Table of Contents
Title Page
Copyright Page
Foreword
About the Editor
Acknowledgements
About the Contributors
PART One - Operational Risk Measurement: Qualitative Approaches
CHAPTER 1 - Modeling Operational Risk Based on Multiple Experts’ Opinions
1.1 INTRODUCTION
1.2 OVERVIEW OF THE AMA MODELS
1.3 USING EXPERTS’ OPINIONS TO MODEL OPERATIONAL RISK: A PRACTICAL BUSINESS CASE
1.4 COMBINING EXPERTS’ OPINIONS
1.5 SUPRA-BAYESIAN MODEL FOR OPERATIONAL RISK MODELING
1.6 CONCLUSION
NOTES
REFERENCES
CHAPTER 2 - Consistent Quantitative Operational Risk Measurement
2.1 INTRODUCTION
2.2 CURRENT PRACTICES OF OPERATIONAL RISK MEASUREMENT AND REGULATORY APPROACHES
2.3 MAIN MEASUREMENT CHALLENGES OF LDA
2.4 CONCLUSION
APPENDIX
NOTES
REFERENCES
CHAPTER 3 - Operational Risk Based on Complementary Loss Evaluations
3.1 INTRODUCTION
3.2 LOSS DISTRIBUTION APPROACH
3.3 COMPLEMENTARY LOSS EVALUATIONS
3.4 SUBJECTIVE INFORMATION ANALYSIS
3.5 INTEGRATION OF THE SUBJECTIVE AND THE QUANTITATIVE ANALYSIS
3.6 CONCLUSION
REFERENCES
CHAPTER 4 - Can Operational Risk Models Deal with Unprecedented Large Banking Losses?
4.1 INTRODUCTION
4.2 WHY SOME UNEXPECTED LOSSES CANNOT BE STUDIED IN SCENARIO GROUPS
4.3 REQUIRED FEATURES FOR A NEW METHODOLOGY TO EXPLORE UNPRECEDENTED CATASTROPHES
4.4 USING STOCHASTIC DYNAMICS TO DRIVE EVENTS IN A NETWORK COMBINING ACTORS
4.5 OBTAINING RISK-GENERATING NODES IN A NETWORK GRAPH
4.6 GENERATING LOSSES IN A STOCHASTIC MULTISTEP DYNAMIC
4.7 VERIFICATION REQUIREMENTS FOR MODEL DYNAMICS
4.8 REQUIREMENTS OF MODEL EVOLUTION BY LEARNING
4.9 CONCLUSION
REFERENCES
CHAPTER 5 - Identifying and Mitigating Perceived Risks in the Bank Service ...
5.1 INTRODUCTION
5.2 BANKS IN THE POST-SUBPRIME ERA: AN IMPORTANT SECTOR IN TURMOIL
5.3 NOTION OF PERCEIVED RISK: LITERATURE REVIEW
5.4 BANK SERVICE CHAIN: CHAIN OF SERVICES AND OF RISK EVENTS
5.5 CONTROL SYSTEM DESIGNED TO ADDRESS THE INTANGIBLE NATURE OF SERVICE RISKS
5.6 APPLICATION OF THE TEID MODEL: THE SOCGéN CASE
5.7 CONCLUSION
REFERENCES
CHAPTER 6 - Operational Risk and Stock Market Returns: Evidence from Turkey
6.1 INTRODUCTION
6.2 OPERATIONAL LOSSES AND THE BANKING SECTOR IN TURKEY
6.3 REACTION OF STOCK RETURNS TO OPERATIONAL RISK EVENTS
6.4 CONCLUSION
NOTES
REFERENCES
PART Two - Operational Risk Measurement: Quantitative Approaches
CHAPTER 7 - Integrating Op Risk into Total VaR
7.1 INTRODUCTION
7.2 A BRIEF REVIEW OF INTEGRATED RISK MANAGEMENT IN THE PRESENCE OF OPR
7.3 CLOSED-FORM APPROXIMATION BASED ON MSHM IN THE MODERATELY HEAVY-TAILED CASE
7.4 SIMULATION RESULTS
7.5 CONCLUSION
NOTES
REFERENCES
CHAPTER 8 - Importance Sampling Techniques for Large Quantile Estimation in ...
