The regulatory loss cut-off level: Does it undervalue the operational capital at risk?

Abstract

The New Capital Accord (Basel II) proposes a minimum threshold of 10,000 Euros for operational losses when estimating regulatory capital for financial institutions. But since this recommendation is not compulsory for the bank industry, banks are allowed to apply internal thresholds discretionally. In this sense, we analyze the potential impact that the selection of a specific threshold could have on the final estimation of the capital charge for covering operational risk, adopting a critical perspective. For this purpose, by using the Internal Operational Losses Database (IOLD) provided by a Spanish Saving Bank, we apply the Loss Distribution Approach (LDA) for different modelling thresholds. The results confirm the opportunity cost in which banks can incur depending on the internal threshold selected. In addition, we consider that the regulatory threshold, established by the Committee, could result inadequate for some financial institutions due to the relative short length of the current IOLDs.