Feb 22

Best summary yet of operational risk under Basel II

by David Harper, CFA, FRM, CIPM

Andreas Jobst recently published an IMF working paper on operational risk approaches under Basel II. It's the most readable summary on Basel II OpRisk that I've read. I'd recommend this as an operational risk primer to any 2008 FRM candidate (Here is a pdf version annotated with my highlights).

Selected highlights (bold type is mine):

Two key challenges are: "accurate estimation of asymptotic tail convergence of extreme operational risk events" and "the consistent definition and implementation of loss reporting and data collection across different areas of banking activity in accordance with the New Basel Capital Accord." The first challenge refers to the classic heavy-tail problem (low frequency, high severity loss events) but it's even worse for operational risk where quantitative data is sparse and hard to define. The second challenge refers to the difficulty of comparing (and aggregating) loss data across the "natural heterogeneity" among different bank business units. To further summarize, collectively this refer to the dual problem of both creating accurate loss parameters for operational events and then benchmarking/summing those parameters across different units and banks.
"The quantitative aspects of AMA define regulatory capital as protection against both EL and UL from operational risk exposure at a soundness standard consistent with a statistical confidence at the 99.9th percentile over a one-year holding period. Although the Basel Committee does not mandate the use of a particular quantitative methodology..." This is deliberately a very high confidence, apparently chosen more to ensure a focus than calibrate an accurate charge.
On the impact of loss timing, there is a nice discussion of the tradeoffs between so-called absolute measures (e.g., peaks over threshold) and relative measures (block maxima).
Makes the point that loss frequency matters: two banks can have similar total exposures, but one may the result of fewer (less frequent) but greater expected loss (EL).
"The current quantitative criteria of the AMA soundness standards allow banks to adjust the regulatory capital charge for UL by up to 20 percent of their operational risk exposure (“capital adjustment”) due to (i) diversification benefits from internally determined loss correlations between individual operational risk estimates (“units of measure”) and (ii) the risk mitigating impact of operational risk insurance."

If you are an FRM candidate, you might also take note of Figure 2 in the appendix. This is a good picture of a generic loss distribution approach (LDA) that can be a stumbling block if you are new to this topic (copied below. Source: Andreas Jobst , Consistent Quantitative Operational Risk Measurement and Regulation: Challenges of Model Specification, Data Collection, and Loss Reporting. International Monetary Fund (IMF). November 2007)

About the diagram below, please note:

It's not symmetrical
Expected loss (EL) + Unexpected loss (UL) = Value at risk (VaR)
As usual, VaR doesn't say anything (doesn't help) about the distribution of extreme losses
The expectation is that reserves, not regulatory capital, cover expected losses (of course, the Accord checks for that. If a bank doesn't cover EL with reserves, then they'll need more regulatory capital). Regulatory capital is for unexpected losses (this isn't shown below)
Capital deduction can be earned up to 20% for qualifying diversification and insurance