8.1 INTRODUCTION
8.2 PRELIMINARIES: POISSON MIXTURES AND IMPORTANCE SAMPLING
8.3 MODERATELY HEAVY-TAILED CASE: LOGNORMAL SEVERITY
8.4 HEAVY-TAILED CASE: PARETO SEVERITY
8.5 SIMULATION RESULTS
8.6 CONCLUSION
REFERENCES
CHAPTER 9 - One-Sided Cross-Validation for Density Estimation with an ...
9.1 INTRODUCTION
9.2 ONE-SIDED CROSS-VALIDATION METHOD FOR DENSITY ESTIMATION
9.3 ASYMPTOTIC THEORY
9.4 FINITE SAMPLE PERFORMANCE
9.5 PRACTICAL REMARKS AND DATA APPLICATIONS
9.6 CONCLUSION
NOTES
REFERENCES
CHAPTER 10 - Multivariate Models for Operational Risk: A Copula Approach Using ...
10.1 INTRODUCTION
10.2 STANDARD LDA APPROACH
10.3 AGGREGATION VIA COPULA
10.4 EMPIRICAL ANALYSIS
10.5 CONCLUSION
REFERENCES
CHAPTER 11 - First-Order Approximations to Operational Risk: Dependence and Consequences
11.1 INTRODUCTION
11.2 FROM PARETO COPULAS TO PARETO L’VY COPULAS
11.3 UNDERSTANDING THE DEPENDENCE STRUCTURE
11.4 APPROXIMATING TOTAL OpVaR
11.5 CONCLUSION
REFERENCES
PART Three - Operational Risk Management and Mitigation
CHAPTER 12 - Integrating “Management” into “OpRisk Management”
12.1 INTRODUCTION
12.2 LIMITED SCOPE OPERATIONAL RISK MANAGEMENT UNDER BASEL II
12.3 MANAGEMENT PERSPECTIVE IN OPERATIONAL RISK MANAGEMENT
12.4 RENDERING OPERATIONAL RISK MANAGEMENT OPERATIONALLY MANAGEABLE
12.5 RECOMMENDATIONS AND OUTLOOK
NOTES
REFERENCES
CHAPTER 13 - Operational Risk Management: An Emergent Industry
13.1 INTRODUCTION
13.2 OPERATIONAL RISK MANAGEMENT AS ENFORCED SELF-REGULATION
13.3 OPERATIONAL RISK: BIRTH OF AN INDUSTRY
13.4 CONCLUSION
REFERENCES
CHAPTER 14 - OpRisk Insurance as a Net Value Generator
14.1 INTRODUCTION
14.2 TREATMENT OF INSURANCE CONCEPTS UNDER BASEL II’S OPRISK CATEGORY
14.3 A MORE ENCOMPASSING VIEW ON INSURANCE CONCEPTS FOR OPRISK MANAGEMENT
14.4 RISK, COST OF CAPITAL, AND SHAREHOLDER VALUE
14.5 OPTIMIZATION OF THE TOTAL COST OF RISK
14.6 CONCLUSIONS, RECOMMENDATIONS, AND OUTLOOK FOR FURTHER RESEARCH
NOTES
REFERENCES
CHAPTER 15 - Operational Risk Versus Capital Requirements under New Italian ...
15.1 INTRODUCTION
15.2 OPERATIONAL RISK CAPITAL REQUIREMENTS UNDER ITALIAN INSTRUCTIONS FOR BANKS
15.3 DATA
15.4 METHODOLOGY
15.5 RESULTS
15.6 CONCLUSION
NOTE
REFERENCES
CHAPTER 16 - Simple Measures for Operational Risk Reduction? An Assessment of ...
