Machine Learning for Financial Risk Management with Python

Chapter 8. Modeling Operational Risk

...It’s not necessarily the biggest missteps that deliver the biggest blows; share prices can plummet as a result of even the smallest events.

Dunnett, Levy, and Simoes (2005)

Thus far, we have talked about three main financial risks: market, credit, and liquidity risks. Now it is time to discuss operational risk, which is more ambiguous than the other types of financial risks. This ambiguity arises from the huge variety of risk sources by which financial institutions may face huge losses.

Operational risk is the risk of direct or indirect loss resulting from inadequate or failed interval processes, people, and systems or from external events (BIS 2019). Please note that loss can be direct and/or indirect. Some direct losses would be:

• Legal liability arising from judicial process

• Write-downs due to theft or reduction in assets

• Compliance emanating from tax, license, fines, etc.

• Business interruption

Indirect cost is related to the opportunity cost in the way that a decision made by an institution may trigger a host of events resulting in a loss at an uncertain time in the future.

Normally, financial institutions allocate a certain amount of money to cover the loss emanating from operational risk, which is known as unexpected loss. However, allocating an appropriate amount of funds to cover unexpected loss is not as easy as it sounds. It is necessary to determine the right amount of unexpected loss; otherwise, either more funds are ...