Jurnal Oprisk 1

Electronic copy available at: http://ssrn.
com/abstract=988282
- 1 -
THE BASIC INDICATOR APPROACH AND THE STANDARDISED
APPROACH TO OPERATIONAL RISK: AN EXAMPLE- AND CASE STUDY-
BASED ANALYSIS

Maike Sundmacher

Maike Sundmacher, School of Economics and Finance, University of Western Sydney
Locked Bag 1797, Penrith South DC, NSW 1797, Australia,
Email: m.sundmacher@uws.edu.au
Electronic copy available at: http://ssrn.com/abstract=988282
- 2 -
THE BASIC INDICATOR APPROACH AND THE STANDARDISED
APPROACH TO OPERATIONAL RISK: AN EXAMPLE- AND CASE STUDY-
BASED ANALYSIS

ABSTRACT
Pillar I of the Basel II framework developed by the Basel Committee on Banking Supervision
(BCBS) deals with the calculation of minimum capital requirements for operational, credit and
market risk exposures in banks. The BCBS proposes three increasingly sophisticated approaches
to calculating operational risk capital. In order of increasing sophistication, these are the Basic
Indicator Approach (BIA), the Standardised Approach (TSA) and the Advanced Measurement
Approach (AMA). The operational risk capital charge under the BIA and the TSA is dependent
on a banks GI level and distribution. Banks that wish to use the TSA or the AMA are required to
fulfil a set of qualifying criteria, resulting in compliance costs for the bank. The benefit would be
a lower capital charge.
Our paper focuses on two distinct themes. In the first theme, we show that, based on a
hypothetical example, banks with a particular GI distribution will not benefit from gradating from
the BIA to the TSA.
In the second theme, we examine if the BIA and the TSA would have captured the operational
risk build-up in the National Australia Banks between 2001 and 2004. These years relate to the
period in which a cohort of traders engaged in fraudulent activities that resulted in foreign
exchange trading losses of $360m. We find that while the TSA would have indicated such a
build-up, the BIA would have pointed towards a decline in the banks operational risk exposure
and thus capital.
We are facing mixed results. While, dependent on a banks distribution of GI, the incentive for
banks to gradate from the BIA to the TSA might be marginal or non-existent, the approach would
have performed better as a predictor for the build up of operational risk in the National Australia
Bank.

- 3 -
1. Introduction
In June 2004 the Basel Committee on Banking Supervision (BCBS) published a framework for
the international convergence of capital measurement and capital standards, known as Basel II.
The framework was updated in November 2005 and a comprehensive version published in June
2006. In the first pillar of the framework, the BCBS outlines methodologies for calculating
minimum capital requirements for financial institutions operational, credit and market risk
exposures. In case of operational risk, the BCBS suggests three increasingly sophisticated
measurement approaches. In order of increasing sophistication, these are the Basic Indicator
Approach (BIA), the Standardised Approach (TSA) and the Advanced Measurement Approach
(AMA). While the latter relies on a financial institutions internally generated loss data and
internally developed measurement and management methodologies, the former two are entirely
pre-determined by regulatory authorities. The Basel Committee offers this range of calculation
methods with the intention that financial institutions seek to improve their risk management
systems and procedures in order to meet the eligibility criteria for one of the more sophisticated
approaches.
1
While improvements of risk management systems will incur development,
implementation and maintenance costs for the institution, the resulting benefit would be a lower
capital charge.
In this paper, we show that a financial institution that initially uses the BIA might only marginally
benefit from moving to the next higher approach, the TSA. The benefits accruing from a lower
capital charge might be offset by the compliance costs associated with the fulfilment of Basels
qualifying criteria for the TSA. Further, the capital-saving in the TSA compared to the BIA will
be highly dependent on the business units in which the financial institution generates the bulk of
its GI. These issues are highlighted based on a hypothetical example. We further apply the BIA
and TSA to annual report data of the National Australia Bank (NAB) to test if the approaches
would have indicated a built-up in the banks operational risk exposure over time.
The paper is structured as follows. The next section briefly summarises Basels methodologies to
operational risk capital calculations. In section 3 we illustrate the limited benefits that may arise
from gradating from the BIA to the TSA dependent on a banks GI distribution across business
lines. In section 4 we summarise the operational risk losses that occurred at the National Australia
Bank between 2001 and 2004. We use the BIA and the TSA to examine if the capital charges
would have captured a build-up in operational risk over this period. The final section concludes.

