Fundamental Aspects of Operational Risk and Insurance Analytics: A Handbook of Operational Risk

Chapter Fourteen Scenario Analysis

14.1 Introduction

The Basel II/Basel III Advanced Management Approach (AMA) includes the requirement for an OpRisk system to have four key elements: internal data, external data, scenario analysis, and factors reflecting the business environment and internal control systems (see BCBS, 2006, p. 152). One of these key elements that is particularly subjective is scenario analysis. In the final proposals, the Basel committee specified more detailed criteria for each of the four fundamental elements, in particular for scenario analysis (BCBS, 2006, paragraph 675, p. 154):

“A bank must use scenario analysis of expert opinion in conjunction with external data to evaluate its exposure to high-severity events. This approach draws on the knowledge of experienced business managers and risk management experts to derive reasoned assessments of plausible severe losses. For instance, these expert assessments could be expressed as parameters of an assumed statistical loss distribution. In addition, scenario analysis should be used to assess the impact of deviations from the correlation assumptions embedded in the bank's OpRisk measurement framework, in particular, to evaluate potential losses arising from multiple simultaneous OpRisk loss events. Over time, such assessments need to be validated and reassessed through comparison to actual loss experience to ensure their reasonableness”.

Estimation of low-frequency/high-severity risks cannot be done ...