Calculating Regulatory Capital Approach
The Basel definition of operational risk is “the risk of direct and indirect loss resulting from inadequate or failed internal processes, people, and systems or from external events.”
The three methods for calculating operational risk capital requirements are: (1) the basic indicator approach, (2) the standardized approach, and (3) the advanced measurement approach (AMA). Large banks are encouraged to move from the standardized approach to the AMA in an effort to reduce capital requirements.
Operational Risk Categories
Operational risk can be divided into seven types: (1) clients, products, and business practices, (2) internal fraud, (3) external fraud, (4) damage to physical assets, (5) execution, delivery, and process management, (6) business disruption and system failures, and (7) employment practices and workplace safety.
Loss Distribution Approach
Operational risk losses can be classified along two dimensions: loss frequency and loss severity. Loss frequency is defined as the number of losses over a specific time period, and loss severity is defined as the size of a loss, should a loss occur.
Data Limitations
Banks should use internal data when estimating the frequency of losses and utilize both internal and external data when estimating the severity of losses. Regarding external data, banks can use sharing agreements with other banks (which includes scale-adjusted data) and public data.
Scenario Analysis
Scenario analysis is a method for obtaining additional operational risk data points. Regulators encourage the use of scenarios since they allow management to incorporate events that have not yet occurred.
Forward-Looking Approaches
Forward-looking approaches are also used to discover potential operational risk loss events. Forward-looking methods include: (1) causal relationships, (2) risk and control self assessment (RCSA), and (3) key risk indicators.
Scorecard Data
Allocating operational risk capital can be accomplished by using the scorecard approach. This approach involves surveying each manager regarding the key features of each type of risk. Answers are assigned scores in an effort to quantify responses.
The Power Law
The power law is useful in extreme value theory (EVT) when we evaluate the nature of the tails of a given distribution. The use of this law is appropriate since operational risk losses are likely to occur in the tails.
Insurance
Two issues facing insurance companies that provide insurance for operational risks are moral hazard and adverse selection. A moral hazard occurs when an insurance policy causes a company to act differently with insurance protection. Adverse selection occurs when an insurance company cannot decipher between good and bad insurance risks.