2. Basels Approaches to Calculating Operational Risk Capital
Both, the Basic Indicator Approach (BIA) and the Standardised Approach (TSA) rely on a
financial institutions gross income (GI). The BCBS (2006: 145) defines GI as net interest
income plus net non-interest income. It is intended that this income figure is gross of operating
expenses, provisions, income from insurance, realised profits or losses from the sale of securities
in an institutions banking book, and any irregular items.
The BIA is the simplest approach and can be applied by all banks that either do not qualify for or
are not obliged by their regulator to use one of the more sophisticated approaches. In the BIA,
operational risk capital is calculated as a fixed percentage of a financial institutions annual three-
year average positive GI:
K
BIA
= [(GI
1..n
* )] / n,

1
A financial institution with sufficiently advanced measurement systems would, subject to approval and
initial monitoring, move to the AMA immediately.
- 4 -
whereby GI
1..n
denominates the amount of GI in those years over the three year horizon, in which
the financial institutions GI was positive and denominates the scaling factor, which is currently
set at 15% (BCBS 2006: 145).
The TSA is a more sophisticated approach compared to the BIA. In order to be eligible to use the
TSA, a financial institution needs to fulfil a set of qualifying criteria.
2
A financial institution that
uses the TSA is required to map its overall annual GI into eight business lines, which are pre-
determined by the BCBS. The GI of each business line is scaled by a fixed scaling factor beta.
Beta is determined by the BCBS, and its value contingent upon a business line's riskiness. The
BCBS identifies the following business lines and their respective betas (2006:147):

A financial institution's total operational risk capital is calculated as the sum of operational risk
capital calculated for each business line
3
:
K
TSA
= {
years1-3
max[(GI
1-8
*
1-8
), 0]} / 3
In contrast to the BIA, negative GI in one business line can be used to offset positive GI in other
business lines, leading to an overall reduced capital charge. The overall capital charge, however,
cannot be negative and thus cannot be used as a deduction from the financial institutions credit
or market risk capital level.
The most sophisticated approach is the Advanced Measurement Approach (AMA). The AMA
requires financial institutions to develop and implement their own measurement methodologies
based on internal loss data and risk measurement systems. According to the BCBS (2001: 5-6) the
rationale of providing institutions with such a high degree of flexibility is to allow the
development of innovation.

3. The TSA Conundrum
A bank has the choice of three approaches, the BIA, the TSA and the AMA. It is generally
assumed that financial institutions which move along the spectrum of approaches benefit from a
decreasing capital charge. In addition, the use of one of the more sophisticated approaches is
assumed to result in a better alignment of actual risks taken by the institution and the minimum
capital charge the institution is required to hold. Thus, financial institutions that use the BIA have

