23 study notes risk management and financial

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Study Notes: Risk Management and Financial Institutions By Zhipeng Yan Chapter 14 Operational Risk 1. Operational risk : the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. - It includes legal risk, but does not include reputation risk or the risk resulting from strategic decisions. 2. 7 Categories of operational risk - Internal fraud (Barings), - External fraud (Republic NY corp. Lost $611 million because of fraud committed by a custodial client, - Employment practices and workplace safety (Merrill Lynch lost $250 million in a gender discrimination lawsuit), - Clients, products, & business practices (Household International lost $484 million from improper lending practices), - Damage to physical assets (911 attacks), - Business disruption and system failures (Solomon Brothers lost $303 million from a change in computing technology). - Execution, delivery, and process management : failed transaction processing or process management, and relations with trade counter-parties and vendors. E.g., Bank of America and Wells Fargo Bank lost $225 and $150 million, respectively, from systems integration failures and transactions processing failures. 3. Loss severity and loss frequency - Loss frequency distribution – the distribution of the number of losses observed during the time horizon (a Poisson distribution is usually used). - Loss severity distribution – the distribution of the size of a loss, given that a loss occurs. (usually assume the two are independent). (a lognormal probability distribution is often used) - The two distributions must be used for each loss type and business line to determine a total loss distribution. Monte Carlo simulation can be used here: a. Sample from the frequency distribution to determine the number of loss events (=n). b. Sample n times from the loss severity distribution to determine the loss experienced for each loss event (L1, L2, … Ln) c. Determine the total loss experienced ( = L1 + L2 +…+ Ln). d. Repeat this many times. - Data: the frequency distribution should be estimated from the bank’s own data as far as possible . For the loss severity distribution, regulators encourage banks to use their own data in conjunction with external data (through sharing arrangements between banks or from data vendors. Both internal and external data must be adjusted for inflation. A scale adjustment should be made to external data). 4. Operational risk capital should be allocated to business units in a way that encourages them to improve their operational risk management . The overall - 24 -
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Study Notes: Risk Management and Financial Institutions By Zhipeng Yan result of operational risk assessment and operational risk capital allocation should be that business units become more sensitive to the need for managing operational risk.
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