Operational risk: A Basel II11 step before Basel III

Abstract

The Banking Committee on Banking Supervision recommended that operational risk should be quantified using the Basel matrix, which enables the sorting of risk incidents. This paper analyses these incidents in depth and suggests strategies for carrying out the supervisory guidelines proposed by the regulators, as follows. On the one hand, banks need to provide a univariate capital charge for each cell of the Basel matrix. That requires constructing loss distribution functions (LDFs), which implies estimating a frequency and a severity distribution. It is shown that the choice of the theoretical distributions to build the LDFs has a tremendous impact on the capital charges, especially if extreme losses are not taken into account. On the other hand, banks also need to provide a global capital charge corresponding to the whole matrix. The paper highlights that a lack of consideration or a poor appreciation of the dependence structure may lead to incorrect capital charges. Finally, the paper finds two crucial points that should be taken into account by regulators and risk managers: (1) The necessity of splitting information sets in two parts while adjusting the severity distribution: the first covering small and medium losses, and the latter containing extreme losses (this point implies problems of granularity as mentioned in the Basel II guidelines); (2) The choice of the risk measure, which provides the capital amount. The paper concludes that the expected shortfall measure enables a better anticipation of large operational risk incidents.