2
The qualifying criteria for the Standardised Approach are outlined in BCBS 2006: 148-149.
3
With the permission of the national supervisor banks might be allowed to use an Alternative Standardised
Approach (ATSA). The ATSA differs from the TSA with respect to two business lines, namely Retail
Banking and Commercial Banking. The principles of the Alternative Standardised approach are outlined
in BCBS 2006: 136, but are not relevant for the further discussion in this paper.
- 5 -
an incentive to gradate to the TSA and, if justifiable based on its size and operations, to the AMA
at a later point in time.
There may be circumstances, however, under which a bank would find a continuous use of the
BIA advantageous. The beta levels for the different business lines in the TSA take the values of
twelve, fifteen or eighteen percent, compared to the single scaling factor (alpha) of fifteen percent
under the BIA. Subject to the nature of its businesses, a financial institution might generate the
bulk of gross income (GI) in high-beta business lines, and only a small proportion in low-beta
business lines. In such a situation, it is possible that the financial institution would need to hold a
higher regulatory capital level under the TSA compared to the BIA, despite the fact that its risk
profile has not changed. The institution would face little incentive to invest in the infrastructure
necessary to gradate to the TSA given the costs of such an investment would provide little return
in terms of capital relief. This point can be illustrated using a simple example. Table 1 shows the
amount of capital a financial institution must hold at a minimum if it used the BIA for its capital
calculations. We assume that the total three-year GI for the bank is $7.8m, of which $2.2m are
generated in the first year, $2.6m are generated in year two and $3m in year three. The total
scaled GI is $1.17m, resulting in a capital charge for year four of $390,000.
Table 1: Capital under the Basic Indicator Approach
Year GI Alpha Scaled GI
1 $2,200,000.00 15% $330,000.00
2 $2,600,000.00 15% $390,000.00
3 $3,000,000.00 15% $450,000.00
Total GI $7,800,000.00 Total scaled GI $1,170,000.00
Let us assume that the same institution uses the TSA for its operational risk capital calculations.
In this case the operational risk capital amount will depend on how GI is distributed across
business units. We illustrate how differences in GI generation impact on the minimum capital
requirement. Table 2 shows the banks minimum capital charge if the bulk of GI is generated in
low-beta business lines.
Table 2: Capital under the Basic Indicator Approach: Focus on Low-Beta Business Lines
Year 1
Business line GI Beta Scaled GI
Corporate finance $205,000.00 18.00% $36,900.00
Trading and sales $205,000.00 18.00% $36,900.00
Retail banking $325,000.00 12.00% $39,000.00
Commercial banking $305,000.00 15.00% $45,750.00
Payment and settlement $205,000.00 18.00% $36,900.00
Agency services $305,000.00 15.00% $45,750.00
Asset management $325,000.00 12.00% $39,000.00
Retail brokerage $325,000.00 12.00% $39,000.00
Total GI $2,200,000.00 Total scaled GI $319,200.00

Year 2
Retail banking $375,000.00 12.00% $45,000.00
- 6 -
Agency services $355,000.00 15.00% $53,250.00

Year 3
Retail banking $425,000.00 12.00% $51,000.00
Agency services $405,000.00 15.00% $60,750.00
While total GI remains unchanged at $7.8m, the total scaled GI is marginally smaller at $1.1376m
compared to the BIA. The resulting capital charge in this scenario is $379,200, which is $10,800
lower than the capital charge that was determined using the BIA. While the bank benefits from a
slight capital relief, it is not guaranteed that this decrease is sufficient to at least off-set the
compliance costs incurred by qualifying for the TSA. Such an analysis would need to be
undertaken on a case-to-case basis.
Table 3 shows the case of a financial institution for which GI is evenly distributed across business
lines. In this case the institution does not benefit from using the more advanced TSA as scaled GI
and thus the resulting capital charges are the same under the TSA and BIA. The reason is that the
average beta value of all business lines is equal to the fifteen percent scaling factor alpha used in
the BIA.
Table 3: Capital according to the Basic Indicator Approach: Even Distribution of
GI across Business Lines
Year 1
Retail banking $275,000.00 12.00% $33,000.00
Agency services $275,000.00 15.00% $41,250.00

Year 2
Retail banking $325,000.00 12.00% $39,000.00
- 7 -
Agency services $325,000.00 15.00% $48,750.00

