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The risk of loss resulting from inadequate or failed internal process, people, and system or from external events Basel committee has identified several loss categories

1. Internal fraud Unauthorized activity, theft or fraud, that involves at least one internal party -

2.External fraud Refers to theft or fraud carried out by a third party outside the organization theft, robbery, compute hacking, theft of information
3. Employment practices and workplace safety -employees compensation claims, wrongful termination, violation of safety and health rules, discrimination claims, harassment

4. Clients, products, and business practices Losses arising from a failure to meet an obligation to a client, or from nature or design of products

Misuse of confidential clients information Money laundering Product defects Exceeding clients exposure limits

5. Damage to physical assets Losses arising out of disaster or other events natural disasters, terrorism or vandalism

6. Business disruption and system failures -hardware and software failures -Telecommunications problems -Power outages/disruptions 7. Execution, delivery, and process management -risk associated with transaction processing, trade counterparties for example, miscommunication, data entry errors, accounting errors, vendor disputes, outsourcing

According to Basel II, banks must hold capital for operational risk that is equal to the average of the previous three years of a fixed percentage () of positive annual gross income, which means that negative gross income figures must be excluded

where K is the capital charge Y positive gross income over the previous three years

and n the number of the previous three years for which gross income is positive The fraction is fixed by the Basel Committee at 15 percent For the purpose of estimating K, the Committee defines gross income as net interest income plus net non-interest income as defined by the national supervisors and/or national accounting standards

The Committee suggests that the recognition of Y requires the satisfaction of the following criteria: (i) being gross of any provisions, (ii) being gross of operating expenses, (iii) excluding realized profi ts/losses from the sale of securities, and (iv) excluding extraordinary and irregular items as well as income from insurance claims.

Accepting that some financial activities are more exposed than others to operational risk (at least in relation to gross income), the BCBS divides banks activities into eight business lines. The capital charge for each business line is calculated by multiplying gross income by a factor () that is assigned to each business line. () is essentially the loss rate for a particular business line with an average business and control environments.

The total capital charge is calculated as a threeyear average of the simple sum of capital charges of individual business lines in each year Hence

Where j is set by the Basel Committee to relate the level of required capital to the level of gross income for business line j.

The BCBS (2004a) suggests that if banks move from the BIA along a continuum toward the AMA, they will be rewarded with a lower capital charge The BCBS makes it clear that the use of the AMA by a certain bank is subject to the approval of the supervisors. The regulatory capital requirement is calculated by using the banks internal operational risk measurement system.

The Committee considers insurance as a mitigator of operational risk only under the AMA Under this approach, banks must quantify operational risk capital requirements for seven types of risk and eight business lines, a total of 56 separate estimates

The Basel II accord allows three alternative approaches under the AMA: (i) the loss distribution approach (LDA); (ii) the scenario-based approach (SBA); and (iii) the scorecard approach (SCA), which is also called the risk drivers and controls approach (RDCA). The three approaches differ only in the emphasis on the information used to calculate regulatory capital