Expect the unexpected

The first time I read The Black Swan, I must confess I read it very quickly. I had to introduce Nassim Nicholas Taleb at our OpRisk USA conference and had run out of time. So this summer I've picked up his book again and found in its pages some real surprises.

In the field of operational risk, Taleb's land of 'Mediocristan' is expected loss. 'Extremistan' is unexpected loss, and is the bit of operational risk that most people are really interested in. Unfortunately for op risk execs, Taleb's conclusion is that the Extremistan 'Black Swan' losses are impossible to predict, no matter how much data we have and how fancy our models are. Taleb adds that attempting to predict these losses can be harmful, as the process of forecasting could blind firms to where losses might come from. Particularly when statisticians, economists and analysts are involved.

Now, Taleb's seeming dislike of professional prognosticators is very entertaining - one of my first jobs was tracking equity analyst predictions for a newsletter, and I remember how low the hit rate was. But if we can't predict what will happen in the face of terrifying potential losses, what is the point of operational risk?

Taleb goes on to say that, although "the probabilities of very rare events are not computable; the effect of an event on us is considerably easier to ascertain ... we can have a clear idea of the consequences of an event, even if we do not know how it is likely to occur ... You can build an overall theory of decision-making on this idea. All you have to do is mitigate the consequences."

This seems like such sensible advice to me. This is what business continuity executives do - they focus on having a disaster recovery plan in place that will work no matter what actually happens. What can firms put in place to manage and mitigate large operational risks - no matter what loss event occurs?

I'll stick my head above the parapet even more ... What can firms put in place to prevent large operational risks happening, no matter what type of operational risk event it is?

Basel II's advanced measurement approach is perhaps focused too much on historical loss events and highly latent internal data. For operational risk to move forward, we need to turn this focus on data on its head, and perhaps go for a swim with a Black Swan or two.