Year 3
Retail banking $375,000.00 12.00% $45,000.00
Agency services $375,000.00 15.00% $56,250.00
In such a scenario, a bank might decide not to gradate from the BIA to the TSA to avoid the
compliance costs that arise from obtaining regulatory approval for the TSA. A counter-argument
would be that a bank learns more about the risks it takes when refining its methodologies, which
might result in more efficient management and better reputation. In Table 4 we show the case of a
financial institution that generates the bulk of its GI in high-beta business units.
Table 4: Capital according to the Basic Indicator Approach: Focus on High-Beta Business Lines
Year 1
Retail banking $205,000.00 12.00% $24,600.00
Agency services $305,000.00 15.00% $45,750.00

Year 2
Retail banking $255,000.00 12.00% $30,600.00
Agency services $355,000.00 15.00% $53,250.00

- 8 -
Year 3
Retail banking $305,000.00 12.00% $36,600.00
Agency services $405,000.00 15.00% $60,750.00
Due to the generation of the bulk of GI in high-beta business lines the overall scaled GI is higher
at $1.2024m compared to the previous scenarios. The resulting capital charge for operational risk
in year four is $400,800, which is $10,800 above the minimum capital level of $390,000
calculated under the BIA. In this scenario, the institution is doubly-penalised. In addition to the
compliance costs resulting from the TSA approval, the institution faces a higher minimum capital
charge.
We find that, dependent on the structure and income sources of a financial institution, the Basel
Committees aim to provide institutions with an incentive to move from the least sophisticated
BIA to the more sophisticated TSA in order to reduce capital cannot be necessarily validated.
4

4. Operational Risk Exposures at the National Australia Bank
4.1 Brief Summary of Losses
In January 2004 the NAB announced $A360m losses resulting from foreign exchange trading.
The losses were attributed to the activities of a small cohort of individuals, David Bullen, Luke
Duffy, Gianni Gray and Vincent Ficarra. After investigating the incident, it was found that
between 2001 and 2004 the traders took excessive risks in their trading activities and incurred
losses due to adverse market movements. The traders concealed their losses by 'smoothing' profits
and losses, stating incorrect dealer rtes for trades and entering into fictitious transactions. Despite
several reports that indicated significant control weaknesses in foreign exchange trading (PWC
2004: 28-30) and extensive knowledge about previous operational risk losses suffered by the
Allied Irish Banks in 2003 due to fraudulent behaviour in the banks trading department, NAB
did not follow up on any warning signs. The losses were detected when a currency options desk
employee raised concerns about the activities in foreign exchange. The Australian Prudential
Regulatory Authority (APRA) responded to the losses by setting NAB's total capital ratio to ten
percent, two percent above the general regulatory requirement (APRA 2004: 8). The losses were
largely attributed to poor operational risk management.

4.2 Changes to NABs Corporate Structure During 1998 and 2004
During the observation period from 1998 to 2004 NAB changed its corporate structure three
times. In 1998 the bank was divided into three major segments, these being Banking, Finance &
Life Insurance, and Merchant & Investment Banking. Due to changes in the Australian

4
For further problems associated with the TSA see Sundmacher (2004).
- 9 -
Accounting and the Financial Accounting Standards
5
, from 1999 onwards banks were required to
disclose the performance of their various operating segments. Thus, in 1999 NAB reported on the
following five major segments: Business & Personal Financial Services, Products & Services,
Global Wholesale Financial Services, HomeSide, and Information Technology. However, in May
2000 NAB re-organised itself into six major operating segments (NAB 2000: 67). The new
operating segments that were established were: Business & Personal Financial Services, Wealth
Management, Wholesale Financial Services, Specialist & Emerging Businesses, HomeSide, and
National Shared Services. This structure was maintained in the financial years ending 2000 and
2001. In January 2002 NAB underwent another re-organisation and decreased the number of
operating segments back to five, namely Financial Services Australia, Financial Services New
Zealand, Financial Services Europe, Wholesale Financial Services
6
, and Wealth Management
(NAB 2002: 86).
7
This structure has been maintained for the rest of the observation period.
In the remainder of this section we use annual report data to calculate hypothetical operational
risk capital charges for the financial years ending 2001 up to and including 2005, i.e. those years
leading up to and including the year of loss detection as well as the year succeeding the loss
announcement. As the BIA and the TSA use a banks average three-year GI as risk proxy to
calculate an operational risk capital charge for the following financial year, we require annual
report data for the financial years ending 1998 up to and including 2004.

