Transaction Cost Analysis A-Z

Transaction Cost Analysis A-Z — November 2008

II. Transaction Cost Components and Drivers

and qualitative criteria. Use of the AMA is subject to supervisory approval and makes it possible to reduce the minimum capital requirements significantly. Under this last regime, widely opted for by major institutions, the actual operational risks measured by means of quantitative and qualitative analysis have a direct impact on capital requirements. The following factors are likely to make a direct impact on the internal measure of operational risks: • Nature of the execution process •  Extent of trade processing automation/ manual interaction • Nature of interfaces with third parties (paper/electronic/fax) •  Extent of operations outsourcing The nature of the execution process (direct trading, algorithmic trading, phone/ electronic interface) provides an important input to the extent of operational risks. As a result, the choice of execution venue and the maturity of the interface between the financial institution and the liquidity pool are key factors behind operational risks and hence capital requirements. The extent to which the processing of trades is automated and the nature of interfaces with third parties are determined by the maturity of the markets on which transactions occur. For example, there are significant differences between emerging/developing and historic markets and exchanges. Similarly, transactions executed on exchanges and those that take place over-the-counter (OTC) are not equally automated. In the latter situation,

Basel II and various supervisory bodies have prescribed a number of soundness standards for operational risk management for banks and similar financial institutions. To complement these standards, Basel II has provided guidance on three broad methods of capital calculation for operational risk: •  Basic indicator approach •  Standardised approach • Advanced measurement approach (AMA) Banks using the basic indicator approach must hold capital for operational risk equal to the average over the previous three years of a fixed percentage (denoted alpha) of positive annual gross income. In the standardised approach , bank activities are divided into eight business lines: corporate finance, trading and sales, retail banking, commercial banking, payment and settlement, agency services, asset management, and retail brokerage. Within each business line, gross income is a broad indicator that serves as a proxy for the scale of business operations and thus the likely scale of operational risk exposure within each of these business lines. The capital charge for each business line is calculated by multiplying gross income by a factor (denoted beta) assigned to that business line (18% for sales and trading, 12% for retail banking, 18% for payments and settlement, 12% for asset management and retail brokerage). In the advanced measurement approach , the regulatory capital requirement will equal the risk measure generated by the bank’s internal operational risk measurement system using quantitative

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An EDHEC Risk and Asset Management Research Centre Publication