Operational Risk: A Guide to Basel II Capital Requirements, Models, and Analysis

CHAPTER 4

Key Challenges in Modeling Operational Risk

Identifying the core principles that underlie the operational risk process is the fundamental building block in deciding on the optimal model to be used. We begin the chapter with an overview of models that have been put forward for the assessment of operational risk. They 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 strategic planning. We discuss some key aspects that distinguish operational risk from credit risk and market risk. They are related to the arrival process of loss events, the loss severity, and the dependence structure of operational losses across a bank’s business units.

Finally, in this chapter we reconsider the normality assumption—an assumption often made in modeling financial data—and question its applicability for the purpose of operational risk modeling.

OPERATIONAL RISK MODELS

Broadly speaking, operational risk models stem from two fundamentally different approaches: (1) the top-down approach, and (2) the bottom-up approach. Figure 4.1 illustrates a possible categorization of quantitative models.

Top-down approaches quantify operational risk without attempting to identify the events or causes of losses.⁸⁶That is, the losses are simply

FIGURE 4.1 Topology of operational risk models.

measured on a macrobasis. The principal advantage of this approach ...