4.3 Hypothetical Operational Risk Capital Charges for NAB under the BIA
In this sub-section we calculate hypothetical operational risk capital charges for NAB using
Basels BIA. We further introduce alternative risk proxies in order to assess how the banks GI
compares to other measures in relation to its capacity to predict a build-up in operational risk
exposure.
Table 5 shows selected annual report data for NAB for the financial years ending 1998 to 2004.
Gross income (GI) has been calculated in accordance with the Basel Committees definition it
includes net interest income plus other income, adjusted for irregular and extraordinary items.
Operating expenses, insurance business, provisions and profits and losses from the sale of
securities in the banking book are omitted from this figure. Total revenue (TR) refers to the
consolidated entity, while total revenue Australia (TR-A) refers to the proportion of total
revenue generated in Australia. It should be noted that total revenue was denominated GI in the
1998 annual report, total operating revenue in the 1999 2001 annual reports and total
revenue from there onwards. Trading income (TI) refer to the consolidated entity.
Table 5: Selected NAB Annual Report Data
NAB ($m) 1998 1999 2000 2001 2002 2003 2004
Gross income (GI) 15,083 16,113 17,119 12,519 14,292 12,429 12,022
Total revenue (TR) 19,380 19,629 24,040 26,185 16,521 25,658 30,184
Trading income (TI) 360 457 468 721 563 625 575
Total revenue
Australia (TR-A) 8,763 9,243 12,385 12,867 11,425 15,905 19,980

5
This change refers to the introduction of AASB 1005 Financial Reporting by Segments and SFAS 131
Disclosures about Segments of an Enterprise and Related Information which became effective on 1
October 1998.
6
The name of this operating segment was changed to Corporate & Institutional Banking in 2003.
7
HomeSide was sold in 2002.
- 10 -
Figure 1 shows the hypothetical operational risk capital charge the NAB would have had to hold
over the years 2001 to 2004 using the BIA. We find that using the BCBS measure the minimum
operational risk capital charge would have fallen from 2001 to 2004. Using the banks GI as
measurement basis hypothetical minimum operational risk capital would have steadily fallen from
$2,415.75m in 2001 to $1,962.00m in 2004.
8
If NAB had used the BIA, not only would have
operational capital at its lowest when the losses were detected in 2004, but the steadily falling
capital charge would have further indicated that the banks operational risk exposure was
decreasing over time, providing a false sense of security.
Figure 1: Hypothetical Operational Risk Capital under the BIA
Hypothetical Capital Charge: BIA
0
500
1000
1500
2000
2500
3000
3500
4000
2001 2002 2003 2004
Time
$
m
TR
GI
TR-A
TI

In addition to the hypothetical capital using GI as the measurement basis, Figure 1 shows
operational risk exposure trends using alternative risk measures, these being the TR, the TR-A
9

and the TI. In all three cases, we treated the measurement bases as alternative risk proxies,
meaning that we formed the three-year average and scaled by the fixed scaling factor alpha of
fifteen per cent. All three indicators would have predicted increasing capital charges and thus
increasing operational risk exposures over time. Particularly interesting is continuous increase in
the TR-A.

