Operational Risk Modeling in Financial Services

CHAPTER 7The Challenges of Measurement

7.1 INTRODUCTION

In the previous chapters, we have shown the need for operational risk measurement that results from regulatory requirements and nonregulatory needs. We will now discuss the challenges of measurement of operational risk.

7.2 MEASURING RISK OR MEASURING RISKS?

If risk is defined as the effect of uncertainty on objectives, measuring risk is measuring uncertainty. Measuring uncertainty is possible only if the type of uncertainty considered is of the nature of “known unknowns”, or possibly “unknown knowns”, but exclude unknown unknowns. This limit means in practice there will always remain an error on the measure of uncertainty. As our risk management professor Jean-Paul Louisot used to say “Risk measurement is about drawing knowledge alleys in a cloud of uncertainty”.

In practice, if we forget for a while about our quantitative or risk management background, what really is risk measurement?

There are essentially two ways to approach the assessment of uncertainty about the achievement of objectives. The first method is analytical, and the second is global.

The analytical method tries to identify all the possible events that could interfere with the objectives, and to assess the likelihood and the impact of these events. When applicable, the global method considers that the set of possible events is impossible to enumerate and prefers to observe the variance of reaching the objectives in similar situations.

We can compare ...