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.”
METHODS FOR CALCULATING OPERATIONAL RISK REQUIREMENTS:
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).
The basic indicator approach and the standardized approach determine capital requirements as a multiple of gross income at either the business line or institution level. The advanced measurement approach (AMA) offers institutions the possibility to lower capital requirements in exchange for investing in risk assessment and management technologies.
The Basel Committee on Banking Supervision disaggregates operational risk into seven types. A majority of the operational risk losses result from clients, products, and business practices.
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.
One method for allocating risk capital to each business unit
is the scorecard approach. This approach involves surveying each manager regarding the key features of each type of risk. Questions are formulated, and answers are assigned scores in an effort to quantify responses. The total score for each business unit represents the total amount of risk. Scores are compared across business units and validated by comparison with historical losses.
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. The law states that for a range of variables:
P(V> X) = K x X–α
where: V =loss variable, X =large value of V, K and a = constants
Managers have the option to insure against the occurrence of operational risks. Two issues facing insurance companies and risk managers are moral hazard and adverse selection.
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