4.4 Hypothetical Operational Risk Capital Charges for NAB under the TSA
In this sub-section we apply Basels TSA to annual report data of the NAB in order to assess
whether this approach would have better predicted the operational risk build-up in the bank. In
order to use the TSA, a financial institution has to map its overall GI into eight pre-set business
lines. Due to the structure of annual reports, it is difficult for external readers to get an accurate
picture of the GI allocation across business lines. It is possible, however, to estimate this
allocation using data provided in the segment analysis of the annual reports. This approach allows
us to identify trends regarding the usefulness of GI and other risk proxies in assessing the banks
operational risk exposures under the TSA.
We mapped NABs overall GI into the eight business lines based on the mapping and principles
for business line mapping as outlined by the BCBS (2006: 302-303). Obviously, the results
cannot be accurate due to limited publicly available data and further due to the different segment

8
The capital figures for 2002 and 2003 were $2,287.55m and $2,196.50m respectively.
9
TR-A was included since the trading losses were incurred by traders operating in the banks Australian
division.

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reporting methods over the observation period. Notwithstanding, using different scenarios it is
possible to identify a trend in the overall hypothetical capital charge over time. Table 6, 8, 9, and
10 show selected segment data for NAB from 1998 to 2004.
Table 6: Selected Segment Data for the Financial Years Ending 1998 and 1999

Total assets
Operating profit
after tax and
outside equity
interests
Total operating income
($m) 1998 1999 1998 1999 1998 1999
Banking 237,802 239,330 1,857 2,505 8,522 8,730
Finance & Life Insurance 10,786 11,271 112 200 562 924
Merchant & Investment Banking 3,126 3,480 45 116 155 435
The Banking segment in Table 6 consists of three broad portfolios, being Global Business
Financial Services, Global Premium & Private Financial Services, and Retail Financial Services
& Channel Management (NAB 1999: 16-17). Due to the limited information in the banks
segment analysis of the 1998 annual report, the year has been omitted in analysing the
hypothetical operational risk capital charge under the TSA.
Table 7: Selected Segment Data for the Financial Year Ending 1999
($m) GI
10

Total revenue after
interest expenses Total assets
Business & Personal Financial Services 7,053 7,280 141,492
Products & Services 1,364 2,034 11,046
Global Wholesale Financial Services 1,037 1,042 86,380
HomeSide 731 671 10,631
IT -13 545 302
Other 517 623 4,230

Table 8: Selected Segment Data for the Financial Year Ending 2000
($m)
GI
11

Total revenue after
interest expenses
Total assets
Business & Personal Financial Services 7,675 7,850 175,959
Wealth Management 1,859 1,859 33,488
Wholesale Financial Services 1,293 1,301 107,402
Specialist and Emerging Businesses 1,325 1,530 12,369
HomeSide 576 576 13,151
National Shared Services -68 1,472 2,717
Other 234 394 -1,409

Table 9: Selected Segment Data for the Financial Years Ending 2001 to 2004
GI
12
Total revenue after interest expenses
($m) 2001 2002 2003 2004 2001 2002 2003 2004
Financial Services 4,754 5,033 5,419 5,445 4,833 5,087 5,469 5,545

