Hybrid model construction: Integration of ILD, ED and SA

Rafael Cavestany, Daniel Rodríguez Perez and Fabrizio Ruggeri

Once the modelling of the four data elements has been performed, as presented in the last three chapters, we now look into the merger of these data elements. The merger will result in a single loss severity distribution (or loss frequency distribution if applied to frequencies) of the operational losses for the operational risk category (ORC) incorporating different data elements.

Regarding the merger of different data elements, the Basel Committee on Banking Supervision “Operational Risk – Supervisory Guidelines for Advanced Measurement Approaches” (BCSG-AMA) states: “A bank should carefully consider how the data elements are combined and used to ensure that the bank’s operational risk capital charge is commensurate with its level of risk exposure”.

This chapter presents credibility theory and various methods for merging the different data elements into a single loss or frequency distribution, organised in the following sections.

    • “Credibility theory: Determining the weights for internal loss data (ILD), external loss data (ED) and scenario analysis (SA) in the hybrid model”: In this section, we look at the different models for credibility theory that permit us to

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