House of Lords criticises statistical models for op risk management

Government report throws doubt on the validity of modelling operational risk

LONDON - A report published on June 2 on banking regulation and supervision by the House of Lords Economic Affairs Committee has cautioned supervisors about relying on statistical models alone for measuring operational risk exposure.

The report is largely a critique of the UK's tripartite regulatory regime but a reference to the flaws inherent in modelling operational risk is also buried within it, which has shocked some in the industry. "It's very odd for it to appear in that report," says one source. "It is frustrating also because even though it is very critical of op risk modelling, it doesn't suggest any alternative."

The report reads: "It is not clear that modelling techniques developed to manage portfolios of liquid financial instruments are well-suited to the management of operational risk." Two witnesses are also quoted in the report. One, Jon Danielsson, a reader in finance at the London School of Economics, who provide an oral testimony to the committee, is quoted as saying "operational risk modelling is very dangerous", while William Perraudin, chair of finance at Imperial College, London states "modelling operational risk and setting capital is in some ways hard to justify." However Perraudin also said charging capital against operational risk might generate the right incentives within firms.

The overall recommendation from the report on modelling operational risk is that "in general, financial models designed for use in liquid markets should not be used in the supervision of illiquid markets" but it does not go on to suggest an alternative method of measuring operational risk. It concludes: "Supervisors should base their assessments of operational risk upon a close understanding of the banks they regulate, and not upon statistical models, which cannot substitute for judgement based on analysis." This is what supervisors have been doing under the Capital Requirements Directive anyway since it was implemented, which suggests the report is either seeking to reiterate the importance of supervisors' judgement or sending a message to banks that have placed too much emphasis on modelling operational risk to the detriment of operational risk management.

This story will be covered in more depth in the July issue of OpRisk & Compliance. If you have any comments to make about this please contact [e-mail].