Modeling, Measuring and Hedging Operational Risk

<body stylesrc="../_private/template_title.htm" topmargin="10" leftmargin="10" bgcolor="#FFFFFF" link="#333366" vlink="#000000" alink="#000000"> <div align="left"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table2"> <tr> <td width="780"> <div align="center"> <table border="0" cellpadding="5" cellspacing="0" height="206" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table3"> <tr> <td align="right" height="198" width="1%"> <p align="left"> <img border="0" src="../images/book_cruz_m_(2002).jpg" width="133" height="200"></td> <td valign="top" align="left" height="198"> <table border="0" cellspacing="1" style="border-collapse: collapse" bordercolor="#111111" cellpadding="0" id="table4"> <tr> <td colspan="3" width="0%"> <p class="book_title">Modeling, Measuring and Hedging Operational Risk</td> </tr> <tr> <td width="1%" class="book_details_tags" valign="top" height="16" align="left"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"><img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> <td width="52%" class="book_details_tags" valign="top" height="144" align="left" rowspan="9"> <map name="FPMap2"> <area href="../main/ratings.htm" shape="rect" coords="72, 0, 164, 33"> </map> <img border="0" src="../images_title/cruz_m26.gif" usemap="#FPMap2" width="187" height="158"></td> <td class="book_details" valign="top" height="16" align="left" width="50%"> </td> </tr> <tr> <td width="1%" class="book_details_tags" valign="top" height="16" align="left"> </td> <td class="book_details" valign="top" height="16" align="left" width="50%"> </td> </tr> <tr> <td width="1%" class="book_details_tags" valign="top" height="16" align="left"> </td> <td class="book_details" valign="top" height="16" align="left" width="50%"> </td> </tr> <tr> <td width="1%" class="book_details_tags" valign="top" height="16" align="left"> </td> <td class="book_details" valign="top" height="16" align="left" width="50%"> </td> </tr> <tr> <td width="1%" class="book_details_tags" valign="top" height="16" align="left"> </td> <td class="book_details" valign="top" height="16" align="left" width="50%"> </td> </tr> <tr> <td width="1%" class="book_details_tags" valign="top" height="16" align="left"> </td> <td class="book_details" valign="top" height="16" align="left" width="50%"> </td> </tr> <tr> <td width="1%" class="book_details_tags" valign="top" height="16" align="left"> </td> <td class="book_details" valign="top" height="16" align="left" width="50%"> </td> </tr> <tr> <td width="1%" class="book_details_tags" valign="top" height="16" align="left"> </td> <td class="book_details" height="32" align="center" width="50%" rowspan="2"> </td> </tr> <tr> <td width="1%" class="book_details_tags" valign="top" height="16" align="left"> </td> </tr> </table> </td> </tr> </table> </div> <div align="center"> <center> <table border="0" cellpadding="10" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="468" id="table5"> <tr> <td align="center"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script> </td></tr> </table> </center> </div> <table border="0" cellpadding="5" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table6"> <tr> <td width="50%" valign="top"> <p class="body">The field of operational risk management is one that is evolving rapidly. Just a few years ago, people couldn't agree on a common definition for operational risk. Today, the debate centers more on how to balance qualitative and quantitative techniques in assessing and managing operational risks. In this context, a practitioner is well advised to read several books on the subject offering different viewpoints. Among these should definitely be Cruz's vigorous, if somewhat quixotic endorsement of the almost exclusive use of quantitative techniques.