Operational Risk

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Operational risk

Operational risk concerns the investigation of four significant risks of a loss to a firm or portfolio: market risk, credit risk, liquidity risk, and operational risk (glimpse Jarrow and Turnbull, 2000,p. 587). Market risk includes the risk of a loss due to unanticipated price movements in financial securities or asset values, and it encompasses price fluctuations due to either equities, interest rates, products, or foreign currencies. Credit risk is the risk of a decrease due to default, and liquidity risk is the risk of a decrease due to the inability to liquidate an asset or economic position at a sensible cost in a sensible time period. And, according to the revised Basel Committee modified report (Basel managing group on Banking Supervision, 2005) “ operational risk is defined as the risk of decrease producing from the insufficient or failed interior processes, persons and schemes or from external events. This definition includes legal risk ”. Furthermore, “legal risk includes, but is not restricted to, exposure to penalties, penalties, or punitive damages producing from supervisory activities, as well as personal settlements”.

The existing literature on operational risk almost solely focuses on two matters: one, the estimation of operational risk loss methods using either extreme value idea or Cox methods, (see [Chavez-Demoulin et al., 2006], [Coleman, 2003], [de Fontnouvelle et al., 2004], [de Fontnouvelle et al., 2005], [Ebnother et al., 2001], [Embrechts and Puccetti, forthcoming], [Jang, 2004], [Moscadelli, 2004], [Lindskog and McNeil, 2003] and [Chavez-Demoulin et al., 2006]) and two, the submission of these estimates to the conclusion of economic capital, (see [de Fontnouvelle et al., 2004], [de Fontnouvelle et al., 2005] and [Moscadelli, 2004]). In the estimation of economic capital for operational risk, the approximates appear to be quite large, in fact, at smallest as large as that essential to cover market risk. The magnitude of the necessary capital for operational risk is a surprising result.

As evidenced by these references, the modeling and estimation of operational risk is treated identically to market and credit risk, i.e., a loss process is modeled and estimated. However, this is where the similarity ends. Unlike market and credit risk, which are external to the firm in their origin, operational risk is internal to the firm. Although this asymmetry between external and internal risk generation is well known, the implications of this asymmetry for either: (i) the pricing of financial securities within the firm, or (III) the determination of economic capital, is not.

The Basel III Capital Accord is the successor of the Basel II Capital Accord (1988). The Basel II Capital Accord represented the first step toward risk-based capital adequacy requirements. However, since 1988 the financial world has altered dramatically and there lived a growing need inside the economic world for a new capital accord. In 2007 a new capital accord will become operative, and it will improve the Basel II Capital Accord on several aspects.

The first part of this report describes the structure for bank and economic services supervision and guideline as delineated by the Basel ...
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