Understanding operational risk capital approximations: First and second orders

Abstract

We set the context for capital approximation within the framework of the Basel II / III regulatory capital accords. This is particularly topical as the Basel III accord is shortly due to take effect. In this regard, we provide a summary of the role of capital adequacy in the new accord, highlighting along the way the significant loss events that have been attributed to the Operational Risk class that was introduced in the Basel II and III accords. Then we provide a semi-tutorial discussion on the modelling aspects of capital estimation under a Loss Distributional Approach (LDA). Our emphasis is to focuss on the important loss processes with regard to those that contribute most to capital, the so called "high consequence, low frequency" loss processes.This leads us to provide a tutorial overview of heavy tailed loss process modelling in OpRisk under Basel III, with discussion on the implications of such tail assumptions for the severity model in an LDA structure. This provides practitioners with a clear understanding of the features that they may wish to consider when developing OpRisk severity models in practice.From this discussion on heavy tailed severity models, we then develop an understanding of the impact such models have on the right tail asymptotics of the compound loss process and we provide detailed presentation of what are known as first and second order tail approximations for the resulting heavy tailed loss process. From this we develop a tutorial on three key families of risk measures and their equivalent second order asymptotic approximations: Value-at-Risk (Basel III industry standard); Expected Shortfall (ES) and the Spectral Risk Measure. These then form the capital approximations.We then provide a few example case studies to illustrate the accuracy of these asymptotic captial approximations, the rate of the convergence of the assymptotic result as a function of the LDA frequency and severity model parameters, the sensitivity of the capital approximation to the model parameters and the sensitivity to model miss-specification.Key words: Basel II/III; Capital Approximation; Loss Distributional Approach; Capital Approximation; Value-at-Risk; Expected Shortfall; Spectral Risk Measure; Subexponential; Regularly Varying. The Changing Landscape of Capital AccordsIn juristictions in which active regulation is applied to the banking sector throughout the world, the modelling of Operational Risk (OpRisk) has progressively taken a prominent place in financial quantitative measurement. This has occurred as a result of Basel II and now Basel III regulatory requirements. For example in the context of banking regulation in Australia, the basic framework of Basel II/III is summarized in Figure 1. In this juristiction one observes that a large amount of the developments in quantitative methodology for estimation of OpRisk capital, development of OpRisk frame- There have been both numerical and simulation based approaches adopted as well as analytical mathematical developments of closed form approximatio...

Should the advanced measurement approach be replaced with the standardized measurement approach for operational risk?

“…This is a reasonable approximation but it is important to note that its accuracy depends on distribution type and values of distribution parameters and further higher order approximations are available; see detailed discussion in (Peters and Shevchenko, 2015, section 8.5.1) and the tutorial paper Peters et al (2013).…”