Mod 24: Assessment of operational risks Flashcards
Outline the drivers of a recent increase in interest in active operational-risk management
Drivers of an increase in interest in active operational-risk management
1. the advent of ERM
2. the introduction of new regulatory capital requirements (which include a requirement to assess operational risk)
3. the increasing availability and emphasis upon sophisticated quantitative models for other sorts of risk
4. unlike many other forms of risk it has no inherent upside potential
Outline the disadvantages of an informal approach to the management of operational risks
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Disadvantages to the past informal management of operational risks
Operational risk:
1. has been the main driver behind many major financial disasters in recent times
2. is inter-linked with credit and market risk and it is particularly important to minimise the likelihood of operational risk failure during already stressed market conditions
3. may be treated differently in different areas of the company leading potentially to key risks being overlooked and decisions being taken based on inaccurate information or an incorrect assessment of a business unit’s risk-adjusted returns.
State:
1. the main specific benefit of a consistent and effective approach to operational risk management (as distinct from the general benefits of effective ERM)
2. the main focus of ERM with regard to operational risks ©
Main benefit and main focus of operational risk management
In addition to the general benefits of consistent and effective ERM (eg minimises losses, improves a company’s ability to meet its business objectives etc), the main specific benefit of consistent and effective operational risk management is that it minimises the otherwise potentially large impact of reputational damage arising from incidents linked to operational loss.
A comprehensive approach should be adopted with the focus being primarily on the management, rather than the measurement, of the risks present.
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Outline the observed characteristics of operational losses that make application of statistical methods difficult
Characteristics of operational losses
Analysis of the (publicly available) data collected so far reveals:
1. the distribution of operational losses is skewed to the right
2. loss severities have a heavy-tailed distribution
3. losses occur randomly in time
4. loss frequency may vary significantly over time
5. some classes of loss appear to have an underlying cyclical component and/or depend on current economic conditions.
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Describe the main bottom-up methods of modelling operational losses
Bottom-up methods of modelling assess operational losses
- Bottom-up models estimate the operational risk capital by starting the analysis at a low level of detail (ie by category of operational risk in turn) and then aggregating the results to obtain an overall assessment.
- Small day-to-day mistakes may be modelled, eg using statistical distributions, non-life reserving techniques, Monte Carlo simulation or, if data is limited, factor-based approaches.
- Infrequent, large events, require other methods, such as extreme value techniques.
- Due to the potential linkage between operational and other risks, scenario analysis can be a useful technique to assessing operational risks, eg Basel II AMA approach.
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Outline the steps involved in a scenario analysis for operational risk
Steps involved in a scenario analysis for operational risk
1. Group risk exposures into broad categories, eg financial fraud, systems errors, seeking input from a wide range of senior staff / experts.
2. Develop a plausible adverse scenario for each category.
3. For each scenario, assess the financial consequences (eg redress, systems corrections, regulatory fees and fines, opportunity costs) and non-financial consequences (eg operational strain, regulatory interest), again involving input from senior staff / experts.
4. Calculate the total costs as the financial cost of all risks represented by the chosen scenario.
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State the main advantage and the limitations of bottom-up approaches to modelling operational risk
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Advantage and limitations of bottom-up approaches
Adv:
give a more robust picture of a company’s overall risk profile
Disadv:
1. differences between companies mean that application of external data is difficult
2. difficult to break down reported aggregate losses into their constituent components
3. may be little robust internal historic data, especially for low probability / high severity events
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State the main advantages and limitations of top-down approaches
Advantages and limitation of top-down approaches
Adv:
1. use readily available data
2. use simple calculations
Disadv:
fail to capture successfully low probability, high consequence risks ©
List four top-down operational risk models ©
Top-down models
1. implied capital model
2. income volatility model
3. economic pricing model
4. analogue model
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Outline the implied capital model including its main advantages and disadvantages
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Implied capital model
Operational risk capital =Total risk capital – credit risk capital – market risk capital – any other-risk capital
Adv:
− simple
- forward-looking
Disadvantage:
1. the total risk capital needs to be estimated (which is not straightforward)
2. the inter-relationships between the different types of risk are ignored
3. this model does not capture cause and effect scenarios, ie where operational risk arises in the company and its specific impact
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Outline the income volatility model including its main advantages and disadvantages
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Income volatility model
Operational risk income volatility =Total income volatility – credit risk income volatility – market risk income volatility – other-risk income volatility
Adv:
better data availability in respect of total income volatility than for implied capital model
Disadva:
1. it is not forward looking as it ignores the fact that over time the income volatility of companies will change
2. by focusing on income rather than value, this model does not capture the “softer” measures of risk, such as opportunity cost and the value of reputation / brand
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Outline the economic pricing model including its main advantages and disadvantages
The economic pricing model
CAPM assumes that all market information is included in a company’s share price and so the impact of any publicised operational losses can be identified by looking at the movement in a company’s share price and stripping out the overall market movement.
Adv:
1. the most widely used economic pricing model
2. includes both the effect of specific risk events and “softer” issues
Disadv:
1. no information is provided on losses due to specific risks – only the aggregate view
2. the level of operational risk capital is unaffected by any controls put in place, so little motivation to improve the risk management process
3. tail-end risks (ie extreme events) are not accounted for thoroughly
4. it does not help anticipate (and so avoid) incidents of operational risk, as there is no consideration of individual risks in isolation
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Outline the analogue model including its main advantages and disadvantages
The analogue model
These models use data from similar companies to derive operational risk capital.
Adv:useful if there is little internal data available
Diadv:it is debatable how accurately one company mirrors another in terms of risk profile
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State the steps in a systematic process for managing a company’s operational risk
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Systematic process for managing operational risk
- risk policy and organisation
- risk identification and assessment
- capital allocation and performance measurement
- risk mitigation and control
- risk transfer and finance
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State what should be included in a comprehensive operational risk management policy
Comprehensive operational risk management policy
- principles for operational risk management
- definitions and taxonomy for operational risk
- objectives and goals of operational risk management
- operational risk management processes and tools
- organisational structure, as it applies to operational risk management
- roles and responsibilities of different business areas involved in operational risk management
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