As spring knocks on our doors we seem to be living through another round of optimism in the financial industry, with people hoping we will return to some kind of normality. However, the usual hiccups are still part of the picture. The disaster scenarios that experts were painting in 2012 for Europe (the breakdown of the euro) and the United States (the fiscal cliff) did not eventually materialize, and the economic data, particularly in the United States, indicates some level of economic recovery. Caution is required, however. In the past six years we have frequently seen confidence evaporate, quickly being replaced by fear of the next imminent crisis. This "bipolar" mood has been the rule in the financial industry since the financial crisis that started in 2007. We all hope we can finally escape from this malaise in 2013.
On the positive side we need to acknowledge that, mostly because of regulatory pressure, risk management has received an enormous amount of attention and resources. Nowadays, operational risk in particular seems to be a key focus of regulators worldwide and the discipline has received a significant amount of investment from financial institutions. This focus the subject has been followed up by academics and here at The Journal of Operational Risk it is reflected in an increasing number of submissions and interest in our work.
I would like to ask potential authors to continue to submit to the journal on matters pertaining to the state of operational risk research. I would like to again emphasize that the journal is not solely for academic authors. Please note that we do publish papers that do not have a quantitative focus; indeed there are examples in this issue. We at The Journal of Operational Risk would be happy to see more submissions containing practical, current views on relevant matters as well as papers focusing on the technical aspects of operational risk.
There are two very interesting research papers in this issue. One reports studies on numerical methods and severity distributions, while the second uses Bayesian techniques to incorporate additional information to loss data.
The first research paper is "A comparison of numerical approaches to determine the severity of losses" by Henryk Gzyl, Pier Luigi Novi-Inverardi and Aldo Tagliani. The authors present a comparison of the performances of a couple of numerical methods in determining the probability density of the severity distribution when the distribution model is known. One method that the authors use is based on the maximum entropy principle applied to fractional moments. The other is a probabilistic method based on knowledge of enough integer moments. Both methods are based on the possibility of having a reliable model for determining the total severity that allows for the computation of the Laplace transform of the total severity.
The second paper in the issue, "Adding prior knowledge to quantitative operational risk models" by Catalina Bolancé, Montserrat Guillén, Jim Gustafsson and Jens Perch Nielsen, addresses the statistical problem of estimating operational risk distributions in different situations, eg, when data is abundant, or when the available data is challenged by the inclusion of external data or even due to underreporting of operational losses. The authors also include a practical example to show that failure to account for underreporting may lead to a substantial underestimation of operational risk capital.
In this section of the journal we publish papers that report day-to-day experiences in operational risk management. We have two Forum papers in this issue: one that deals with the issue of different perspectives in operational risk management from the point of view of the business unit and the operational risk manager; and one that discusses whether there is such a thing as systemic operational risk in the financial industry.
In "Adequate communication about operational risk in the business line", Udo Milkau deals with a very pragmatic issue in day-to-day operational risk management. While there is an established framework for quantitative modeling of operational risk as a "lingua franca" on an expert level, active operational risk management in the business line as a "first line of defense" requires adequate communication between the various business lines and the operational risk experts. The author suggests a pragmatic alternative with a simplified approach to adequate communication of operational risk with the business lines.
In the second forum paper, "Systemic operational risk: does it exist and, if so, how do we regulate it?", Patrick McConnell and Keith Blacker raise an interesting issue, that is, the possibility of a "systemic operational risk", ie, an operational risk event that affects the industry as a whole. The authors argue that, before the financial crisis of 2008, operational risk was pervasive in the financial industry and that it was one of the main factors that caused the crisis. The paper then describes the microprudential approach to operational risk within the Basel II regulations and identifies and describes operational risks that were present prior to the financial crisis. McConnell and Blacker go further by making suggestions as to how the management of systemic operational risks may be addressed by banks and regulators. This is the type of provocative text that we welcome in this section.