This paper provides an economic and mathematical characterization of operational risk useful for clarifying the issues related to estimation and the determination of economic capital. The insights for this characterization originate in the corporate finance literature. Operational risk is subdivided into two types, either: (i) the risk of a loss due to the firm's operating technology, or (ii) the risk of a loss due to agency costs. These two types of operational risks generate loss processes with different economic characteristics. We argue that the current methodology for the determination of economic capital for operational risk is overstated. It is biased high because the computation omits the bank's net present value (NPV) generating process. We also show that although it is conceptually possible to estimate the operational risk processes' parameters using only market prices, the non-observability of the firm's value makes this an unlikely possibility, except in rare cases. Instead, we argue that data internal to the firm, in conjunction with standard hazard rate estimation procedures, provides a more fruitful alternative.
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- Antje Berndt & Rohan Douglas & Darrell Duffie & Mark Ferguson & David Schranz, 2005.
"Measuring default risk premia from default swap rates and EDFs,"
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- Antje Berndt & Rohan Douglas & Darrell Duffie & Mark Ferguson, . "Measuring Default Risk Premia from Default Swap Rates and EDFs," GSIA Working Papers 2006-E31, Carnegie Mellon University, Tepper School of Business.
- Joost Driessen, 2005. "Is Default Event Risk Priced in Corporate Bonds?," Review of Financial Studies, Society for Financial Studies, vol. 18(1), pages 165-195.
- Kabir Dutta & Jason Perry, 2006. "A tale of tails: an empirical analysis of loss distribution models for estimating operational risk capital," Working Papers 06-13, Federal Reserve Bank of Boston.
- Chavez-Demoulin, V. & Embrechts, P. & Neslehova, J., 2006. "Quantitative models for operational risk: Extremes, dependence and aggregation," Journal of Banking & Finance, Elsevier, vol. 30(10), pages 2635-2658, October.
- R. Jarrow & A. Purnanandam, 2007. "The valuation of a firm’s investment opportunities: a reduced form credit risk perspective," Review of Derivatives Research, Springer, vol. 10(1), pages 39-58, January.
- Marco Moscadelli, 2004. "The modelling of operational risk: experience with the analysis of the data collected by the Basel Committee," Temi di discussione (Economic working papers) 517, Bank of Italy, Economic Research and International Relations Area.
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