Operational Risk Capital Models

Foreword
Marcelo Cruz

Introduction
Rafael Cavestany

PART I - Capture and Determination of the Four Data Elements

1. Collection of Operational Loss Data: ILD and ED
Brenda Boultwood

• Towards a Common Understanding of Operational Loss
• Completeness of Data Collection
• Consistency with Accounting
• External Data

2. Scenario Analysis Framework and BEIFCs Integration
Rafael Cavestany, Brenda Boultwood and Daniel Rodriguez

• Scenario Support Data and Preparation
• Scenario Rating
• Scenario Validation
• BEICFs as an Input into Scenario Analysis

PART II - General Framework for Operational Risk Capital Modelling

3. Loss Data Modelling: ILD and ED
Rafael Cavestany and Daniel Rodriguez

• Exploratory Analysis and Selection of a Homogeneous Data Sample
• Optimal Modelling Granularity
• Tail Shape and Threshold Determination through Extreme Value Theory
• Severity Distributions Fitting
• Frequency Distribution Fitting
• Goodness-of-Fit (GoF) Evaluation
• Stability Analysis of Capital Estimates, Distribution Parameters, and GoF
• Evaluating if the Capital Estimates are Realistic
• External Data Rescaling
• Definition of the Loss Data Modelling Process

4. Scenario Analysis Modelling
Rafael Cavestany

• Translating Scenario Analysis Questions into Distribution Characteristics
• Fitting a Full Distribution to Scenario Analysis
• Distribution Shape Control during the Scenario Distribution Fit
• Goodness of Fit in Scenario Analysis
• Splitting Scenario into Lower Organizational Entities

5. BEICFs Modelling and Integration into Capital Model
Rafael Cavestany

• Ex-post Capital Adjustment Driven by BEICFs
• Modelling BEICFs
• Qualitative and Structured Determination of Correlations based on BEICFs
• Capital Attribution Driven by BEICFs

6. Hybrid Model Construction: Integration of ILD, ED and SA
Rafael Cavestany, Daniel Rodriguez and Fabrizio Ruggeri

• Credibility Theory: Determining the Weights for ILD, ED and SA in the Hybrid Model
• The Mixture Approach
• The Bayesian Approach
• Tail Complementing with External Data Losses
• Tail Complementing with Scenarios
• Mixing Distribution Properties from Different Data Elements during the Fit

7. Derivation of the Joint Distribution and Capitalisation of Operational Risk
Rafael Cavestany

• Monte Carlo Simulation
• Single Loss Approximation: Analytical Derivation of the Loss Distribution
• Operational Risk Correlations
• Using Copulas for Replicating Operational Risk Dependencies
• Capitalization of Operational Risk
• Allocation of Operational Risk Capital
• Operational Risk Profile Measurement

8. Backtesting, Stress Testing and Sensitivity Analysis
Rafael Cavestany and Daniel Rodriguez

• Backtesting of Severities
• Backtesting of Annual Frequency
• Backtesting of Annual Total Losses
• Stress-testing of Severities and Frequencies
• Stress-testing of Operational Risk Correlations

9. Evolving from a Plain Vanilla to a State of the Art Model
Rafael Cavestany

PART III - Use Test, Integrating Capital Results into the Institution´s Day-To-Day Risk Management

10. Strategic and Operational Business Planning and Monitoring
Lutz Baumgarten, Rafael Cavestany and Brenda Boultwood

• Integrating the Operational Risk Profile into the Strategic and Operational Planning
• Integrating Capital Results into the GRC Risk Reporting
• ORA for Monitoring the Strategic and Business Plan

11. Risk/reward Evaluation of the Mitigation and Control Effectiveness
Rafael Cavestany and Javier Moguerza

• Insurance Programmes: Evaluation of their Mitigation Impact
• Risk/reward Evaluation of the Mitigation Impact of Action Plans
• Internal Audit Non-Conformities Evaluation
• Process Improvement: Six Sigma and Operational Risk
• Operational Loss Prediction Analytics
• Adversarial Risk Analysis: Linking Risk Measurement with Optimal Mitigation

Appendix I - Distributions for Modelling Operational Risk Capital
Daniel Rodriguez

Appendix II - Credibility Theory
Daniel Rodriguez

Appendix III – Mathematical Optimization Methods Required for Operational Risk Modelling and Other Risk Mitigation Processes
Laureano Escudero

Appendix IV – Business Risk Quantification
Lutz Baumgarten

Rafael Cavestany has over fifteen years of experience in the financial services industry covering the banking and insurance sectors.  He currently works as a director in True North Partners Group and SKITES. Before, Rafael worked at Everis as Executive Director of the risk management practice and PwC as Senior Manager. He has worked on projects for a number of leading financial institutions in USA, Canada, UK, Spain, Italy, LatAm and South Africa and his experience is focused on consulting projects for the development of risk management tools and the corresponding methodologies, workflows and data requirements, etc. with special emphasis on operational risk modelling. Rafael Cavestany received the MBA degree from University of Michigan in 1997, a degree in Economics from Universidad Autónoma de Madrid and is currently finishing his PhD thesis in Statistics.

Brenda Boultwood is the Senior VP of Industry Solutions at MetricStream. Previously, Brenda served as Senior Vice President and Chief Risk Officer at Constellation Energy. Prior to that, she served as Global Head of Strategy, Alternative Investment Services, at J.P. Morgan Chase & Company. At Bank One Corporation, she served as Head, Corporate Market Risk Management and Counterparty Credit, and Head of Corporate Operational Risk Management, before advancing to Head, Global Risk Management for the company’s Global Treasury Services group.

Brenda has also worked with PricewaterhouseCoopers and Chemical Bank Corporation. In addition, she has spent time teaching at the University of Maryland’s MBA program. Brenda was a member of the CFTC Technology Advisory Committee, and has also served on the Board of the Global Association of Risk Professionals (GARP).  She currently serves on the Board of the Committee of Chief Risk Officers (CCRO). Brenda graduated with honors from the University of South Carolina with a Bachelor’s degree in International Relations. She also earned a Ph.D. in Economics from the City University of New York.

Professor Laureano F. Escudero received the PhD. Degree in Economics from the Universidad de Deusto, Bilbao, Spain, in 1974 and a degree in Computer Science from Universidad Politecnica de Madrid, Spain, 1972. He has been Professor of Statistics and Operations Research at the Universidad Rey Juan Carlos, Spain, 2007-2013. In the period 2003-04 he was the President of EURO (Association of European Operational Research Societies).  He has worked at IBM Research, Scientific and Development Centers in Madrid (Spain), Palo Alto (California), Sindelfingen (Germany) and Yorktown Heights (NY), 1972-1991. He taught Mathematical Programming at the Mathematical Sciences School, Universidad Complutense de Madrid, Spain, 1992-2000 and Stochastic Programming at the Universidad Miguel Hernandez, Spain, 2000-2007. He is the author of 5 books, has co-edited 5 others, and has published over 135 scientific papers in leading journals and over 30 chapters in edited books. He has worked in different mathematical programming fields (linear, integer, nonlinear, stochastic) and its risk management applications to finance, energy, supply chain management and air traffic, among other sectors.