VRM 7 Flashcards
What is operational risk?
The risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events.
Defined by the Basel Committee and the International Association of Insurance Supervisors.
What are the seven categories of operational risk according to the Basel Committee?
- Internal fraud
- External fraud
- Employment practices and workplace safety
- Clients, products, and business practices
- Damage to physical assets
- Business disruption and system failures
- Execution, delivery, and process management
Each category encompasses various specific risks.
What is the basic indicator approach for calculating operational risk capital?
Operational risk capital is set equal to 15% of the three-year average annual gross income.
Gross income is defined as interest earned minus interest paid plus non-interest income.
How does the standardized approach differ from the basic indicator approach?
Separate calculations are carried out by each business line, with different percentages applied to gross income across business lines.
Eight business lines have specified capital percentages.
What is the advanced measurement approach (AMA) in Basel II?
Capital is set equal to the 99.9 percentile of the loss distribution minus the expected operational loss.
This approach treats operational risk like credit risk.
What is the purpose of scenario analysis in operational risk management?
To identify potential risks and their impacts when data is scarce.
Scenario analysis can help in understanding potential future risks.
What is the formula for calculating the Business Indicator (BI) in the standardized measurement approach?
The BI is calculated using a piecewise linear relationship based on gross income and other financial metrics.
Designed to provide a more relevant measure of bank size.
What is the average loss frequency in operational risk?
The average number of times in a year that large losses occur, often modeled with a Poisson distribution.
The parameter λ represents the average number of losses.
What is loss severity in operational risk?
The probability distribution of the size of each loss, often fitted to a lognormal distribution.
Mean and standard deviation of loss size are key parameters.
What are the common data issues that can introduce inaccuracies in loss estimation?
Inaccuracies and biases can arise from poor data quality, incomplete data, and misreporting.
Accurate data is crucial for reliable risk assessment.
What is the risk of moral hazard in the context of operational risk insurance?
The risk that insured parties may take greater risks because they do not bear the full consequences of those risks.
This can lead to increased operational risks for financial institutions.
What is the difference between internal fraud and external fraud?
Internal fraud involves acts by internal parties, while external fraud involves acts by third parties.
Examples include employee theft vs. robbery.
What is the significance of the Basel II regulations?
They provide a framework for calculating credit risk capital and include approaches for determining operational risk capital.
Basel II emphasizes the importance of managing operational risks.
What are the main risks associated with compliance in operational risk?
The risk of incurring fines or penalties due to failure to comply with laws, regulations, and internal policies.
Non-compliance can lead to significant financial and reputational damage.
What is the purpose of Risk and Control Self-Assessment (RCSA)?
To identify and assess risks and controls within an organization.
RCSA helps in measuring and managing operational risks effectively.
Fill in the blank: The _______ is used to measure operational risk capital under the advanced measurement approach.
[99.9 percentile of the loss distribution minus the expected operational loss]
True or False: Cyber risks are considered a category of operational risk.
True
Cyber risks include threats from hacking, data theft, and other cyber crimes.
What is the impact of rogue trading on financial institutions?
It can lead to significant financial losses and regulatory scrutiny.
Notable examples include the collapses of Barings Bank and Société Générale.
How can Monte Carlo simulations be used in operational risk management?
To determine the probability distribution of losses based on estimated parameters.
Monte Carlo simulations help in understanding potential financial impacts.
What is the first step in the Monte Carlo simulation procedure for determining loss distribution?
Sample from the Poisson distribution to determine the number of loss events 𝑛 in a year.
In step 2 of the Monte Carlo simulation, what is sampled for each loss event?
Sample 𝑛 times from the lognormal distribution of the loss size.
What is calculated in step 3 of the Monte Carlo simulation?
Sum the 𝑛 loss sizes to determine the total loss.
How many times should steps 1 to 3 be repeated in the Monte Carlo simulation?
Many times.
If the average loss frequency is 4 and the random number sampled is 0.31, how many loss events does this correspond to?
Three loss events.
