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Operational Risk Modelling and Management K11986_FM.indd 1 9/1/10 12:40:04 PM CHAPMAN & HALL/CRC FINANCE SERIES CHAPMAN & HALL/CRC FINANCE SERIES Series Editor Michael K. Ong Stuart School of Business Illinois Institute of Technology Chicago, Illinois, U. S. A. Operational Risk Modelling Aims and Scopes As the vast field of finance continues to rapidly expand, it becomes increasingly important to present the latest research and applications to academics, practitioners, and students in the field. and Management An active and timely forum for both traditional and modern developments in the financial sector, this finance series aims to promote the whole spectrum of traditional and classic disciplines in banking and money, general finance and investments (economics, econometrics, corporate finance and valuation, treasury management, and asset and liability management), mergers and acquisitions, insurance, tax and accounting, and compliance and regulatory issues. The series also captures new and modern developments in risk management (market risk, credit risk, operational risk, capital attribution, and liquidity risk), behavioral finance, trading and financial markets innovations, financial engineering, alternative investments and the hedge funds industry, and financial crisis management. The series will consider a broad range of textbooks, reference works, and handbooks that appeal to academics, practitioners, and students. The inclusion of numerical code and concrete real-world case studies is highly encouraged. Published Titles Decision Options®: The Art and Science of Making Decisions, Gill Eapen Claudio Franzetti Emerging Markets: Performance, Analysis, and Innovation, Greg N. Gregoriou Introduction to Financial Models for Management and Planning, James R. Morris SERV and John P. Daley Zurich, Switzerland Pension Fund Risk Management: Financial and Actuarial Modeling, Marco Micocci, Greg N. Gregoriou, and Giovanni Batista Masala Stock Market Volatility, Greg N. Gregoriou Portfolio Optimization, Michael J. Best Operational Risk Modelling and Management, Claudio Franzetti Proposals for the series should be submitted to the series editor above or directly to: CRC Press, Taylor & Francis Group 4th, Floor, Albert House 1-4 Singer Street London EC2A 4BQ UK K11986_FM.indd 2 9/1/10 12:40:04 PM CHAPMAN & HALL/CRC FINANCE SERIES CHAPMAN & HALL/CRC FINANCE SERIES Series Editor Michael K. Ong Stuart School of Business Illinois Institute of Technology Chicago, Illinois, U. S. A. Operational Risk Modelling Aims and Scopes As the vast field of finance continues to rapidly expand, it becomes increasingly important to present the latest research and applications to academics, practitioners, and students in the field. and Management An active and timely forum for both traditional and modern developments in the financial sector, this finance series aims to promote the whole spectrum of traditional and classic disciplines in banking and money, general finance and investments (economics, econometrics, corporate finance and valuation, treasury management, and asset and liability management), mergers and acquisitions, insurance, tax and accounting, and compliance and regulatory issues. The series also captures new and modern developments in risk management (market risk, credit risk, operational risk, capital attribution, and liquidity risk), behavioral finance, trading and financial markets innovations, financial engineering, alternative investments and the hedge funds industry, and financial crisis management. The series will consider a broad range of textbooks, reference works, and handbooks that appeal to academics, practitioners, and students. The inclusion of numerical code and concrete real-world case studies is highly encouraged. Published Titles Decision Options®: The Art and Science of Making Decisions, Gill Eapen Claudio Franzetti Emerging Markets: Performance, Analysis, and Innovation, Greg N. Gregoriou Introduction to Financial Models for Management and Planning, James R. Morris SERV and John P. Daley Zurich, Switzerland Pension Fund Risk Management: Financial and Actuarial Modeling, Marco Micocci, Greg N. Gregoriou, and Giovanni Batista Masala Stock Market Volatility, Greg N. Gregoriou Portfolio Optimization, Michael J. Best Operational Risk Modelling and Management, Claudio Franzetti Proposals for the series should be submitted to the series editor above or directly to: CRC Press, Taylor & Francis Group 4th, Floor, Albert House 1-4 Singer Street London EC2A 4BQ UK K11986_FM.indd 3 9/1/10 12:40:04 PM CRC Press Taylor & Francis Group 6000 Broken Sound Parkway NW, Suite 300 Boca Raton, FL 33487-2742 © 2011 by Taylor and Francis Group, LLC CRC Press is an imprint of Taylor & Francis Group, an Informa business No claim to original U.S. Government works Printed in the United States of America on acid-free paper 10 9 8 7 6 5 4 3 2 1 International Standard Book Number-13: 978-1-4398-4477-9 (Ebook-PDF) This book contains information obtained from authentic and highly regarded sources. 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William Ockham (1285-1349) Far better an approximate answer to the right question, than the exact answer to the wrong question, which can always be made precise. John W. Tukey We move forward, ignoring the risks we create. From time to time an accident shakes us up from our numbness, and we glance into the precipice. Ivar Ekeland Contents List of Figures xv List of Tables xix Preface xxi About the Author xxiii 1 Introduction to Operational Risk 1 1.1 Why Regulate Banks? . . . . . . . . . . . . . . . . . . . . . . 1 1.2 Additional Supervision . . . . . . . . . . . . . . . . . . . . . 4 1.3 The Basel Regulatory Effort . . . . . . . . . . . . . . . . . . 10 1.4 Risk and Capital . . . . . . . . . . . . . . . . . . . . . . . . . 13 1.4.1 How Do We Define Risk? . . . . . . . . . . . . . . . . 13 1.4.2 What Is Risk Management? . . . . . . . . . . . . . . . 16 1.4.3 Capital . . . . . . . . . . . . . . . . . . . . . . . . . . 17 1.4.4 Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . 22 1.4.5 Ruin Theory . . . . . . . . . . . . . . . . . . . . . . . 24 1.4.6 Risk and Aversion . . . . . . . . . . . . . . . . . . . . 26 1.5 What Is Operational Risk? . . . . . . . . . . . . . . . . . . . 28 1.6 Economic Capital for Operational Risk . . . . . . . . . . . . 34 1.7 Operational Risk under Basel 2 . . . . . . . . . . . . . . . . 36 1.7.1 Basic Indicator Approach . . . . . . . . . . . . . . . . 36 1.7.2 Standardised Approach . . . . . . . . . . . . . . . . . 37 1.7.3 Advanced Measurement Approach . . . . . . . . . . . 39 1.8 Role of Insurance . . . . . . . . . . . . . . . . . . . . . . . . 40 1.9 Regulation after the Crisis . . . . . . . . . . . . . . . . . . . 44 2 The Problem Context 49 2.1 General Remarks . . . . . . . . . . . . . . . . . . . . . . . . 49 2.2 The Data Problem . . . . . . . . . . . . . . . . . . . . . . . 50 2.2.1 Scaling . . . . . . . . . . . . . . . . . . . . . . . . . . 51 2.2.2 Mixing . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 2.2.3 Paucity . . . . . . . . . . . . . . . . . . . . . . . . . . 51 2.2.4 External Loss Data . . . . . . . . . . . . . . . . . . . . 53 2.3 The Dependency Problem . . . . . . . . . . . . . . . . . . . 53 ix