Quantification of Operational Risk Under Basel II: the Good, Bad and Ugly

287 Pages·2008·1.838 MB·English

by  Imad A. Moosa (auth.)

QUANTIFICATION OF OPERATIONAL RISK UNDER BASEL II
Also by the Author
Moosa, I.A, and Bhatti, R.H. (1997) International Parity Conditions: Theory, Econometric
Testing and Empirical Evidence, London: Macmillan.
Moosa, I.A. (1998) (first edition) and (2004) (second edition) International Finance: An
Analytical Approach, Sydney: McGraw Hill.
Taylor, J.B., Moosa, I.A. and Cowling, B. (2000) Microeconomics, Brisbane: Wiley.
Taylor, J.B. and Moosa, I.A. (2000) (first edition) and (2002) (second edition) Macroeconomics,
Brisbane: Wiley.
Moosa, I.A. (2000) Exchange Rate Forecasting: Techniques and Applications, London:
Macmillan.
Moosa, I.A. (2002) Foreign Direct Investment: Theory, Evidence and Practice, London:
Palgrave Macmillan.
Moosa, I.A. (2003) International Financial Operations: Arbitrage, Hedging, Speculation,
Financing and Investment, London: Palgrave Macmillan.
Moosa, I.A. (2005) Exchange Rate Regimes: Fixed, Flexible or Something in Between?
London: Palgrave Macmillan.
Moosa, I.A. (2006) Structural Time Series Modelling: Applications in Economics and Finance,
Hyderabad: ICFAI University Press.
Moosa, I.A. (2007) Operational Risk Management, London: Palgrave Macmillan.
Quantification of
Operational Risk under
Basel II: the Good,
Bad and Ugly
IMAD A. MOOSA
Professor of Finance,
Monash University,
Australia
© Imad Moosa 2008
Softcover reprint of the hardcover 1st edition 2008 978-0-230-22266-3
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accordance with the Copyright, Designs and Patents Act 1988.
First published 2008 by
PALGRAVE MACMILLAN
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ISBN 978-1-349-30822-4 ISBN 978-0-230-59514-9 (eBook)
DOI 10.1057/9780230595149
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A catalogue record for this book is available from the British Library.
Library of Congress Cataloging-in-Publication Data
Moosa, Imad A.
Quantifi cation of operational risk under Basel II : the good, bad
and ugly / Imad A. Moosa.
p. cm.—(Finance and capital markets series)
Includes index.
1. Financial risk management – Mathematical models. 2. Bank
capital – Mathematical models. 3. Banks and banking,
International – Risk management. I. Title.
HD61.M6144 2009
332.1(cid:2)50681—dc22 2008037609
10 9 8 7 6 5 4 3 2 1
17 16 15 14 13 12 11 10 09 08
To Nisreen and Danny
This page intentionally left blank
Contents
List of Figures ix
List of Tables xii
Preface xiii
List of Acronyms xvii
1 Preliminary Concepts and Issues 1
1.1 Definition and Measurement of Risk 1
1.2 Classification of Risk 7
1.3 Analysis of Risk 15
1.4 The Rising Importance of Operational Risk 20
1.5 Banks and Banking Regulation 26
1.6 Capital, Capital Adequacy and Related Concepts 30
2 From Basel I to Basel II: A Great Leap Forward? 39
2.1 The Basel Committee 39
2.2 The Basel I Accord 46
2.3 The Basel II Accord 52
2.4 The Pillars of Basel II 55
2.5 A Critique of Basel II 65
Appendix 2.1: Capital Charges under the BIA and STA 79
3 Operational Risk: Definition, Features and Classification 83
3.1 Definition of Operational Risk 83
3.2 The Distinguishing Features of Operational Risk 89
3.3 Classification of Operational Risk 95
3.4 Surveys of Operational Loss Data 110
3.5 External Operational Loss Databases 117
3.6 Internal Operational Loss Databases 122
vii
viii CONTENTS
Appendix 3.1: T he Foreign Exchange Committee’s Sixty
Best Practices 128
Appendix 3.2: T he BCBS’s Sound Practices 131
Appendix 3.3: Description of Some Highly
Publicised Loss Events 132
4 The Advanced Measurement Approach to Operational Risk 137
4.1 Operational Risk Measurement, Assessment
and Modelling 137
4.2 Classification of Operational Risk Models 143
4.3 The Advanced Measurement Approach(es) 146
4.4 A Critique of the AMA 156
4.5 Concluding Remarks 169
5 Theoretical and Empirical Studies of Operational Risk 170
5.1 Introduction 170
5.2 Methodological Studies 171
5.3 Empirical Studies 184
5.4 Studies of the Effects of Operational Risk 190
5.5 A Final Thought 194
6 Monte Carlo Simulation: Description and Examples 196
6.1 Introduction 196
6.2 The Basic Idea 197
6.3 Specification of Frequency and Severity Distributions 198
6.4 Fitting Severity Distributions 202
6.5 Modelling Risk Dependence to Calculate the Firm-Wide
Capital Charge 205
6.6 Examples Using Hypothetical Data 209
6.7 Conclusion 225
Appendix 6.1: Discrete Frequency Distributions 226
Appendix 6.2: Continuous Severity Distributions 227
7 Operational Risk: Where Do We Stand? 229
7.1 Recapitulation 229
7.2 The Subprime Crisis as an Operational Loss Event 234
7.3 Societe Generale et al. 243
7.4 Operational Risk Management: The Rights and Wrongs 244
7.5 The Good, Bad and Ugly 247
7.6 A Concluding Note 249
References 251
Index 265
Figures
1.1 VAR, ETL, Expected Loss and Unexpected Loss 5
1.2 Classification of Risk 7
1.3 Classification of Uncertainties 11
1.4 The FSA’s Classification of Risk Faced by
Insurance Companies 12
1.5 Risks Facing a Bank 12
1.6 Overlapping of Risk Types 14
1.7 Probability Distributions with Similar Best and
Worst Cases 16
1.8 Risk Analysis of Carry Trade 18
1.9 A Schematic Representation of the
Simulation Exercise (1) 19
1.10 A Schematic Representation of the
Simulation Exercise (2) 20
1.11 Factors Leading to Rising Exposure to
Operational Risk 23
1.12 Components of Tier 1 and Tier 2 Capital 34
1.13 An Illustration of Regulatory Capital Arbitrage 36
1.14 The Effect of Securitisation 37
2.1 The Basel Committee’s Structure (up to October 2006) 41
2.2 The Basel Committee’s Present Structure 41
2.3 Risk-Based Weights under Basel I 47
2.4 The Three Pillars and Objectives of Basel II 56

2.5 Components of Credit Risk 57
2.6 The Betas Assigned to Business Lines 60
2.7 The BCBS Business Lines with Examples 60
2.8 Alternative Measures of Exposure to Operational
Risk by Business Line 62
2A1.1 Difference between Capital Charges under the
BIA and STA Case (1) 80
ix