An operational risk capital model based on the loss distribution approach

Ruben D Cohen

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A capital model for operational risk is constructed based on the observation that losses converge into two distinct categories: conduct and non-conduct.
The resulting model, derived here via the LDA, is simple, transparent and universal. It focuses on non-conduct losses only and has built into it many of their empirical features.
For conduct losses, however, a radically different approach may be required for capital estimation.

Abstract

In this paper, we construct a capital model for operational risk based on the observation that operational losses can, under a certain dimensional transformation, converge into a single, universal distribution, as previously established by Cohen in a 2016 paper. Derivation of the model is accomplished by directly applying the loss distribution approach to the transformed data, yielding a calibratable expression for risk capital. The expression, however, is applicable only to nonconduct losses because it incorporates empirical behaviors that are specific to them. For loss data that falls under the conduct category, this approach may not be valid; in such cases, one may have to resort to a different type of modeling technique.

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