Safety First - Scenario Analysis under Basel II

Abstract

In mid 2004, after a lengthy period of industry consultation, the Basel Committee finally released its definitive rules on capital charges for Operational Risk under Basel II. In its proposals for allowing banks to calculate regulatory capital using their own internal models, the Basel Committee backed away from its original quantitative emphasis, concentrating instead on ‘qualitative standards ’ for Operational Risk Management (ORM) systems. A key element of the standards for accreditation to use an ‘own model ’ or Advanced Measurement Approach (AMA) for calculating a capital charge for Operational Risk is the use of Scenario Analysis to identify low-probability, high-severity loss events. Unfortunately, other than specify that Scenario Analysis must be robust and methodical, the Basel Committee provided few clues as to what Scenario Analysis should cover in practice. This paper proposes a structured approach to ‘Scenario Analysis ’ for Basel II, based on concepts proven in other industries, specifically the concept of ‘Safety Management ’ and in particular the “Bow-Tie Diagram”. After giving a brief introduction to the ‘Bow-Tie ’ concept, the paper describes how such a concept may be used by banks and regulators to satisfy the requirements of Basel II and to improve Operational Risk management across the industry. An example of the use of the Bow-Tie technique is included for illustration.