Financial Risk Management

Operational Risk

Following P. Jorion, Financial Risk Management Chapter 24

Daniel HERLEMONT

Introduction
By now, the financial industry has developed standard methods to measure and manage market and credit risk. The industry is turning next to operational risk which has proved to be an important cause of financial losses. Indeed, most financial disasters can be attributed to a combination of exposure to market or credit risks along with some failure of controls that is a form of operational risk For the first time, the Basle Committee is proposing to establish capital charges for operational risks, that is about 20% of of the overall capital requirements Problem: operational risk is much harder to identify than market and credit risks. Even, the definition of opertional risk is still vague ...
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Importance of operational risk - case histories

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Breakdown of Financial Risks

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Examples of Operational Risks

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Definition of Operational Risk

There are still no consensus on exact definition the broadest
operational risk is any financial other than market and credit risk. too broad, include also business risk, ...

the narrowest
operational risk as risk arising from operations. includes back office problems, failure in transactions and systems, ... but does not include internal fraud, improper sales practices, ...

Intermediate definition
the risk of direct of indirect loss resulting from inadequate or failed internal process, people or systems or from external events. exclude business risk, strategic and reputational risks. but include external events such as external fraud, regulatory effects, natural disasters legal risks, ... It is now the Basle II definition ...
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Operational Risk Classifications

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Model Risk
Among operational risk, a notable risk for complex products is Model Risk which is due to using the wrong models for valuing and hedging products Internal risks that combines
lack of knowledge (people) product complexitiy valuation errors programming errors

Examples:
March 1997, Bank Tokio/Mitsubishi $83 million loss due to overvaluing swaps and options 1997, NatWest, 50 millions loss due to misspricing in swaptions

Currently under active research (Rama Cont)

worst case approaches
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Model Risk

Input Risk

Deal Database

Market Database

Estimation Risk

Statistical Tools

Vendors of parameters

Model Risk (valuation)

Model 1

Model n
Model Calibration Deal Valuation

Model N

Hedging Risk

Hedging Models

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source Crouhy-Galai-Mark

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FRM questions

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FRM questions

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FRM questions

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Approaches to Operational Risks Models

Top Down Bottom up

Tools
Audit Critical self assessment Key risk indicators Earnings volatility Causal Networks Actuarial models

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Managing Operational Risks Like market VAR, the distirbution of operational losses can be used to estimate exptected losses as well as the amount of capital required

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Regulatory requirements The new Basle Accord introduce charge against operational risk (www.bis.org/publ/bcbsca07.df) 3 Methods
Basic Indicator Method Standardized approach Internal measurement approach (IMA)

calibration still in development stage ...

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Preventing Operational Risk Straight Through Processing (STP) Internal control:

clear separation of functions dual entries Reconciliations Tickler Systems Confirmations Verification of prices Authorization Settlement Internal / External Audits
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FRM questions

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