What is the formula for the probability of observing n loss events in the Poisson distribution?
𝑃𝑟 𝑛 = e^(-λn) / n!
What are the probabilities for different numbers of losses given in the example?
- 𝑃𝑟 0 losses = 0.018
- 𝑃𝑟 1 loss = 0.073
- 𝑃𝑟 2 losses = 0.147
- 𝑃𝑟 3 losses = 0.195
What is the cumulative probability for losses less than or equal to 2?
0.238
What is the cumulative probability for losses less than or equal to 3?
0.433
What are the mean and standard deviation of the loss size in the example provided?
- Mean = 80
- Standard deviation = 40
What are the mean and variance of the logarithm of loss size as mentioned?
- Mean = 7.959
- Variance = 0.223
What total loss is calculated from the sampled lognormally distributed losses of 4.1, 5.1, and 4.4?
305.81
What is the challenge with estimating loss frequency and severity for operational risk?
Historical data on operational risk losses is scarce.
How can loss severity be estimated when a financial institution has no data?
Using losses experienced by other financial institutions as a guide.
What type of data can potentially bias loss severity estimates?
Data from vendors that typically report only large losses.
What adjustment should be made to loss severity estimates over time?
Adjust for inflation.
What is the purpose of scenario analysis in estimating loss frequencies and severities?
To assess low frequency but high severity loss events.
What should operational risk experts estimate regarding loss severity?
The 1 percentile to 99 percentile range of the loss distribution.
What is a potential cause of operational risk losses that can be managed?
Increasing employee training.
What is the Risk Control and Self Assessment (RCSA)?
A process for understanding operational risks and creating awareness among employees.
What are Key Risk Indicators (KRIs)?
Data points indicating a heightened chance of operational risk losses.
What can employee education help reduce in the context of operational risk?
Compliance-related operational risk losses.
What is economic capital allocated for in business units?
To calculate a return on capital.
What is the power law in the context of probability distributions?
A relationship that describes how fat the right tail of the probability distribution is.
What does moral hazard refer to in the context of insurance?
The risk that the existence of an insurance contract will cause the insured to behave in a way that makes a loss more likely.
What is adverse selection in insurance?
The risk that only high-risk individuals seek insurance, leading to higher costs for insurers.
What is a method insurers use to manage moral hazard?
Using deductibles and coinsurance provisions.
What is moral hazard in the context of insurance companies?
Moral hazard refers to the risk that a party engages in risky behavior because it is insulated from the consequences, often due to insurance coverage.
Insurance companies manage moral hazard by specifying trading limits and investigating losses carefully.
How do insurance companies manage moral hazard?
Insurance companies manage moral hazard by:
* Specifying trading limits
* Requiring policies not to be revealed to traders
* Using deductibles
* Implementing co-insurance provisions
* Setting limits on total payouts
* Increasing premiums after a loss
Deductibles mean the financial institution is responsible for the first part of any loss.
What is adverse selection in insurance?
Adverse selection is the issue of distinguishing low-risk situations from high-risk situations in insurance underwriting.
It occurs when an insurer charges the same premium for all, attracting higher-risk clients.
What happens when insurance companies charge the same premium for all risks?
Charging the same premium for all risks leads to attracting clients with the highest risk.
For example, banks with poor internal controls would buy more insurance compared to those with good controls.
How do insurance companies address adverse selection?
Insurance companies address adverse selection by:
* Researching potential customers
* Requiring proof of good risk controls before providing quotes
This is particularly relevant in rogue trader insurance.
Fill in the blank: Insurance companies often require _______ to manage moral hazard.
[deductibles]
True or False: Adverse selection only affects low-risk financial institutions.
False
Adverse selection affects insurance companies by attracting high-risk clients.
What is a co-insurance provision?
A co-insurance provision is when an insurance company pays only a percentage of a loss rather than the full amount.
This helps mitigate moral hazard.
What might happen if financial institutions fail to follow insurance requirements?
They might forfeit their payout.
This emphasizes the importance of compliance with insurance terms.