</p> <p class="body">The book opens with an excellent chapter on gathering data that is necessary to perform any sort of statistical modeling of operational risks. This is a very practical discussion, focusing first on "mapping" the specific forms of operational risk a firm might want to gather data for:</p> <p class="body"> <img border="0" src="../images/bullet.gif" width="20" height="10">legal and liability<br> <img border="0" src="../images/bullet.gif" width="20" height="10">regulatory/tax penalties<br> <img border="0" src="../images/bullet.gif" width="20" height="10">loss or damage to assets<br> <img border="0" src="../images/bullet.gif" width="20" height="10">restitution<br> <img border="0" src="../images/bullet.gif" width="20" height="10">loss or recourse<br> <img border="0" src="../images/bullet.gif" width="20" height="10">write downs<br> <img border="0" src="../images/bullet.gif" width="20" height="10">systems<br> <img border="0" src="../images/bullet.gif" width="20" height="10">people/organizational issues<br> <img border="0" src="../images/bullet.gif" width="20" height="10">data flow and integrity<br> <img border="0" src="../images/bullet.gif" width="20" height="10">volume sensitivity<br> <img border="0" src="../images/bullet.gif" width="20" height="10">control gaps<br> <img border="0" src="../images/bullet.gif" width="20" height="10">external environment</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="125" align="left" id="table7"> <tr> <td width="120"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script> </td><td width="5"> </td> </tr> </table> <p class="body">Next, procedures for recording loss events must be specified. This is more easily said than done. Losses often result from a confluence of events, and identifying one as the cause can be difficult. The problem is compounded by employees' disinclination to identify or accept blame for losses they might have prevented. The chapter offers lots of practical examples and insights. It alone is worth the price of the book.</p> <p class="body">The next eight chapters focus on statistical modeling techniques—some of which are quite advanced—that might be applied to the data. Discussions are technical, but not too technical. Reading this book, you will not master all the techniques, but you will understand what they generally do. You will be able to assess which might be useful in your own work, and you will know enough to access more technical references on specific techniques. In this sense, these chapters provide a high-level roadmap to statistical techniques that might be useful in modeling operational risk.</p> <p class="body">A reasonable criticism is that, if anything, the author offers too many techniques:</p> <p class="body"> <img border="0" src="../images/bullet.gif" width="20" height="10">extreme value theory<br> <img border="0" src="../images/bullet.gif" width="20" height="10">frequency models<br> <img border="0" src="../images/bullet.gif" width="20" height="10">ruin theory<br> <img border="0" src="../images/bullet.gif" width="20" height="10">goodness-of-fit tests<br> <img border="0" src="../images/bullet.gif" width="20" height="10">Akaike information criterion<br> <img border="0" src="../images/bullet.gif" width="20" height="10">Schwarz Bayesian criterion<br> <img border="0" src="../images/bullet.gif" width="20" height="10">spectral analysis<br> <img border="0" src="../images/bullet.gif" width="20" height="10">Kalman filter<br> <img border="0" src="../images/bullet.gif" width="20" height="10">neural networks<br> <img border="0" src="../images/bullet.gif" width="20" height="10">fuzzy logic<br> <img border="0" src="../images/bullet.gif" width="20" height="10">a data augmentation algorithm<br> <img border="0" src="../images/bullet.gif" width="20" height="10">etc. etc. etc.</p> <p class="body">These chapters are more a survey of statistical techniques than a survey of statistical techniques that are useful for modeling operational risk. It would have been nice if the author had been more selective or made some effort to identify which techniques are most applicable to specific forms of operational risk. Instead, he plows along citing statistical technique after statistical technique. Examples employ actual operational risk data, but they could just as easily use data on bird migrations or incidents of infectious disease. The data is just numbers, so there is little that ties the examples to operational risk management.