10
Due to limited data availability we define GI as net interest income plus non-interest income.
11
12
- 12 -
Australia
Financial Services
Europe 3,145 3,262 3,136 2,833 3,202 3,415 3,265 2,970
Financial Services New
Zealand 791 830 1,756 1,013 798 832 980 1,026
Corporate &
Institutional Banking
13
1,944 1,998 4,386 1,734 1,952 1,990 1,950 1,726
Wealth Management 1,323 893 4,386 6,670 1,324 891 4,398 6,677
Other 1,269 2,581 116 37 6,728 5,307 182 1,162
Based on the banks descriptions of business segments in the annual reports, we allocated beta-
levels to be used under the TSA that best matched the pre-set business lines under Basel II. The
results are shown in Table 10.
Table 10: Beta-Levels for NABs Business Segments and Corresponding Basel Business Lines
Business Segment Allocated Beta Best match: Basel Business Lines Basel Beta
Business & Personal Financial
Services
13.5% 1. Commercial Banking
2. Retail Banking
15%
12%
Corporate & Institutional Banking
14
17% 1. Commercial Banking
2. Corporate Finance
3. Trading & Sales
15%
18%
18%
Financial Services Australia 13.5% 1. Commercial Banking
2. Retail Banking
15%
12%
Financial Services Europe 13.5% 1. Commercial Banking
2. Retail Banking
15%
12%
Financial Services New Zealand 13.5% 1. Commercial Banking
2. Retail Banking
15%
12%
HomeSide 12% Retail Banking 12%
IT (1999) 12.89% N/A N/A
National Shared Services (2000) 13.795% N/A N/A
Other (1999) 12.89% N/A N/A
Other (2000) 13.795% N/A N/A
Other (2001) 11.91% N/A N/A
Other (2002) 11.98% N/A N/A
Other (2003) 12.63% N/A N/A
Other (2004) 11.93% N/A N/A
Products & Services 15% N/A N/A
Specialist & Emerging Businesses 15% 1. Commercial Banking
2. Retail Banking (card services)
3. Trading & Sales
15%
12%
18%
Wealth Management 12% Asset Management 12%
As the segment Business & Personal Financial Services comprises both, elements of commercial
and elements of retail banking we apply an average beta of 13.5%. This assumes that GI in this
segment is evenly distributed, a necessary assumption as there is no detailed data available
regarding the actual GI generation within the segment. The same applies to the business segments
Financial Services Australia, Financial Services New Zealand, and Financial Services Europe.
We calculate the beta level for the segment Corporate & Institutional Banking in the same
manner. In this case, based on the information provided, the products & services offered in this

13
This business unit was called Wholesale Financial Services in the financial year ending 2001.
14
The data for this segment also corresponds to the segment Global Wholesale Financial Services in the
financial year ending 1999 and Wholesale Financial Services in the financial year ending 2000.
- 13 -
segment consist of a mix of commercial banking, corporate finance and trading & sales activities.
Thus, we apply a weighted average beta of 17%, again assuming that the GI generation is equally
distributed. Similarly, we derive at a beta level of 15% for the Specialist & Emerging Businesses
segment, which comprises elements of the commercial banking, retail banking, particularly cards
services, and trading & sales business lines described in Basel II.
There is no information provided regarding the business segment Products & Services. Thus we
simply assume the middle-risk beta level of 15%, which would also be applicable under the BIA.
The business segments IT, National Shared Services and Other are assumed to be support lines
for the remaining segments. According to the BCBS (2006: 303) any GI generated by support
lines needs to be mapped into those business lines that the ancillary segment supports. As this is
subject to an institutions internal accounting methods, it is impossible for external parties to map
these GI figures. For simplicity reasons we assume that the business segments use these ancillary
functions in line with the proportion of total GI generated in the respective business segment.
Thus we calculate the respective betas based on the average beta levels of all business segments
that the ancillary unit supports in any given year.
Figure 2: Hypothetical Operational Risk Capital Charges under the TSA
Hypothetical Capital Charge: TSA
0
500
1,000
1,500
2,000
2,500
2002 2003 2004 2005
Time
$
m
GI
Total revenue after
interest expenses

Figure 2 shows the hypothetical operational risk capital charges using the individual segment GIs
as measurement basis. For comparison purposes we included the total revenue after interest
expenses. Due to aggregated data it was not possible to extract the individual segments interest
expense figures. Using approximated GI figures for NABs business segments, we find that the
hypothetical operational risk capital charge would have increased over time, clearly indicating a
build-up in the banks operational risk exposure. It needs to be noted, however, that while the GI
figures are gross of operating expenses, provisions and irregular items, they are also gross of any
expenses that do not qualify for one of these categories. The reason is that there is no break-down
of segment expenses in the banks annual report. Thus the annual GIs and the resulting capital
charges are likely to be overstated. In fact, depending on the behaviour of expenses across
business lines and over time we might be looking at a different trend for the calculated capital
charge.

