Basel II has transformed the regulatory landscape for the banking industry. Regulatory capital required to be maintained by the banks is all set to change with the introduction of capital charge for operational risk, apart from the refinements in the area of credit risk. The paper begins with a brief overview of the capital adequacy guidelines under Basel II since its origins in the 1988 Basel Accord. It introduces the concept of operational risk, reviews the quantitative framework for operational risk under Basel II, and outlines the key challenges and varying practices in the development of an operational risk framework.

The process of capital adequacy regulations has its origin in the Basel I proposals, where for the first time, a risk-based capital adequacy framework was prescribed for banks. The Basel Capital Accord of 1988 or Basel I as it is commonly known, was the outcome of the focused attention of the Central Banks and supervisors on management of financial crisis having its roots in banks with cross-border operations. Basel I addressed the issue of capital for credit risk, the predominant risk in banking industry at the time. However, growing complexity in banking operations meant risks were multiplying and new risks were emerging. For banks to survive, compete and make profit in this scenario, it became imperative for them to effectively monitor, measure and manage these risks. This in turn meant challenges for the regulators and supervisors, for these "other risks" were also to be captured in the regulatory framework. An amendment to Basel I in 1996 implied recognition of market risk in the capital framework. The concern of regulators about the lack of an effective control mechanism in banks compared to the speed with which the balance sheets were growing, and complexities embedded in the products therein led to a broad consensus that operational risks in banks was increasing and was an issue that needed focused attention. The need for recognizing "operational risk" coupled with other weaknesses in the Basel I framework set the stage for the creation of "International Convergence of Capital Measurement and Capital Standards: A Revised Framework", popularly know as Basel II, which was finalized in June 2004.

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