Corporate Risk Management

CHAPTER 14Quantification of Banks' Operational Risk

This chapter covers operational risk, which is very different from the other risks previously discussed.¹ Operational risk is more similar to a pure risk rather than a financial risk intended to obtain a future return, such as market risk or credit risk. Although operational risk is also insurable, very few forms of insurance coverage for several components of operational risk exist on the market. Financial institutions must therefore opt for self-protection (prevention) and self-insurance to limit this risk. One form of self-insurance is to establish a capital reserve. This chapter will present models for calculating optimal capital for operational risk to satisfy regulatory requirements.

14.1 CONTEXT AND PRESENTATION OF OPERATIONAL RISK

Operational risk for banks and insurance companies is now regulated. We will discuss these regulations in relation to Basel II, which introduced the regulation of bank capital for operational risk in 2004.

In Europe, the regulation of operational risk for insurance companies is also well defined under Solvency II. Regulation of implementation procedures was discussed in Canada, and the rules took effect in 2017. In the United States, a task force (Capital Adequacy (E) Task Force) was put in place in 2013 by the NAIC (National Association of Insurance Commissioners) to evaluate how operational risk could be integrated in insurers' risk capital management.

14.1.1 Basel Accord and Regulation ...