Journal of Operational Risk

Marcelo Cruz

Welcome to the fourth issue of the third year of The Journal of Operational Risk. It seems like yesterday that we started this venture of publishing high-quality papers on operational risk. In completing three successful years, I need to congratulate the entire Journal community, editors, publishers, reviewers, authors and readers, for their collaboration to our success. I am absolutely thrilled to verify our increased influence in the industry, particularly when I see papers published in The Journal of Operational Risk being referred to in many other papers and at conferences and also by our increasingly significant subscriber base.

I believe I need to comment again on the perennial financial crisis that has been with us for over a year and that took a turn for the worst in September with the bankruptcy of Lehman Brothers. The financial crisis spilled all over the economy and we verify the entire world going into a steep recession. The news headlines prove that we are living in very challenging times. The current banking system situation also challenged the risk management profession and both practitioners and academics are debating what went wrong with risk management. There are quite a few streams of thought: one, more qualitative, blaming risk governance issues for the demise of banks and the other stream, more quantitative, defending the view that badly developed models and scenario analysis were to blame. Maybe the answer is a combination or both or neither. I would love to see this discussion in our Journal and invite contributors to join this crucial discussion in our profession. Whatever the outcome of this crisis, we know that risk management will be very different after 2008.

Regarding the state of operational risk research, I would like to ask potential authors not to feel discouraged by the crisis and to continue submitting to the Journal. We have seen a decreased flow of papers recently that we are blaming on the current economic environment. I would like also to re-emphasize that the Journal is not just for academics to publish in. We at The Journal of Operational Risk encourage readers to submit papers to the “Forum” section. This section is aimed at promoting discussion of current events without too much concern with the technical aspect, formulas and mathematics.We at the Journal would be extremely happy to see more submissions with a more practical, current view of relevant matters that affect your day-to-day business.

In this issue we bring you three papers in the research section and one paper in the forum section. All the papers delve into the subject of using external data, one of the most difficult issues to tackle in operational risk.

Research Papers

In the first paper, “Combining underreported internal and external data for operational risk measurement”, Guillen et al propose another model for operational losses that aims at improving information on internal losses by combining it with external losses. They also develop an underreported loss function to cope with the issue of poor reporting of losses.

Although this is not a special issue by itself we decided to publish two highquality papers that were submitted by the ORX consortia as we thought that this would make sense as the first paper is also about external data. Therefore, in the second paper of the issue and the first from the ORX researchers, “Operational loss scaling by exposure indicators: evidence from the ORX database”, Cope and Labbi investigate the hypothesis of correlation of operational losses with geographical region and firm size. They do, through the use of quantile regression, test whether these distributional scaling relations can be described using simple location-shift or location-scale shift models. They also develop an algorithm that addresses statistical issues that arise when estimating loss scaling models when the data is subjected to a loss reporting threshold that can be very helpful for using the external data better.

In the third paper, “Observed correlations and dependencies among operational losses in the ORX consortium database”, Cope and Antonini benefit from their access to the ORX database by using the extensive data contained on ORX to research correlation and dependencies among operational losses. Unfortunately the authors found little evidence of strong correlations, and some slight evidence of tail dependencies among quarterly aggregate loss values among business line, event type and Basel cell (combination business line/event type) units of measure. In any case I believe many practitioners have empirically seen this and it is most certainly valid to be shown. The authors also show in practice the effects of diversification in operational risk measurement.

Operational Risk Forum

In the forum section, Yeh discusses one of the most important practical issues in implementing Basel II worldwide concerning international banks and their reach across the globe. His paper is titled, “Key motifs in the home-host mantra of operational risk management”. Yeh takes this opportunity to discuss the key policy issues around Basel II advanced measurement approach implementation such as operational risk governance, capital measurement and allocation, and future advances in operational risk transfer. Although Yeh assesses these issues from a host supervisor’s perspective, these key policy issues most certainly have practical implications in a broader home-host context and this is debated throughout the paper.