5. Conclusions
The BCBSs rationale for introducing three increasingly sophisticated approaches to the
calculation of operational risk capital is to create an incentive for banks to improve their risk
management and measurement methods while benefiting from lower capital throughout the
process from gradating from the least to the most sophisticated measurement tool. In case of
moving from the BIA to the TSA, there might be, however, little incentives for financial
- 14 -
institutions to do so. We showed that the operational risk capital under the TSA compared to the
BIA is smaller in only one of the three hypothetical scenarios that we discussed in section 3, this
being the case in which the focus of GI generation lies in the low-beta business units.
In section 4 we applied Basels BIA and TSA methodologies to actual annual report data of the
NAB. As the losses that occurred at the NAB between 2001 and 2004 were classified as
operational risk losses, we assessed whether the Basels methodologies would have captured the
build-up in the banks operational risk exposure over time. We found that, using the BIA, the
institutions GI would have been a poor indicator for operational risk. In fact, it showed a
declining capital charge over time. We introduced benchmark figures all of which provided a
better indication of an operational risk build-up in the bank. The TSA, on the other hand, clearly
indicated an increasing operational risk exposure in the bank over the observation period. There
were, however, problems in clearly identifying the GI levels for the eight pre-set business lines by
the BCBS and in establishing appropriate beta-levels for those business units that seemed to
incorporate elements of more than one business line. A further problem arose from aggregated
information regarding segment expenses and from the several structural changes that NAB
underwent from 1998 to 2004.
Due to NABs size and scope of operations the bank will be required to use the AMA for
calculating its operational risk capital. It is not possible to apply the AMA to annual report data as
the AMA are based on internally-gathered data, validated by external data and are further reliant
on internally-developed measurement methodologies. While the resulting hypothetical capital
charges might have been more in line with the banks actual risk profile over the observation
period and thus would have provided a better buffer once the losses were announced, one thing is
for sure: no matter whether the bank would have used the BIA, the TSA or the AMA to calculate
operational risk capital, the true sources of the operational risk losses would not have been
detected. All methodologies would have provided the institution with a re-active measure to
absorb losses once they were detected, but would have captured neither the traders fraudulent
behaviour, nor the control deficiencies in the bank.

REFERENCES
APRA (2004) "Report into Irregular Currency Options Trading at the National Australia Bank",
23 March.
BCBS (2001) Working Paper on the Treatment of Operational Risk, Bank for International
Settlements, Basel, September.
BCBS (2006) International Convergence of Capital Measurement and Capital Standards: A
Revised Framework Comprehensive Version, Bank for International Settlements, Basel,
June.
NAB (1998) 1998 Annual Report, National Australia Bank,
http://www.nabgroup.com/vgnmedia/downld/ar1998_long.pdf.
NAB (1999) Annual Report 1999, National Australia Bank,
http://www.nabgroup.com/vgnmedia/downld/99_full_report.pdf.
NAB (2000) Annual Financial Report 2000, National Australia Bank,
http://www.nabgroup.com/vgnmedia/downld/0,,1347,00.pdf.
http://www.nabgroup.com/vgnmedia/downld/Annual_Financial_Report_2001.pdf.
- 15 -
http://www.nabgroup.com/vgnmedia/downld/Annual_Report_2002-413909987.pdf.
http://www.nabgroup.com/vgnmedia/downld/NABFullFi2003NoSigWCovers.pdf.
http://www.nabgroup.com/vgnmedia/downld/Full_Financials_NAB04.pdf.
PWC Report (2004) Investigation into Foreign Exchange Losses at the National Australia
Bank, PricewaterhouseCoopers, 12 March.
Sundmacher, M. (2004) Operational Risk Capital: Arbitrage Adjustments and Alternatives,
Proceedings of the AIBF/UTS Basel II What will it achieve? Conference, Sydney, 16
August.

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