Encyclopedia of Financial Models III

Operational Risk Models

ANNA CHERNOBAI, PhD

Assistant Professor of Finance, M. J. Whitman School of Management, Syracuse University

SVETLOZAR T. RACHEV, PhD, DrSci

Frey Family Foundation Chair Professor, Department of Applied Mathematics and Statistics, Stony Brook University, and Chief Scientist, FinAnalytica

FRANK J. FABOZZI, PhD, CFA, CPA

Professor of Finance, EDHEC Business School

Abstract: In general terms, operational risk is the risk of loss resulting from inadequate or failed internal processes, people, or systems or from external events. The models that have been proposed for assessing operational risk can be broadly classified into top-down models and bottom-up models. Top-down approaches quantify operational risk without attempting to identify the events or causes of losses. Bottom-up models quantify operational risk on a micro level being based on identified internal events. The obstacle hindering the implementation of these models is the scarcity of available historical operational loss data.

Identifying the core principles that underlie the operational risk process is the fundamental building block in deciding on the optimal model to be used. In this entry we provide an overview of models that have been put forward for the assessment of operational risk. These models are broadly classified into top-down models and bottom-up models.

Operational risk is distinct from credit risk and market risk, posing difficulties of implementation of the Basel II guidelines and ...