Journal of Operational Risk

Risk.net

The issues with the standardized measurement approach and a potential future direction for operational risk capital modeling

Ruben D. Cohen

  • This paper states that so far, despite all the criticisms of the SMA, there is still no analytical evidence that supports the superiority of the AMA over it.
  • However, there is analytical evidence to support the benefits of a single LDA-based model, which uses only internal data and is applied at the entity level, over the SMA.
  • Therefore, until a robust theoretical framework for operational risk is discovered, a single and universal LDA-based model is recommended, as it brings transparency and avoids the issues with the SMA, as well as the complications of the AMA.

Tensions have risen in the area of operational risk following the standardized measurement approach (SMA) proposal and the possible removal of the advanced measurement approach (AMA). These tensions, created by the desire for simplicity and transparency on the one hand and risk sensitivity on the other, are well reflected in many recent articles, which mostly criticize the SMA but praise the AMA. Here, we look at the criticism and praise in two current technical papers and note that although the validity of the SMA criticism is demonstrated with analytical precision, the praise for the AMA appears to lack similar justification. The reason for this is that the simplicity and transparency of the SMA allow objective analysis, whereas the complexity and opacity of the AMA do not. Moving on from this, it is proposed that a single, universal loss distribution approach-type (LDA-type) model may be the way forward for the next generation of operational risk capital models. This way, simplicity and transparency are retained as model qualities, while risk sensitivity, albeit at the entity level, is also improved over that of the SMA due to the nature of the LDA.

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