Backtesting, Stress Testing and Sensitivity Analysis

Rafael Cavestany and Daniel Rodríguez

So far, we have described an end-to-end statistical process of estimating capital requirements for operational risk. In this chapter, we look at the backtesting and stress testing of such models, in order to provide a quality control and validation of the completeness of the operational risk capital model. The backtesting represents an ex post validation of the accuracy of the modelling and compares the new experienced operational risk losses with those predicted by the models used during the capital estimation. This helps to validate whether the capital model was actually over or underestimating the risk profile. On the other hand, stress testing estimates the potential losses of severely adverse operational risk scenarios and serves as an additional capital adequateness validation.

OPERATIONAL RISK BACKTESTING

Backtesting is a necessary analysis in any risk estimation and provides us with an ex post evaluation of the precision of the calculations. Backtesting of operational risk capital estimations involves the challenge of backtesting risk estimations performed for a one-year time horizon and a high confidence interval of generally 99.9%. This implies that more than 1,000

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