16.1 INTRODUCTION
16.2 LOSS PROCESS AND CONTRACTS
16.3 PRICING OF INSURANCE CONTRACTS
16.4 RISK REDUCTION
16.5 MONTE CARLO SIMULATION
16.6 POLICY IMPLICATIONS
16.7 CONCLUSION
NOTES
REFERENCES
PART Four - Issues in Operational Risk Regulation and the Fund Industry
CHAPTER 17 - Toward an Economic and Regulatory Benchmarking Indicator for ...
17.1 INTRODUCTION
17.2 IMPORTANCE OF A SOUND LEGAL FRAMEWORK
17.3 LITERATURE ON STOCK MARKET RETURNS AND COUNTRY RISK
17.4 MARKET RISK AND ECONOMIC CAPITAL
17.5 SYSTEMIC EARNINGS AT RISK MODEL
17.6 INTERNATIONAL COMPARATIVE ADVANTAGE IN BANKING SYSTEMS
17.7 MODEL AND METHODOLOGY
17.8 ECONOMIC AND REGULATORY CAPITAL MODEL
17.9 DISCUSSION
17.10 CONCLUSION
NOTES
REFERENCES
CHAPTER 18 - Operational Risk Disclosure in Financial Services Firms
18.1 INTRODUCTION
18.2 RISK DISCLOSURE STUDIES
18.3 REGULATORY GUIDELINES ON RISK DISCLOSURE
18.4 STUDY OF OPERATIONAL RISK DISCLOSURES
18.5 CONCLUSION
NOTES
REFERENCES
CHAPTER 19 - Operational Risks in Payment and Securities Settlement Systems: A ...
19.1 INTRODUCTION
19.2 OVERVIEW OF THE REGULATORY APPROACHES TO OPERATIONAL RISK IN PCSSs
19.3 IMPLICATIONS OF OPERATIONAL RISK FOR PAYMENT, CLEARING, AND SETTLEMENT SYSTEMS
19.4 CONCLUSION
NOTES
REFERENCES
CHAPTER 20 - Actual and Potential Use of Unregulated Financial Institutions ...
20.1 HISTORY OF THE SUBPRIME CRISIS AND THE ROLE OF HEDGE FUNDS, FINANCE ...
20.2 CURRENT PRUDENTIAL REGULATORY SYSTEM GOVERNING NBFIs
20.3 ROLE OF HEDGE FUNDS
20.4 POTENTIAL FOR SYSTEMIC RISK AND CONTAGION FROM HEDGE FUNDS, MORTGAGE ...
20.5 LACK OF PROTECTION OF BORROWERS AND LENDERS EXPOSED BY THE SUBPRIME CREDIT CRISIS
20.6 MECHANISMS FOR TRANSNATIONAL CRIME
20.7 CONCLUSION: A REGULATORY BLACK HOLE AND A FIELD RIFE FOR FUTURE RESEARCH
NOTES
REFERENCES
CHAPTER 21 - Case Studies in Hedge Fund Operational Risks: From Amaranth to ...
21.1 INTRODUCTION
21.2 MARKET RISK AND OPERATIONAL RISK
21.3 DUE DILIGENCE AND MANAGER TRANSPARENCY
21.4 FOUR RECENT FRAUDS HIGHLIGHT THE IMPORTANCE OF OPERATIONAL RISKS
21.5 RED FLAGS IN THE HEDGE FUND INDUSTRY
21.6 PROPOSAL FOR PARTIAL TRANSPARENCY
21.7 CONCLUSION
REFERENCES
CHAPTER 22 - A Risk of Ruin Approach for Evaluating Commodity Trading Advisors
22.1 INTRODUCTION
22.2 DATA
22.3 METHODOLOGY
22.4 RESULTS
22.5 CONCLUSION
ACKNOWLEDGMENTS
REFERENCES
CHAPTER 23 - Identifying and Mitigating Valuation Risk in Hedge Fund Investments
23.1 INTRODUCTION
23.2 WHAT IS OPERATIONAL VALUATION RISK?
23.3 VALUATION RISK: STRATEGY RELATED
23.4 VALUATION RISK: CONTROL RELATED
23.5 EVALUATING AND MITIGATING VALUATION RISK
23.6 SUMMARY AND SYNTHESIS OF SOUND PRACTICE GUIDELINES FOR FUND VALUATION FROM ...
23.7 CONCLUSION
REFERENCES
Index
Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding.
