on an individual basis.

2.2

A CRR consolidation entity must comply with this Part on a consolidated basis.

2.3

An institution or CRR consolidation entity to which this Part is applied in a sub-consolidation requirement must comply with this Part on a sub-consolidated basis, as set out in that requirement.

2.4

[Deleted]

2.5

[Deleted]

2.6

[Deleted]

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4

Own Funds Requirements

4.1

A firm must calculate its own funds requirement for operational risk in accordance with the standardised approach by multiplying the Business Indicator Component and the Internal Loss Multiplier.

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5

The Standardised Approach

General

5.1

The standardised approach comprises:

  1. (1) the Business Indicator;
  2. (2) the Business Indicator Component; and
  3. (3) the Internal Loss Multiplier.

Business Indicator

5.2

The Business Indicator is the sum of the following three components:

  1. (1) the interest, leases and dividend component;
  2. (2) the services component; and
  3. (3) the financial component,

which are to be calculated in accordance with the table at 5.3.

5.3

Table: calculation of the Business Indicator

Component Formula
interest, leases and dividend component \[Min \left[ \overline{Abs(Interest\ Income-Interest\ Expense)}\ ;2.25\%\times \overline{Interest\ Earning\ Assets}\right]+ \overline{Dividend\ Income}\]
services component \[Max \left [ \overline{Other \ Operating \ Income}; \overline{Other \ Operating \ Expense} \right ]+ \ Max \ \left [ \overline{Fee \ Income}; \ \overline{Fee \ Expense} \right ]\]
financial component \[\overline{Abs \ \left ( Net \ Profit \ and \ Loss \ Trading \ Book \right )} \ + \ \overline{Abs \ \left ( Net \ Profit \ and \ Loss \ Banking \ Book \right )}\]

5.4

In the table at 5.3:

  1. (1) a bar above a term indicates that the value must be calculated as an average over the last three years, except that a firm may use forward looking estimates where it has been in operation for less than three years;
  2. (2) the absolute value of net items must firstly be calculated year by year and after that calculation the average over the last three years must be calculated, except that a firm may use forward looking estimates where it has been in operation for less than three years;
  3. (3) a firm must use audited figures where they are available but may use business estimates where audited figures are not available;
  4. (4) at financial year end, the current financial year must be included in the calculation of the three-year average for the purposes of (1) and (2).

5.5

In calculating the Business Indicator:

  1. (1) subject to (2), a firm must include any business acquisitions, mergers or disposals of entities or activities which occurred during the three year period referred to in 5.4;
  2. (2) a firm may apply to the PRA for permission to exclude business acquisitions, mergers or disposals of entities or activities which occurred during the three year period referred to in 5.4 where it can demonstrate that, due to an acquisition or merger, disposals of entities or activities, using the three year period referred to in 5.4 would lead to a biased estimation for the own funds requirement for operational risk.

[Note: This is a permission under section 144G and 192XC of FSMA to which Part 8 of the Capital Requirements Regulations applies]

5.6

In applying the standardised approach within a consolidation group, the applicable Business Indicator figures are as follows:

  1. (1) at the consolidated level, the fully consolidated Business Indicator figures which net all intragroup income and expenses;
  2. (2) at a sub-consolidated level, the Business Indicator figures for the firms consolidated at the particular sub-consolidation level which net all income and expenses at this level; and
  3. (3) at the subsidiary level, the Business Indicator figures for the subsidiary.

Business Indicator Component

5.7

A firm must calculate the Business Indicator Component by multiplying the Business Indicator by the applicable marginal coefficients set out in the table at 5.8.

5.8

Table: Business Indicator range and marginal coefficients

Bucket Business Indicator range
(GBP bn)
  Business Indicator
marginal coefficients
1 ≤ 0.88 12%
2  0.88 < Business Indictor ≤ 26  15% 
3  > 26  18%

Internal Loss Multiplier

5.9

The Internal Loss Multiplier is equal to one.

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6

Policies and Processes

6.1

A firm must establish, implement and maintain policies and processes to evaluate and manage its exposure to operational risk.

