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Benchmarking Operational Risk Models

Author

Listed:
  • Curti, Filippo
  • Ergen, Ibrahim
  • Le, Minh
  • Migueis, Marco
  • Stewart, Rob T.

Abstract

The 2004 Basel II accord requires internationally active banks to hold regulatory capital for operational risk, and the Federal Reserve's Comprehensive Capital Analysis and Review (CCAR) requires banks to project operational risk losses under stressed scenarios. As a result, banks subject to these rules have measured and managed operational risk more rigorously. But some types of operational risk - particularly legal risk - are challenging to model because such exposures tend to be fat-tailed. Tail operational risk losses have significantly impacted banks' balance sheets and income statements, even post crisis. So, operational risk practitioners, bank analysts, and regulators must develop reasonable methods to assess the efficacy of operational risk models and associated equity financing. We believe benchmarks should be used extensively to justify model outputs, improve model stability, and maintain capital reasonableness. Since any individual benchmark can be misleading, we outline a set of principles for using benchmarks effectively and describe how these principles can be applied to operational risk models. Also, we provide some examples of the benchmarks that have been used by US regulators in assessing Advanced Measurement Approach (AMA) capital reasonableness and that can be used in CCAR to assess the reasonableness of operational risk loss projections. We believe no single model's output and no single benchmark offers a comprehensive view, but that practitioners, analysts, and regulators must use models combined with rigorous benchmarks to determine operational risk capital and assess its adequacy.

Suggested Citation

  • Curti, Filippo & Ergen, Ibrahim & Le, Minh & Migueis, Marco & Stewart, Rob T., 2016. "Benchmarking Operational Risk Models," Finance and Economics Discussion Series 2016-070, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgfe:2016-70
    DOI: 10.17016/FEDS.2016.070
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    File URL: http://www.federalreserve.gov/econresdata/feds/2016/files/2016070pap.pdf
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    References listed on IDEAS

    as
    1. Acharya, Viral V. & Cooley, Thomas & Richardson, Matthew & Walter, Ingo, 2010. "Manufacturing Tail Risk: A Perspective on the Financial Crisis of 2007–2009," Foundations and Trends(R) in Finance, now publishers, vol. 4(4), pages 247-325, April.
    2. Danielsson, Jon, 2002. "The emperor has no clothes: Limits to risk modelling," Journal of Banking & Finance, Elsevier, vol. 26(7), pages 1273-1296, July.
    3. Wesley C. Mitchell, 1909. "The Decline in the Ratio of Banking Capital to Liabilities," The Quarterly Journal of Economics, Oxford University Press, vol. 23(4), pages 697-713.
    4. Panjer, Harry H., 1981. "Recursive Evaluation of a Family of Compound Distributions," ASTIN Bulletin: The Journal of the International Actuarial Association, Cambridge University Press, vol. 12(01), pages 22-26, June.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    Banking Regulation; Benchmarking; Operational Risk; Risk Management;

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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