Journal of Operational Risk

Marcelo Cruz

Welcome to the fourth issue of the fourth volume of The Journal of Operational Risk. Once again I thank our collaborators for all their hard work in 2009 and send my best wishes for the holiday season. It finally looks like we are getting out of the worst economic crisis since the Great Depression of the 1930s. This crisis was the biggest test that our profession has ever faced as it happened at a point in time when we were more established than ever before (at least for market and credit risks). Nonetheless, we still failed to prevent the disaster and save many large institutions from collapsing. We are already seeing substantial changes in risk management as a byproduct of the crisis. As examples of these changes we now see many insurance companies hiring chief risk officers and putting a lot of emphasis on operational risk; operational risk officers are feeling that they have growing clout inside their organizations; and almost all institutions are taking a closer look at their risk governance. If anything, the responses of boards and senior executive management to the crisis have been to rethink the importance of their risk management frameworks within their company strategies. This upgrade is here to stay and will give us lots of work to do in the next few years

Regarding the state of operational risk research, again I would like to encourage potential authors to continue submitting papers to the Journal as we have recently seen a reduction in the usual flow of papers. I would also like to stress that the Journal is not only for academic authors. The ‘Forum’ section of the Journal contains discussion of current events without too much emphasis on the mathematics and technical aspect. We would be thrilled to see more submissions to this section containing practical, current views on matters that affect your day-to-day business.

RESEARCH PAPERS

Basel II developed the first set of regulations for operational risk. The industry needs to appreciate the importance of these rules in forcing the financial sector to pay more attention to this risk. However, as we have previously stated here and have heard from many practitioners, the devil lies in the detail. As these rules were signed when most banks were still in their infancy in measuring operational risk they were fully accepted as new challenges. As firms get ahead and progress in measuring operational risk quite a few roadblocks begin to appear. This is the main theme of the first two papers.

In the first paper, “Challenges and pitfalls in measuring operational risk from loss data”, Eric W. Cope, Giulio Mignola, Gianluca Antonini and Roberto Ugoccioni survey the difficulties in applying the loss distribution approach at very large quantiles such as 99.9%; this is a very common problem that all practitioners face. The interesting feature of this paper is that the authors do not find a solution to the problems but rather propose changes to the regulations that would make practitioners’ lives much easier.

In the second paper, “Estimating operational risk capital for correlated, rare events”, Stefan Mittnik and Tina Yener corroborate what previous Journal articles have found concerning regular correlation methods not being able to properly assess the correlation of rare events. The authors prove that the objective of reducing capital by bringing correlation into play in operational risk capital calculations cannot be achieved under the current Basel II regulations.

In the third paper, “A new algorithm for the loss distribution function with applications to operational risk management”, Dominique Guégan and Bertrand Hassani adapt the Panjer recursion method, which aggregates severity and frequency distributions, by developing a mix of the Monte Carlo method, a progressive kernel lattice and the Panjer recursion itself. The authors claim that this simple approach enabled them to drastically reduce the variance of the estimated VaR associated with operational risks and also to lower the aliasing error we would have if using the regular Panjer recursion alone.

FORUM PAPER

The final paper is in the forum section. “As risk management evolves, is operational risk management important?”, asks Philip H. Martin. The author looks at the importance of risk management, its role in business, its influence on corporate governance, what causes failures and the impact of events. He also examines core issues and potential remedies to prevent similar failures recurring. The Journal of Operational Risk Volume 4/Number 4, Winter 2009/10