6.2

In establishing, implementing and maintaining policies and processes to evaluate and manage its exposure to operational risk a firm must:

  1. (1) have an independent risk management function for operational risk;
  2. (2) ensure that its internal measurement system for operational risk is closely integrated into its day-to-day risk management processes and that the output is an integral part of the process of monitoring and controlling the firm's operational risk profile;
  3. (3) implement a system of reporting to senior management that provides operational risk reports to relevant functions within the firm and procedures for taking appropriate action according to that information;
  4. (4) implement an assessment and management system for operational risk which is well documented with clear responsibilities assigned for this system and practices for ensuring compliance and addressing non-compliance;
  5. (5) conduct regular reviews of its operational risk management processes and measurement systems which are performed by internal or external auditors;
  6. (6) ensure that internal validation processes for operational risk management operate in a sound and effective manner; and
  7. (7) ensure that data flows and processes associated with its risk measurement system for operational risk are transparent and accessible.

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7

Identification, Collection and Treatment of Loss Data

7.1

A firm must identify, collect and treat internal loss data in accordance with the following general requirements:

  1. (1) it must have documented procedures and processes for the identification and collection of internal loss data which must be subject to regular independent reviews by internal and/or external audit functions;
  2. (2) it must base its internal loss data on an observation period of 10 years: in the event that reliable data is not available over a period of 10 years it may, exceptionally, be based on a shorter period of no less than five years;
  3. (3) it must map its historical internal loss data into the relevant Level 1 supervisory categories and document criteria for allocating losses to the specified event types consistently with the descriptions, categories and examples set out in the second, third and fourth columns of the table in Annex 2 of this Part;
  4. (4) its internal loss data must be comprehensive and capture all material activities and exposures from all appropriate subsystems and geographic locations: the minimum threshold for including a loss event in the data collection is GBP 20,000;
  5. (5) in addition to information on gross loss amounts, it must collect information about the reference dates of operational risk events including:
    1. (a) the date when the event happened or first began, where available;
    2. (b) the date on which the firm became aware of the event; and
    3. (c) the date (or dates) when a loss event results in a loss, reserve or provision against a loss being recognised in the firm’s profit and loss accounts;
  6. (6) in addition to (5), it must collect information on recoveries of gross loss amounts as well as descriptive information about the drivers or causes of the loss event: the level of detail of any descriptive information should be commensurate with the size of the gross loss amount;
  7. (7) operational loss events that relate to credit risk:
    1. (a) must not be included in the loss data set where the event is accounted for in the risk-weighted exposure amount for credit risk; and
    2. (b) must be included in the loss data set where the event is not accounted for in the risk-weighted exposure amount for credit risk;
  8. (8) operational risk losses related to market risk must be treated as operational risk losses; and
  9. (9) it must implement processes to independently review the comprehensiveness, accuracy and quality of loss data.

7.2

A firm must identify, collect and treat internal loss data in accordance with the following specific requirements:

  1. (1) it must be able to identify the gross loss amounts, non-insurance recoveries, and insurance recoveries for all operational loss events;
  2. (2) it must use losses net of recoveries (including insurance recoveries) in the loss dataset and may only use recoveries to reduce losses after the firm receives payment;
  3. (3) it must provide the PRA with information which verifies the receipt of payments used to reduce losses if requested by the PRA;
  4. (4) it must include the following items in the gross loss computation of the loss data set
    1. (a) direct charges (including impairments and settlements) to the firm’s profit and loss accounts and write-downs due to the operational risk event;
    2. (b) costs incurred as a consequence of the operational risk event including external expenses with a direct link to the event (such as legal expenses directly related to the event and fees paid to advisors or suppliers) and costs of repair or replacement incurred to restore the position that was prevailing before the operational risk event;
    3. (c) provisions or reserves accounted for in the profit and loss account against the potential operational loss impact;
    4. (d) losses stemming from operational risk events with a definitive financial impact which are temporarily booked in transitory and/or suspense accounts and are not yet reflected in the profit and loss account: material losses in this category must be included in the loss data set within a time period commensurate with the size and age of the pending item; and
    5. (e) negative economic impacts booked in a financial accounting period due to operational risk events impacting the cash flows or financial statements of previous financial accounting periods: material losses in this category must be included in the loss data set when they are due to operational risk events that span more than one financial accounting period;
  5. (5) it must exclude the following items from the gross loss computation of the loss data set:
    1. (a) costs of general maintenance contracts on property, plant or equipment;
    2. (b) internal or external expenditures to enhance the business after the operational risk losses (including upgrades, improvements, risk assessment initiatives and enhancements); and
    3. (c) insurance premiums;
  6. (6) in relation to accounting dates:
    1. (a) it must use the date of accounting for building the loss data set;
    2. (b) it must use a date no later than the date of accounting for including losses related to legal events in the loss data set and for such events the date of accounting is the date when a legal reserve is established for the probable estimated loss in the profit and loss account; and
    3. (c) it must allocate losses caused by a common operational risk event, or by related operational risk events over time but posted to the accounts over several years, to the corresponding years of the loss database in line with their accounting treatment.

