Scenario Analysis in the Measurement of Operational Risk Capital: A Change of Measure Approach

Authors

  • Kabir K. Dutta,

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    • Kabir K. Dutta is a Senior Consultant at Charles River Associates in Boston. David F. Babbel is a Fellow of the Wharton Financial Institutions Center, Professor at the Wharton School of the University of Pennsylvania, and a Senior Advisor to Charles River Associates. The authors can be contacted via e-mail: Kabir.Dutta.wg97@Wharton.UPenn.edu and Babbel@Wharton.UPenn.edu, respectively. We are grateful to David Hoaglin for painstakingly helping us by editing the article and making many valuable suggestions for improving the statistical content. We also thank Ravi Reddy for providing several valuable insights and for help with the methodological implementation, Ken Swenson for providing guidance from practical and implementation points of view at an early stage of this work, Karl Chernak for many useful suggestions on an earlier draft, and Dave Schramm for valuable help and support at various stages. We found the suggestions of Paul Embrechts, Marius Hofert, and Ilya Rosenfeld very useful in improving the style, content, and accuracy of the method. We also thank seminar participants at the Fields Institute, University of Toronto, American Bankers Association, Canadian Bankers Association, and anonymous referees for their valuable comments and their corrections of errors in earlier versions of article. Any remaining errors are ours. Three referees from the Journal of Risk and Insurance provided thoughtful comments that led us to refine and extend our study, and we have incorporated their language into our presentation in several places. The methodology discussed in this article, particularly in the “Calculation of Implied Probability Distributions” section, in several paragraphs of the “Economic Evaluation of Scenarios: The Change of Measure” section, and in the Appendix, is freely available for use with proper citation.
  • David F. Babbel

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    • Kabir K. Dutta is a Senior Consultant at Charles River Associates in Boston. David F. Babbel is a Fellow of the Wharton Financial Institutions Center, Professor at the Wharton School of the University of Pennsylvania, and a Senior Advisor to Charles River Associates. The authors can be contacted via e-mail: Kabir.Dutta.wg97@Wharton.UPenn.edu and Babbel@Wharton.UPenn.edu, respectively. We are grateful to David Hoaglin for painstakingly helping us by editing the article and making many valuable suggestions for improving the statistical content. We also thank Ravi Reddy for providing several valuable insights and for help with the methodological implementation, Ken Swenson for providing guidance from practical and implementation points of view at an early stage of this work, Karl Chernak for many useful suggestions on an earlier draft, and Dave Schramm for valuable help and support at various stages. We found the suggestions of Paul Embrechts, Marius Hofert, and Ilya Rosenfeld very useful in improving the style, content, and accuracy of the method. We also thank seminar participants at the Fields Institute, University of Toronto, American Bankers Association, Canadian Bankers Association, and anonymous referees for their valuable comments and their corrections of errors in earlier versions of article. Any remaining errors are ours. Three referees from the Journal of Risk and Insurance provided thoughtful comments that led us to refine and extend our study, and we have incorporated their language into our presentation in several places. The methodology discussed in this article, particularly in the “Calculation of Implied Probability Distributions” section, in several paragraphs of the “Economic Evaluation of Scenarios: The Change of Measure” section, and in the Appendix, is freely available for use with proper citation.

Abstract

At large financial institutions, operational risk is gaining the same importance as market and credit risk in the capital calculation. Although scenario analysis is an important tool for financial risk measurement, its use in the measurement of operational risk capital has been arbitrary and often inaccurate. We propose a method that combines scenario analysis with historical loss data. Using the Change of Measure approach, we evaluate the impact of each scenario on the total estimate of operational risk capital. The method can be used in stress-testing, what-if assessment for scenario analysis, and Loss Given Default estimates used in credit evaluations.

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