Bahria University, Islamabad Omar Safdar, CPA

MBA Fall Semester

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

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

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

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

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

Table 2: Risk types comparison

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

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)

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

Basic Indicator Approach:

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

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

Standardized Approach Method:

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 1. Corporate Finance 2. Trading and Sales 3. Retail Banking 4. Commercial Banking 5. Agency & Custody Services 6. Settlement & Payment services 7. Asset Management 8. Retail Brokerage Beta Factors 18 % 18 % 12 % 15 % 18 % 15 % 12 % 12 %

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

Standardized Approach Method: 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

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

Advanced Measurement Approaches (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 This method includes : - Internal Measurement Approach (IMA) - Loss Distribution Approach (LDA) - Scorecard Approaches (SCA)

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

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

Frequency & Severity

Low Frequency Low Severity High Frequency High Severity High Frequency Low Severity Low Frequency High Severity

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

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

Loss Distribution Approach

Frequency & Severity are statistically independent Both modeled separately Aggregate loss distribution developed Concept of OpVar applied

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

` `

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

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

Mitigation

Mean

Reg. Capital

Economic Capital

Probability

VaR 99.9%

Expected Losses

Unexpected Losses
Tail Events

Aggregate Losses

Extreme value theory (EVT)

x different distribution for modeling tail and body of a data sample block maxima method (BMM)
x The BMM divides data into independent blocks of the same size and considers the highest observation from such a block

peak over threshold method (POTM)

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

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

Extreme value theory (EVT)

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

following table.

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

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`

Loss severity distributions

Parametric distributions
g&h distribution
x provides consistent capital estimates for scenario analysis method

Weibull distribution lognormal distribution gamma distribution

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

Scenario Analysis

Support the KRIs with subjective scenario analysis :

` ` `

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.

Examples include: Corporate Finance / Advisory Project Finance and other specialist areas Assess the level of Risk on a consequence / likelihood scale ` Consider collecting data on various frequency basis not just one basis (risk impact usually inversely linked to frequency).

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

Key Risk Indicators

Inherent Risk / Exposure indicators ` 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

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

Risk & Control Self Assessment

Works best when risk areas are well known Identify risks first (enterprise wide review of risks) Develop CSA worksheet
x x x x Describe core risks and key controls in each area Request businesses to assess each risk carefully Risk and control are both assessed separately Businesses often over-estimate control strength

Business Units self assess level of risk

` ` `

` ` `

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

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

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

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

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.

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

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.

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

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