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Annex 1 – Business Indicator components

Table A: items to be included in the interest, leases and dividend component

Items Description Sub items 
Interest income Interest income from all financial assets and other interest income Interest income
Profits form leased assets Operating leases other than investment property
Interest expense Interest expenses from all financial liabilities and other interest expenses
 Interest expense
Losses from leased assets and depreciation and impairment of operating leased assets
 Operating leases other than investment property
Interest earning assets
 Total gross outstanding loans, advances, interest-bearing securities (including government bonds) and lease assets measured at the end of the financial year
 Cash, cash balances at central banks and other demand deposits
Financial assets held for trading
Non-trading financial assets mandatorily at fair value through profit or loss
Financial assets designated at fair value through profit or loss
Financial assets at fair value through other comprehensive income
Financial assets at amortised cost
Derivatives – hedge accounting
Tangible and intangible assets: assets subject to operating lease
Dividend income
 Dividend income from investments in stocks and funds not consolidated in the firm’s financial statements, including dividend income from non-consolidated subsidiaries, associates and joint ventures
 Dividend incomes

Table B: items to be included in the services component

Items Description Sub items
Fee and commission income Income received from providing advice and services. Includes income received by the firm as an outsourcer of financial services Fee and commission income 
Fee and commission expense
 Expense paid for receiving advice and services. Includes outsourcing fees paid by the firm for the supply of financial services but not outsourcing fees paid for the supply of non-financial services
 Fee and commission expense
Other operating income
 Income from ordinary banking operations not included in other Business Indicator items but of a similar nature (income from operating leases should be excluded)
 Other operating expense
MINUS Operating leases other than investment property
Profit from non-current assets and disposal groups classified as held for sale not qualifying as discontinued operations
Other operating expense
 Expenses and losses from ordinary banking operations not included in other Business Indicator items but of a similar nature and from operational loss events (expenses from operating leases should be excluded)
 Other operating expense
MINUS Operating leases other than investment property
Expenses related to establishing provisions/reserves for operational loss events: new additions including increases in existing provisions
MINUS Expenses related to establishing provisions/reserves for operational loss events: unused amounts reversed during the period
Losses from non-current assets and disposal groups classified as held for sale not qualifying as discontinued operations

Table C: items to be included in the financial component

Items Description Sub items
Net trading (loss) on trading book Net profit (loss) on trading book Gains or (-) losses on financial assets and liabilities held for trading, net
Net profit (loss) on banking book
 Realised gains/losses on financial assets and liabilities not measured at fair value through profit and loss
 Gains or (-) losses on de-recognition of financial assets and liabilities not measured at fair value through profit or loss, net
Net profit/loss on financial assets and liabilities measured at fair value through profit and loss
 Gains or (-) losses on non-trading financial assets mandatorily at fair value through profit or loss, net
Gains or (-) losses on financial assets and liabilities designated at fair value through profit or loss, net
Net profit/loss from hedge accounting
 Gains or (-) losses from hedge accounting, net
Net profit/loss from exchange differences
 Exchange differences (gain or (-) loss), net

Table D: items which do not contribute to any components of the Business Indicator

