Journal of Operational Risk

Marcelo Cruz

Lehman Brothers

Welcome to the second issue of The Journal of Operational Risk. The main focus of the Journal is research on the risk measurement and management of operational risk and to promote greater understanding of this new and fast growing area of risk. This Journal also aims at being an exclusive forum for discussions on this subject, as until now there has been no dedicated forum for operational risk technical papers. Research in operational risk is a growth field in both the financial industry and academia. There are currently many lines of research, most of them trying to overcome the challenges presented by the new regulatory standards created by the Basel II Accord. However, currently there is not a single forum for the debate of these ideas. The Journal of Operational Risk intends to fulfill this much-needed role.

The Journal of Operational Risk is the vehicle for communicating results in the modeling and management of operational risk. Examples of some areas of interest are: statistical/actuarial methods and estimation issues, causal models, scenario analysis based models, Bayesian methods, uses of external data within the framework, etc. We also encourage you to submit papers on new ideas and research on subjects such as corporate governance, business continuity plans, enterprise-wide risk, financial crime and the development of controls to avoid them, insurance, etc.

I would like to take this opportunity to thank you for the many kind notes congratulating us on the initiative after the first issue was released. I would also like to highlight that every article that is pertinent to operational risk can be published, not just the quantitative ones. Therefore, submissions of qualitative articles that, for example, tell of your experience in implementing an operational risk framework in your firm will be well received.

Research Papers

In this second issue, we present four research papers in the main section.

In the first paper, Time horizon scaling for operational risk VAR, Steif tackles a very controversial issue in the industry: the scaling of operational risk measures for longer periods. Steif justifies mathematically that the operational risk VAR scales linearly with time as intuition suggests. He gives a simple argument using the Central Limit Theorem generalized to random sums to demonstrate that, at least for Poisson distributed loss frequency with a sufficiently large average loss, the VAR indeed scales linearly with time. He confirms the theory with a practical application using Monte Carlo simulation to aggregate losses.

In the second paper, An econometric model to scale operational losses, Na et al develop a scaling methodology to incorporate external data into the measurement framework. In their paper, the authors defend the idea that there is a power law relationship between losses incurred in business units and their gross revenue.

In the third paper, Sources of uncertainty in modeling operational risk losses, Mignola and Ugoccioni analyze the source of errors in the calculation of the operational VAR using the loss distribution approach. The authors initially describe the usual goodness-of-fit tests for distributions and its application to a database.

The authors also cover the statistical uncertainty that models bear by describing the sources of uncertainties in simulation to aggregate frequency and severity distributions. This is a very interesting article that can help analysts to validate models developed to quantify operational risk.

In the last paper of this issue, Extreme value theory and high quantile convergence, Makarov provides examples to illustrate his concerns on the estimation of high quantiles when using extreme value theory for a wide class of distributions as it does not provide good approximation to the estimated distribution.

Operational Risk Forum

This section is intended to provide a less formal forum on findings and ideas about operational risk without the academic rigor demanded in the main section. The mission of the Forum is to promote active discussions of current issues in operational risk. Articles submitted to this section should preferably not exceed 8,000 words.

Contributions to the Forum can be articles that seek to explain difficult, unclear but otherwise known concepts and results. The articles that we would like to see in the Forum should be designed to be tutorial and highly educational in nature.

The main goal of the submitted articles is to bring a higher level of understanding to both industry and academia on issues and topics that might not normally be readily and easily accessible to either side.

In this issue, Bernard Bresnahan writes about the challenge of implementing Basel II standards in a sector that it is not as regulated as the banking industry is. Also, in a second piece, Sean Lyons debates if the shareholders interests are adequately defended in corporations.