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Scenario Analysis in the Measurement of Operational Risk Capital: A Change of Measure Approach
Author(s) -
Dutta Kabir K.,
Babbel David F.
Publication year - 2014
Publication title -
journal of risk and insurance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.055
H-Index - 63
eISSN - 1539-6975
pISSN - 0022-4367
DOI - 10.1111/j.1539-6975.2012.01506.x
Subject(s) - operational risk , economic capital , measure (data warehouse) , scenario analysis , risk adjusted return on capital , capital (architecture) , credit risk , actuarial science , risk analysis (engineering) , probability of default , market risk , capital requirement , basel ii , econometrics , computer science , finance , financial capital , risk management , business , economics , capital formation , human capital , data mining , microeconomics , history , archaeology , incentive , economic growth
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.