The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation, and financial instrument analysis, as well as much more.
For a list of available titles, visit our Web site at www.WileyFinance.com.
Foreword
This is an important book, and it is published at just the right time. I have accepted with great pleasure the invitation to write the Foreword for Greg Gregoriou’s new volume on operational risk, but I had not anticipated that it would allow me to reflect on the concurrent unfolding of the disastrous September events. As one financial institution after another is failing or is subjected to an emergency sale, we start to comprehend that the basic rules of banking are in the process of being fundamentally redefined. A significant fallout for the real economy is by now more than likely, and the resulting political tremors will have a potentially decisive impact on the November elections. The reported loss figures are staggering and of almost incomprehensive magnitude for the average citizen. The rescue of the German IKB has, for instance, led to accumulated losses of 9 billion euros so far, an amount that is equivalent to an extra burden of approximately 300 euros for every taxpayer. Hundreds of billions of dollars need to be committed as part of the U.S. government’s bailout program, translating into a still-unknown cost for the U.S. taxpayer.
While the crisis is clearly of a systemic nature, its ultimate source lies with the notoriously myopic behavior of the banking community and, as some commentators have argued, is the outcome of collective greed. Bankers have increasingly viewed their careers as long call options that, in the worst case, could force them into a lengthy retirement in a lavish country home. The investor community valued the extraordinary returns and forced the banking community into a prisoner’s dilemma where playing the transaction game became a dominant strategy for everybody involved. Betting the bank by taking on excessive liquidity risk exposures was ultimately acceptable because the buildup of counterparty risk made a governmental bailout all the more likely. Industry insiders have warned for quite some time that credit volume growth far exceeding economic growth has historically always led to some form of a financial crisis. Without question, it is particularly worrisome that the whole problem did not appear on the radar of regulatory authorities until it was too late.
The subprime crisis and its fallout in financial markets as well as the real economy will trigger far-reaching regulatory reforms and should also lead to a toughening of the penalty structure for bankers in charge of running complex financial market operations. It, however, also requires institutional efforts by banks to reexamine and strengthen their approaches to risk management. Trading and credit risk management systems must obviously be extended to capture liquidity risk exposures. Financial institutions must, however, also reevaluate the way they are dealing with operational risks in order to impose checks and balances on the bankers’ irrational ignorance of the aforementioned prisoner’s dilemma problem. It will require changes in the governance structures and the development of adequate back-office systems.
We are still in the early stages of developing a sound understanding of operational risk management. Hence, there is still considerable scope for academics to make valuable contributions with their ongoing research. Greg Gregoriou’s new book helps to fill this knowledge gap and does so in a very timely fashion. It provides a comprehensive coverage of this exciting field, ranging from quantitative and qualitative risk measurement approaches to risk mitigation and regulatory implications. The edited volume includes American as well as European viewpoints and brings together academics as well as practitioners. The 23 chapters in total cover a lot of ground and give readers an in-depth overview of the current state of the art in operational risk management. While the contributors could not fully predict recent events, their contributions are nevertheless strongly influenced by the financial market woes of the past 14 months. This volume will therefore shape the discussion on how to better shield financial institutions against operational breakdown in future years.
—ULRICH HOMMEL, PH.D.
