Operational Risk Modeling in Financial Services

CHAPTER 2Introduction to the XOI Method

2.1 A RISK MODELLING DOCTRINE

From these observations and reflexions, we have formulated an Operational Risk Modelling doctrine. This doctrine proposes to adopt a statistical method for recurrent risks, and a scenario analysis method for rare risks.

It can be summarized in two sentences.

What has happened quite often will happen in similar conditions, in the absence of new preventative actions. For what has never happened, or very rarely occurred, we need to understand how this can happen and unfold, and assess the consequences in the absence of new protective actions.

If we interpret this in the space of risk represented in a usual way on a “Frequency – Severity” map (Figure 2.1), this doctrine is expressed as follows:

FIGURE 2.1 Modelling Approach by Risk Type

Potential losses due to high severity and low frequency risks are addressed through the development of probabilistic scenarios based on the analysis of the loss generation mechanism.

This approach can be extended to frequency risks with a potential for high severity, and for which an in-depth study of the possible evolutions of the risk is necessary (prevention and protection).

Potential losses due to low severity and high or medium frequency risks can be addressed by statistical models. In this context, the use of the LDA is acceptable. In fact, frequent losses can be ...