VRM7 - Operational Risk

Question 1

Describe the different categories of operational risk and explain how each type of risk can arise

Answer 1

1. internal fraud
2. external fraud
3. employment practices and workplace safety
4. clients, products, business practices
5. damage to physical assets
6. business disruption and system failures
7. execution, delivery, process management

Question 2

Compare basic indicator approach, standardised approach, and the advanced measurement approach for calculating operational risk regulatory capital

Answer 2

1. Basic: op risk capital set to 15% of three year average annual gross income
2. Standardised: same as basic but each LOB has its own calculation and required %
3. Advanced: treat each LOB then same as credit risk individually and estimate 99.9% losses

Question 3

Describe the standardised measurement approach and explain its reasons for its introduction by the Basel Commitee

Answer 3

Implements ability to take into account banks size in the calculation by business indicator

Question 4

Explain how a loss distribution is derived from an appropriate loss frequency distribution and loss severity distribution using monte carlo simulation

Answer 4

Just an RFO basically

Question 5

Describe common data issues that can introduce inaccuracies and biases in the estimation of loss frequency and severity distributions

Answer 5

• Reporting thresholds
• level of exposure

Question 6

Describe how to use scenario analysis in instances when data are scarce

Answer 6

Come up with scenarios with low frequency but high impact and analyse how this would affect the company

Question 7

Describe how to identify causal relationships and how to use Risk and Control Self-assessment (RCSA), Key Risk Indicators (KRIs), and education to understand and manage operational risks

Answer 7

RCSA finds out what employees perceive risks to be - likely to flag issues

KRIs, such as staff turnover and unfilled positions can show heightened chance of operational risk

Question 8

Describe the allocation of operational risk capital to business units

Answer 8

Use Euler’s theorem to find out each BU contributes to operational risk, provides incentive to reduce op risk

Question 9

Explain how to use the power law to measure operational risk

Answer 9

Power law P(v > x) = Kx^(-a) can be used to estimate the tail losses arising from operational risk