Professor of Corporate Finance and Director of the Strategic Finance
Institute (SFI), European Business School (EBS), International
University, Oestrich-Winkel, Germany
September 2008
About the Editor
Anative of Montreal, Dr. Gregoriou obtained his joint PhD at the University of Quebec at Montreal in Finance, which merges the resources of Montreal’s four major universities (McGill University, Concordia University, and HEC-Montreal). He has written over 50 articles on hedge funds and managed futures in various peer-reviewed publications. His articles have appeared in the Journal of Portfolio Management, Journal of Futures Markets, European Journal of Operational Research, Annals of Operations Research, and others. In addition to a multitude of publications with a variety of publishers, Gregoriou is author of the Wiley books Stock Market Liquidity; International Corporate Governance After Sarbanes-Oxley; Commodity Trading Advisors; Hedge Funds: Insights in Performance Measurement, Risk Analysis, and Portfolio Allocation; and Evaluating Hedge Fund and CTA Performance.
Professor Gregoriou is hedge fund editor and editorial board member for the Journal of Derivatives and Hedge Funds, as well as editorial board member for the Journal of Wealth Management, the Journal of Risk Management in Financial Institutions, and the Brazilian Business Review. Professor Gregoriou’s interests focus on hedge funds and managed futures.
Acknowledgments
I would like to thank Jennifer MacDonald, Bill Falloon, and Laura Walsh at John Wiley & Sons for their immense help. I am also deeply indebted to Dr. Georges Hübner, Deloitte Professor of Financial Management in the Department of Accounting, Finance and Law, HEC Management School- University of Liège, for his comments and valuable suggestions, and also thank Jean-Philippe Peters, manager at Deloitte Luxembourg S.A. Finally, I thank the handful of anonymous referees who assisted in the selection and review process of the chapters in this text. Neither the editor nor the publisher is responsible for the accuracy of each individual chapter.
About the Contributors
Marco Bee is Assistant Professor in Economic Statistics at the University of Trento (Italy). After spending one year as a visiting scholar at the Department of Mathematics of the Indiana University and receiving a PhD in Mathematical Statistics from the University of Trento in 1998 he has held positions at the Risk Management department of Banca Intesa in Milan from 1999 to 2005. His current research interests focus on quantitative risk management and computational statistics.
Keith H. Black serves as an associate at Ennis Knupp + Associates. He is a member of the firm’s opportunistic strategies group, which advises foundations, endowments, and pension funds on their asset allocation and manager selection strategies in the alternative investment space. His prior professional experience includes commodities derivatives trading at First Chicago Capital Markets, stock options research and CBOE market-making for Hull Trading Company, and building stock selection models for mutual funds and hedge funds for Chicago Investment Analytics. He has also served as a research consultant to an equity brokerage firm and a hedge fund marketing firm. Mr. Black contributes regularly to The CFA Digest, and has published in the Journal of Global Financial Markets, the Journal of Trading, the Journal of Financial Compliance and Regulation, and Derivatives Use Trading and Regulation. He is the author of Managing a Hedge Fund, which was named to the list of the top 10 books of 2005 by the Financial Engineering News. He has been quoted over 50 times on hedge fund and equity market topics in the print and broadcast media, including the Financial Times, Chicago Tribune, CFA Magazine, Pensions and Investments, NPR, Fox, and NBC. Mr. Black previously served as an assistant professor at the Illinois Institute of Technology, where he taught a variety of courses in portfolio management and alternative investments, including equity valuation, hedge funds, and enterprise formation and finance. Mr. Black earned a BA from Whittier College in Economics and Mathematics/Computer Science as well as an MBA in Finance and Operations Research from Carnegie Mellon University. He has earned the Chartered Financial Analyst (CFA) and the Chartered Alternative Investment Analyst (CAIA) designations. He serves as a member of the CFA Institute’s Retained Speakers Bureau, where he is regularly invited to present to CFA Society members worldwide on topics related to alternative investments.