</p> </td> <td width="50%" valign="top" class="body" rowspan="2"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table8"> <tr> <td width="100%" bgcolor="#333366"> <p class="header_yellow" align="center">Contents</td> </tr> <tr> <td width="100%" class="explanatory_text"> <table border="1" cellpadding="0" cellspacing="5" style="border-collapse: collapse" bordercolor="#CCCCFF" bgcolor="#CCCCFF" width="100%" id="table9"> <tr> <td class="contents_expanded"> <p class="contents_expanded"><font size="2">1 Overview </font> </p> <p class="contents_expanded"><b><font size="2">Database Modeling </font> </b></p> <p class="contents_expanded"><font size="2">2 Database modeling </font> </p> <p class="contents_expanded"><b><font size="2">Stochastic Modeling </font></b></p> <p class="contents_expanded"><font size="2">3 Severity models </font> </p> <p class="contents_expanded"><font size="2">4 Extreme value theory </font> </p> <p class="contents_expanded"><font size="2">5 Frequency models </font> </p> <p class="contents_expanded"><font size="2">6 Operational value at risk </font> </p> <p class="contents_expanded"><font size="2">7 Stochastic processes in operational risk </font> </p> <p class="contents_expanded"><b><font size="2">Causal Modeling </font> </b></p> <p class="contents_expanded"><font size="2">8 Causal models: applying econometrics and time series statistics to operational risk </font> </p> <p class="contents_expanded"><font size="2">9 Non-linear models in operational risk </font> </p> <p class="contents_expanded"><font size="2">10 Bayesian techniques in operational risk </font> </p> <p class="contents_expanded"><b><font size="2">Operational Risk Management </font></b></p> <p class="contents_expanded"><font size="2">11 Operational risk reporting, control and management </font> </p> <p class="contents_expanded"><font size="2">12 Stress tests and scenario analysis </font> </p> <p class="contents_expanded"><b><font size="2">Hedging Operational Risk </font></b></p> <p class="contents_expanded"><font size="2">13 Operational risk derivatives </font> </p> <p class="contents_expanded"><font size="2">14 Developing a hedging program for operational risk </font> </p> <p class="contents_expanded"><b><font size="2">Regulatory Capital </font></b></p> <p class="contents_expanded"><font size="2">15 Operational risk regulatory capital </font> </p> <p class="contents_expanded"><b><font size="2">Measuring "Other Risks" </font></b></p> <p class="contents_expanded"><font size="2">16 An enterprise-wide model for measuring reputational risk </font> </p> <p class="contents_expanded"><font size="2">17 Measuring concentration (or key personnel) risk </font> </p> <p class="contents_expanded"><font size="2">18 Using real options in modeling and measuring operational and "other" risks </font> </p> </td> </tr> </table> </td> </tr> </table> <p class="body_expanded">Next, two chapters discuss how to use output from models to communicate and manage operational risk. Some of these discussions are quite practical, detailing useful reports. Some are more hypothetical. Cruz suggests that models might support a system of operational risk limits—and that risk managers might call a halt to trading activities on any day the models indicate excessive operational risk. Operational risk is incorporated into risk-adjusted performance measures. Cruz also discusses stress testing of operational risk.</p> <p class="body_expanded">Two chapters discuss the hedging of operational risk through insurance and a hypothetical market for operational risk derivatives. </p> <p class="body_expanded">Another chapter discusses regulatory initiatives related to operational risk. This gives a good overview of the state of Basle 2 as of 2002.</p> <p class="body_expanded">The final three chapters return to the topic of statistical modeling techniques, covering:</p> <p class="body_expanded" style="line-height: 150%"> <img border="0" src="../images/bullet.gif" width="20" height="10">econometrics events-analysis models<br> <img border="0" src="../images/bullet.gif" width="20" height="10">the Gini concentration index<br> <img border="0" src="../images/bullet.gif" width="20" height="10">multifactor logit models<br> <img border="0" src="../images/bullet.gif" width="20" height="10">real-options analysis<br> <img border="0" src="../images/bullet.gif" width="20" height="10">etc.</p> <p class="body_expanded">I stopped reading when the author presented a convoluted statistical model for assessing the risk of a key trader quitting. I couldn't help but wonder if it might be more effective to buy the trader a drink and ask if he is happy in his job ...