Journal of Operational Risk

Risk.net

How to turn uncertainties of operational risk capital into opportunities from a risk management perspective

Arjan Bakker and Philippe Meunier

  • Credibility weight combines elegantly backward-looking and forward-looking risk information.
  • Scenario Analysis assessment estimates are prone to biases, which can be mitigated.
  • Capital uncertainty from a scenario topic perspective can attract senior management attention.
  • Transparency on capital uncertainty helps to manage expectation on model noise. 

ABSTRACT

The supervisory guidelines for the Basel Committee on Banking Supervision's Advanced Measurement Approaches require the uncertainty of operational risk capital to be acknowledged by financial institutions. The estimated capital charge is inherently uncertain due to the heaviness and scarcity of operational risk losses in the tail region. Beyond the regulatory requirements, we build on this sound quantitative information to provide the bank with relevant business applications: a hybrid capital model with balanced weighting between backward-looking and forward-looking risk information; scenario bias mitigation; and managing future capital-based risk appetite limits for scenario topics. Making businesses sensitive to the sources of capital uncertainty will help reduce inherent uncertainty by identifying ways to develop scenario analysis coverage in line with the internal and external business environment assessment outcomes. Looking at capital uncertainty from a scenario topic perspective is really sensible and appealing. Transparency on capital uncertainty within the business helps to manage expectation on model noise against what remains actionable.

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