Operational risk : regulation, measurement and management

Foreword xix Preface xxi PA R T I Regulation 1 The three pillars of operational risk Ralph Andrew Nash 3 1.1 Introduction 3 1.2 Pillar 1 4 1.3 Pillar 2 9 1.4 Pillar 3 11 1.5 Insurance 12 1.6 Conclusion 12 2 A qualitative operational risk framework: guidance, structure and reporting Kenneth Swenson 14 2.1 Introduction 14 2.2 Guidance 15 2.3 Management structure 20 2.4 Reporting 23 2.5 Conclusion 29 3 Measurement of operational risk: the Basel approach Victor Dowd 31 3.1 Introduction 31 3.2 Development of the Basel Accord 32 3.3 Definition of operational risk 36 3.4 The Basic Indicator Approach 40 3.5 The Standardized Approach 42 Contents 3.6 Quantification of management quality 45 3.7 Conclusion 47 4 A constructive review of the Basel proposals on operational risk Jacques Pézier 49 4.1 Introduction 49 4.2 Critical examination of the Basel proposals 50 4.3 Analysis of reported operational loss data 60 4.4 Other supervisory proposals and conclusions 69 5 Legal risks and fraud: capital charges, control and insurance Christos Hadjiemmanuil 74 5.1 The Basel definitions of operational risk and legal risk 74 5.2 The varied meanings of ‘legal risk’ 76 5.3 Banks and the risk of fraud 85 5.4 Implications for the proposed capital charges for operational risk 88 5.5 Containing and managing legal risks and fraud 92 5.6 Insurance and the mitigation of losses from legal risks and fraud 95 6 Operational risk and insurance Thomas Michael Leddy 101 6.1 Introduction 101 6.2 Definition of insurance: a working draft 102 6.3 Definition of operational risk 104 6.4 The mechanics and nature of insurance contracts 108 6.5 The present and future role of insurance in financial institutions 121 6.6 Conclusion 126 PA R T I I Analysis 7 Statistical models of operational loss Carol Alexander 129 7.1 Introduction 129 7.2 Operational risk types 130 7.3 Bayesian estimation 137 7.4 Introducing the Advanced Measurement Approaches 142 7.5 Analytic approximations to unexpected annual loss 148 ....xiv.... Contents ....xv.... 7.6 Simulating the annual loss distribution 156 7.7 Aggregation and the total loss distribution 158 7.8 Conclusion 167 Appendix 7.1 Some remarks on the use of copulas in operational risk 168 8 The Loss Distribution Approach Michael Haubenstock and Lloyd Hardin 171 8.1 What is the Loss Distribution Approach? 171 8.2 Basel requirements 172 8.3 Why use historical loss data? 173 8.4 Steps to modelling with LDA 174 8.5 Case study 178 8.6 Key assumptions 189 8.7 Advantages and limitations of the LDA 190 8.8 Issues for further research 191 8.9 Summary 192 9 A general simulation framework for operational loss distributions Diane Reynolds and David Syer 193 9.1 Introduction 193 9.2 The regulatory landscape 195 9.3 Setting the stage 196 9.4 A simulation approach for operational risk 200 9.5 Example applications 203 Appendix 9.1 Loss models 208 Appendix 9.2 Model distributions 210 Appendix 9.3 More on actuarial models 211 10 The path to operational risk economic capital Ulrich Anders 215 10.1 Introduction 215 10.2 What is economic capital? 215 10.3 How to compute economic capital 216 10.4 How to derive a good economic capital model 217 10.5 Where to obtain good-quality input data 221 10.6 How to validate input data 224 10.7 How to validate the economic capital number 225 10.8 Summary 225 Contents PA R T I I I Management 11 Scorecard approaches Tony Blunden 229 11.1 Introduction 229 11.2 Why use a scorecard model? 230 11.3 Risks and controls 230 11.4 The scorecard approach 233 11.5 Model simulations 234 11.6 Quantification of gross and net risks 236 11.7 Risk appetite 238 11.8 Stress testing and scenario analysis 239 11.9 Conclusion 240 12 The operational risk management framework Michael Haubenstock 241 12.1 Introduction 241 12.2 Defining operational risk 243 12.3 Strategy 244 12.4 The operational risk process 246 12.5 Infrastructure 257 12.6 Environment 257 12.7 The role of internal audit 259 12.8 Tying risk management into the business process 259 12.9 Success factors 260 12.10 Summary 261 13 Using operational risk models to manage operational risk Anthony Peccia 262 13.1 Introduction 262 13.2 Operational risk and reward 263 13.3 The integrated operational risk framework 265 13.4 Risk and control self-assessment 267 13.5 Exposures and losses 270 13.6 Gamma and the measure of operational risk 273 13.7 Sufficiency, relevancy and completeness of loss data 274 13.8 Scenario analysis 275 13.9 Operational risk classes and key risk drivers 276 13.10 Management applications of an operational risk model 280 ....xvi.... Contents 13.11 Modelling and the new regulatory requirements 281 13.12 Summary 283 14 Managing operational risks with Bayesian networks Carol Alexander 285 14.1 Introduction 285 14.2 Bayesian networks: useful references and web links 286 14.3 Introducing Bayesian networks 287 14.4 Application of Bayesian networks in banking and finance 288 14.5 Bayesian decision networks 293 14.6 Conclusion 295 15 Operational risk management Jacques Pézier 296 15.1 Introduction 296 15.2 Risk management – an integral part of good management 296 15.3 Nominal, ordinary and exceptional operational risks 299 15.4 An ordinary operational risk case study 302 15.5 Understanding exceptional operational risks 307 15.6 An exceptional operational risk case study 310 15.7 Conclusions 320 Appendix 15.1 A primer on utility theory 322 References 325 Index