Income and expenses from insurance or reinsurance businesses
Premiums paid and reimbursements/payments received from insurance or reinsurance policies purchased
Administrative expenses including staff expenses, outsourcing fees paid for the supply of non-financial services (for example logistical, IT, human resources), and other administrative expenses (for example IT, utilities, telephone, travel, office supplies, postage)
Recovery of administrative expenses including recovery of payments on behalf of customers (for example taxes debited to customers)
Expenses of premises and fixed assets (except when these expenses result from operational loss events) 
Depreciation/amortisation of tangible and intangible assets (except depreciation related to operating lease assets, which should be included in financial and operating lease expenses)
Provisions/reversal of provisions (for example on pensions, commitments and guarantees given) except for provisions related to operational loss events
Expenses due to share capital repayable on demand
Impairment/reversal of impairment (for example on financial assets, non-financial assets, investments in subsidiaries, joint ventures and associates)
Changes in goodwill recognised in profit or loss
Corporate income tax (tax based on profits including current tax and deferred)

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Annex 2 – Detailed loss event type classification

Event-type category
(Level 1)		 Description Categories
(Level 2)		 Activity examples
(Level 3)
Internal fraud Losses due to acts of a type intended to defraud, misappropriate property or circumvent regulations, the law or company policy, excluding diversity/discrimination events, which involves at least one internal party Unauthorised activity

Transactions not reported (intentional)

Transaction type unauthorised (with monetary loss)

Mismarking of position (intentional)
Theft and fraud

Fraud/credit fraud/worthless deposits

Theft/extortion/embezzlement/robbery

Misappropriation of assets

Malicious destruction of assets

Forgery

Check kiting

Smuggling

Account takeover/impersonation etc.

Tax non-compliance/evasion(wilful)

Bribes/kickbacks

Insider trading (not on firm’s account)
External fraud Losses due to acts of a type intended to defraud, misappropriate property or circumvent the law, by a third party Theft and fraud

Theft/robbery

Forgery

Check kiting
Systems security

Hacking damage

Theft of information (with monetary loss)
Employment practices and workplace safety Losses arising from acts inconsistent with employment, health or safety laws or agreements, from payment of personal injury claims, or from diversity/discrimination events Employee relations

Compensation, benefit, termination issues

Organised labour activity
Safe environment

General liability (slip and fall etc.)

Employee health and safety rules events

Workers compensation
Diversity and discrimination All discrimination types
Clients, products and business practices Losses arising from an unintentional or negligent failure to meet a professional obligation to specific clients (including fiduciary and suitability requirements), or from the nature or design of a product Suitability, disclosure and fiduciary

Fiduciary breaches/guideline violations

Suitability/disclosure issues (know-your-customer etc.)

Retail customer disclosure violations

Breach of privacy

Aggressive sales

Account churning

Misuse of confidential information

Lender liability
Improper business or market practices

Antitrust

Improper trade/market practices

Market manipulation

Insider trading (on firm’s account)

Unlicensed activity

Money laundering
Product flaws

Product defects (unauthorised etc.)

Model errors
Selection, sponsorship and exposure

Failure to investigate client per guidelines

Exceeding client exposure limits
Advisory activities Disputes over performance of advisory activities
Damage to physical assets Losses arising from loss or damage to physical assets from natural disaster or other events Disasters and other events

Natural disaster losses

Human losses from external sources (terrorism, vandalism)
Business disruption and system failures Losses arising from disruption of business or system failures Systems

Hardware

Software

Telecommunications

Utility outage/disruptions
Execution, delivery and process management Losses from failed transaction processing or process management, from relations with trade counterparties and vendors Transaction capture, execution and maintenance

Miscommunication

Data entry, maintenance or loading error

Missed deadline or responsibility

Model/system mis-operation

Accounting error/entity attribution error

Other task mis-performance

Delivery failure

Collateral management failure

Reference data maintenance
Monitoring and reporting

Failed mandatory reporting obligation

Inaccurate external report (loss incurred)
Customer intake and documentation

Client permissions/disclaimers missing

Legal documents missing/incomplete
Customer/client account management

Unapproved access given to accounts

Incorrect client records (loss incurred)

Negligent loss or damage of client assets
Trade counterparties

Non-client counterparty mis-performance

Miscellaneous non-client counterparty disputes
Vendors and suppliers

Outsourcing

Vendor disputes

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