Rethinking Operational Risk Capital Requirements

Operational risk capital requirements represent a relative backwater of the Basel capital framework for banks. We examine both the existing Basel II framework and the latest Basel Committee proposals for reform and conclude that neither are effective in creating appropriate incentives and loss absorbency to minimize negative externalities from operational risk events. We evaluate an alternative approach that would appear to be much more effective in achieving the regulatory objectives. We do not offer a view on the amount of capital required, focusing instead on the methodology and structure of the capital requirement.