Operational Risk Capital Models (2nd edition)
First published:
ISBN: 9781782724223
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Backtesting, stress testing and sensitivity analysis
Introduction
Challenges of operational risk advanced capital models
Part I: Capture and Determination of the Four Data Elements
Collection of operational loss data: ILD and ED
Scenario analysis framework and BEICFs integration
Part II: General Framework for Operational Risk Capital Modelling
Loss data modelling: ILD and ED
Distributions for modelling operational risk capital
Scenario analysis modelling
Exposure-based approaches
BEICFs modelling and integration into the capital model
Hybrid model construction: Integration of ILD, ED and SA
Derivation of the joint distribution and capitalisation of operational risk
Backtesting, stress testing and sensitivity analysis
Regulatory approval report
Evolving from a plain vanilla to a state-of-the-art model
Part III: Use Test, Integrating Capital Results into the Institution’s Day-to-day Risk Management
Strategic and operational business planning and monitoring
Risk/reward evaluation of mitigation and control effectiveness
Appendix 1: Credibility theory
Appendix 2: Mathematical optimisation methods required for operational risk modelling and other risk mitigation processes
Business risk quantification
So far, we have described an end-to-end statistical process of estimating capital requirements for operational risk. In this chapter, we will look at the backtesting and stress testing of such models, to provide a quality control and validation of completeness of the operational risk capital model. The backtesting represents an ex post validation of the accuracy of the modelling, and compares the new experienced operational risk losses with those predicted by the models used during the capital estimation. On the other hand, stress testing estimates the potential losses of adverse operational risk scenarios and serves as an additional capital adequateness validation.
OPERATIONAL RISK BACKTESTING
Backtesting is a necessary analysis in any risk estimation, and one that provides us with an ex post evaluation of the precision of the calculations. Backtesting of operational risk capital estimations involves the challenge of backtesting risk estimations performed for a one-year time horizon and a high confidence interval of generally 99.9%. This implies that more than 1,000 yearly observations of total operational losses would be required for the direct backtesting of operational
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