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This paper proposes a simple continuous time model to analyze capital charges for operational risk. The authors find that undercapitalized banks have fewer incentives to reduce their operational risk exposure. They view operational risk charge as a tool to reduce the moral hazard problem. These results show that only Advanced Measurement Approach may create appropriate incentives to reduce the frequency of operational losses, while Basic Indicator Approach appears counterproductive. Banking regulation aims to discipline banks and to promote financial stability in the economy on the whole. It relies on three pillars, capital requirements, market discipline, and supervisory review process.
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