</p> <p class="body_expanded">In summary, this book is easy to criticize for its unbridled and largely uncritical embrace of all conceivable techniques of statistical modeling. Some of the book's recommendations may be visionary. Others seem impractical.</p> <p class="body_expanded">On the other hand, there is a tremendous amount of substance here, and it is informed by the author's experience working for a number of major institutions. Given its exclusive focus on quantitative techniques, this should not be the only book you read on operational risk, but it should definitely be one of the books you read.</p> <p align="center" class="body"> </p> </td> </tr> <tr> <td width="50%" valign="bottom"> <table border="0" cellpadding="5" cellspacing="0" style="border-collapse: collapse" width="100%" bgcolor="#CCCCFF" height="24" id="table10"> <tr> <td width="100%" align="left"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script> </td></tr> </table> </td> </tr> </table> <div align="left"> <table border="0" cellpadding="10" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table11"> <tr> <td width="50%" bgcolor="#FFFFCC" align="center" valign="top"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" bgcolor="#FFFFCC" id="table12"> <tr> <td> <p class="body" style="margin-bottom: 6"><b><font color="#333366" size="3">For related books, see sections:</font></b></p> <p class="bullet_line_space"><strong style="font-weight: 400"> <img border="0" src="../images/bullet.gif" width="20" height="10"><a target="_top" href="../link_topic/risk_management_operational_risk.htm">Risk Management - Operational Risk</a></strong></p> <p class="bullet_line_space"><img border="0" src="../images/bullet.gif" width="20" height="10"><a target="_top" href="../link_topic/risk_management_general.htm">Risk Management - General</a></td> </tr> </table> </td> </tr> </table> </div> </td> <td>  </td> </tr> </table> </div>  <table border="0" style="border-collapse: collapse" width="100%" cellpadding="0" id="table1" bgcolor="#FFFFFF"> <tr> <td colspan="2" height="12"> <p style="margin-top: 0"> </td> </tr> <tr> <td align="right"> <p align="left" style="margin-bottom: 2px"> <a target="_top" href="http://www.riskexpertise.com/link/advertising.htm"> <font size="1" color="#000000" face="Arial">Ads by Contingency Analysis.</font></a></td> <td align="left"> <p align="right" style="margin-bottom: 2px"> <a target="_top" href="http://www.riskexpertise.com/link/advertising.htm"> <font size="1" color="#000000" face="Arial">Advertise on this site.</font></a></td> </tr> <tr> <td align="center" colspan="2">  <iframe src="http://servedbyadbutler.com/adserve/;ID=147917;size=300x250;setID=93136;type=iframe" allowtransparency="true" background-color="transparent" style="margin: 0px; padding: 0px; border-width: 0px" width="300" height="250" frameborder="0" marginwidth="0" marginheight="0" scrolling="no"> <![if lt IE 4]> <script src="http://servedbyadbutler.com/adserve/;ID=147917;size=300x250;setID=93136;type=js" type="text/javascript"> </script> <noscript> <a href="http://servedbyadbutler.com/go2/;ID=147917;size=300x250;setID=93136"> <img src="http://servedbyadbutler.com/adserve/;ID=147917;size=300x250;setID=93136;type=img" border="0" height="250" width="300" alt=""></a> </noscript><![endif]> </iframe>   </td> </tr> </table> <p align="center" style="margin-top: 20"> <map name="FPMap0_I1"> <area href="http://www.riskbook.com" shape="rect" coords="0, 0, 184, 29" target="_top"></map> <img border="0" src="../images/open_book_riskbook.gif" usemap="#FPMap0_I1" width="185" height="30"></p> <p class="a" align="center"><font face="Arial" size="2"><a href="../main/disclaimer.htm">disclaimer</a></font></p> <p class="a" align="center"><span class="verdana10">website:</span> <a target="_top" href="http://www.contingencyanalysis.com"> <font size="2" face="Arial">http://www.contingencyanalysis.com</font></a><br> <span class="verdana10">books direct link:</span> <a target="_top" href="http://www.riskbook.com"><font size="2" face="Arial">http://www.riskbook.com</font></a><br> copyright <font face="Times New Roman">©</font> Contingency Analysis, 1996 - current</p> <p class="a" align="center"><map name="FPMap1_I1"> <area target="_top" href="http://www.contingencyanalysis.com" shape="rect" coords="0, 0, 240, 88"> </map><img border="0" src="../images/logo_book_white.gif" usemap="#FPMap1_I1" width="241" height="89"></p>  </body>