On modeling contagion in the formation of operational risk loss

Xiang Gao and Zhan Wang

Abstract

This paper models an overall operational risk loss caused by the accumulation of intermediate losses incurred at each process via a mechanism of network contagion across distinct processes within the boundary of a bank. We lay a theoretical foundation for the choice of an exponential–Pareto combined distribution to model the severity of the operational risk. We derive, on a theoretical basis, the functional form of the operational risk severity distribution. The resulting loss severity distribution, in theory, is consistent with the parametric distribution that previous empirical works suggest is the best fit for loss data.