frm lecture 3 op risk

8/3/2019 FRM Lecture 3 Op Risk

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Bahria University, Islamabad

Omar Safdar, CPAMBA Fall Semester

FRM - MBA (Fall Semester),Instructor: Omar Safdar


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DEFINITION:

x the risk of direct or indirect loss resulting from inadequate or failed internal

processes, people and systems or from external events

` MAIN FACTORS OF OR:

People

Systems

Processes

External Events



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Table 2: Risk types comparison


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` OR MEASUREMENT TECHNIQUES

` Basel II sets three operational measurement methodologies for calculating operational risk capital

charge in a continuum of increasing sophistication and risk sensitivity.

` 1.Basic Indicator Approach

` 2.Standardized Approach

The Standardized Approach (TSA)

Alternative Standardized Approach (ASA)

` 3.Advanced Measurement Approach (AMA)

Internal Measurement Approach (IMA)

Loss Distribution Approach (LDA)

Scorecard Approaches (SCA)

`


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` Basic IndicatorApproach:

A simple method for calculating Operational Risk Capital Requirement (ORR).

This may be adopted easily by the banks or financial institutions immediately: There are no

qualitative quantifying criteria

It includes both internal and external factors for Operational risk


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` StandardizedApproachMethod:

This method is seen as the probable entry level for large banks, subject to regulators being

satisfied that certain qualitative and quantitative standards are met.

No need to collect operational loss data

BUSINESS LINES Beta Factors

1. Corporate Finance 18 %

2. Trading and Sales 18 %

3. Retail Banking 12 %

4. Commercial Banking 15 %

5. Agency & Custody Services 18 %

6. Settlement & Payment services 15 %

7. Asset Management 12 %

8. Retail Brokerage 12 %


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` StandardizedApproachMethod:

Events Risk Types:

1. Internal Fraud

2. External Fraud

3. Employment practices & workplace Safety

4. Clients, Products & Business practices

5. Damage to physical Assets

6. Business Disruption & System Failures

7. Execution , Delivery & Process management


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` Advanced MeasurementApproaches (AMA)

Banks may use their internal operational risk measurement systems to calculate capital

charges with the approval of their supervisory authority.

Approval will require complying with qualitative & quantitative criteria set by the Basel

Committee plus additional criteria established by national authorities

AMAs should be subject to a period of initial monitoring before it can be used for regulatory

purposes

Thismethod includes :

- InternalMeasurementApproach (IMA)

- Loss Distribution Approach (LDA)

- Scorecard Approaches (SCA)


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` Frequency & Severity

` Low Frequency Low Severity

` High Frequency High Severity

` High Frequency Low Severity

` Low Frequency High Severity



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` Loss Distribution Approach

Frequency & Severity are statistically independent

Both modeled separately

Aggregate loss distribution developed

Concept of OpVar applied



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` OpVaR

` Minimum potential loss that an entity could incur

Within a particular business line

Due to a given operational risk event

During time horizon of one year

With confidence level of 99.9



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Economic

CapitalReg.Capital

Mitigation

Unexpected

Losses

Expected Losses

Mean

VaR

99.9%

Tail Events

Aggregate Losses

Probability


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` Extreme valuetheory (EVT)x different distribution for modeling tail and body of a data sample

blockmaximamethod (BMM)

x The BMM divides data into independent blocks of the same size and considers the highestobservation from such a block

peakoverthreshold method (POTM)

x The POTM uses all observations that exceed certain high threshold level. These models are morefrequently used in practice for OR exposure measurement.



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` Extreme valuetheory (EVT)



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following table.


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` Lossseverity distributions

` Parametric distributions

g&h distribution

x provides consistent capital estimates for scenario analysis method

Weibull distribution

lognormal distribution

gamma distribution



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` ScenarioAnalysis

Supportthe KRIs withsubjectivescenarioanalysis :

` Risk workshops can assist

` Use judgment to assess the level of risk

` Good for new projects, and areas with low volume where KRIs and LDA are less effective.

Examplesinclude: Corporate Finance / AdvisoryProject Financeand otherspecialistareas

AssessthelevelofRiskon aconsequence / likelihood scale

` Consider collecting data on various frequency basis not just one basis (risk impact usually

inversely linked to frequency).



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` Key Risk Indicators

Inherent Risk / Exposureindicators

` Relatively easy to collect from systems

` Do NOT measure the precise risk` Indicate the level of risk/exposure taken

` Very useful in high volume areas as a preliminary risk indicator

Total trades, total volume, total value,

days outstanding, No# of unreconciled items,

system efficiency level,

staff positions vacant, % temporary/contract staff



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` Risk & Control SelfAssessment

Business Unitsselfassesslevelofrisk

` Works best when risk areas are well known

` Identify risks first (enterprise wide review of risks)

` Develop CSA worksheet

x Describe core risks and key controls in each area

x Request businesses to assess each risk carefully

x Risk and control are both assessed separately

x Businesses often over-estimate control strength

` Standardize the answers into common groups (categorization common risks,

specific incidents)` Validate the Key Risk Indicators that are used

` Risk specialists review the answers (accept/reject)

` Audit the CSA responses from time to time



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` Regulatory capital is the amount of capital necessary to provide adequate

coverage of banks exposures to financial risks as defined in the capital adequacy

rules set by the Basel II. A one-year minimum regulatory capital is calculated as 8%

of risk-weighted assets.3 Empirical studies show that operational risk regulatory

capital, in general, constitutes 10%-25% of overall capital adequacy requirements.

` economic capital is a buffer against future, unexpected losses brought about

by credit, market, and operational risks inherent in the business of lending

money4 or alternatively economic capital might be defined as the amount necessary

to be in the financial business.



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` The focus should be on modeling both regulatory and economic capital for OR

because this concept is to be used for the Advanced Measurement Approach (AMA)

as it should cover all unexpected losses even the extreme events with the Value at

Risk (VaR) higher than 99.9%.

` Regulatory capital covers expected losses and unexpected losses only to a certain

confidence level and it does not consider the extreme events5 like economic

capital does.

`



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frm lecture 3 op risk

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