Operational Risk toward Basel III: Best Practices and Issues in Modeling, Management, and Regulation

CHAPTER 16

Simple Measures for Operational Risk Reduction? An Assessment of Implications and Drawbacks

Silke N. Brandts and Nicole Branger

 

 

ABSTRACT

The chapter evaluates whether simple measures for the risk mitigation achieved by operational risk insurance, such as the “premium” and “limit” approaches, can serve as appropriate proxies for the true risk reduction. We demonstrate that the risk reduction implied by the simple measures can deviate substantially from the true regulatory risk reduction. Additionally, most of the simple measures incite regulatory capital arbitrage.

16.1 INTRODUCTION

Insurance is an important instrument for the risk mitigation of infrequent but severe losses due to operational risk. Given an appropriate methodology to quantify the risk-mitigating impact of operational risk insurance, financial institutions can reduce their regulatory capital requirements if they use such an insurance. As long as the value created by the lower capital requirement is positive, the use of operational risk insurance creates value for the financial institution.¹

The authors would like to thank Christian Laux, Christian Schlag, and Anton Wakolbinger for helpful comments and discussions. Responsibility for any errors, omissions, and all views lies solely with the authors.

The reduction in the regulatory capital requirement is supposed to reflect the degree of the actual risk reduction achieved by the use of operational risk insurance. The main prerequisite is the existence ...