Klaus Böcker is Senior Risk Controller at UniCredit Group. In this capacity, one of his primary responsibilities is overseeing all quantitative aspects of UniCredit Group’s economic capital model. He studied theoretical physics at the Munich University of Technology. His main research interest is quantitative finance with special focus on risk integration and operational risk. Mr. Böcker published several papers in Risk Magazine and the Journal of Risk, and together with his coauthor, Claudia Klüppelberg, he recently received the 2007 New Frontiers in Risk Management Award of the PRMIA Institute for their research paper entitled “Multivariate Models for Operational Risk.”
Silke N. Brandts is currently head of innovation and consulting management for transaction banking at DZ BANK in Frankfurt, Germany. Previously she was Project Manager at Bain & Company, Germany, in the financial service practice. She obtained her doctorate at the graduate program Finance and Monetary Economics at the Johann Wolfgang Goethe-Universität Frankfurt, Germany, after having pursued her Master’s degree in Economics at the Universities of Bonn, Germany, and University of California, Berkeley.
Nicole Branger is currently Professor for Derivatives and Financial Engineering at the Westfälische Wilhelms-Universität Münster. Previously she held positions as Associate Professor at the University of Southern Denmark, Odense, as Visiting Professor of Management at the Owen Graduate School of Management, Vanderbilt University, United States, and as Assistant Professor at the Johann Wolfgang Goethe-Universität Frankfurt, Germany. She obtained her doctorate as well as her Master’s in Industrial Engineering and Management at the University of Karlsruhe, Germany.
Tyrone M. Carlin is Professor and Dean of Law at Macquarie University and holds concurrent posting as Professor of Management at Macquarie Graduate School of Management. His research is concentrated in the areas of corporate governance and corporate financial reporting. He has published more than 100 articles in his fields of interest and is coeditor of the Journal of Law & Financial Management and the Journal of Applied Research in Accounting and Finance.
Simona Cosma is Researcher of Financial Institutions and Lecturer in Financial Institutions Management at the University of Salento (Italy). She holds a PhD in Banking and Finance from the University of Rome “Tor Vergata.” Her research interests and publications include risk management and bank organization and marketing. She has been also coordinator and lecturer in professional training courses for banks, and she also acted as a consultant for the Italian Bankers’ Association.
Carolyn Vernita Currie is a member of the Association of Certified Practising Accountants, the Chartered Secretaries Association, and a fellow of Finsia, a merger of the Australian Institute of Banking and Finance and the Securities Institute. She has almost four decades of experience in the public and private sector, as a merchant banker, regulator, internal auditor, and financial trainer. For the last 15 years she has been a Senior Lecturer in Financial Services at the University of Technology Sydney (UTS) as well as Managing Director of her own consulting company and several private investment companies.
Magali Dubosson is Dean of the Economics and Management Department of the Geneva School of Business Administration (HEG-Genève). She is a marketing professor at HEG Genève and also lecturer at EPFL, Essec Management Education Paris and at Ecole des Ponts et Chauss’es Paris (AFT-IFTIM). She got her Master’s degree in International Management and her PhD at HEC, University of Lausanne. Her main research interests are the pricing of services, customer service, and business models.
Giuseppe Espa is Professor in Economic Statistics at the University of Trento (Italy). In 1995 he received a PhD in Statistics from the University of Rome “La Sapienza.” From 1994 to 2001 he was assistant professor and from 2001 to 2006 associate professor in economic statistics. He has been working with the Italian National Statistical Office (Istat), the Italian National Research Council (CNR), and the College of Europe. His main research interests concern spatial econometrics and applied statistics.
John Evans holds a PhD from the University of Illinois. He is currently a Professor and Pro Vice Chancellor of Curtin University in Miri, Sarawak. He is a well-experienced academic with a corporate finance background, and he is well published in internationally refereed journals in financial economics and corporate finance.
Dean Fantazzini is a Lecturer in econometrics and finance at the Moscow School of Economics—Moscow State University. He graduated with honors from the Department of Economics at the University of Bologna (Italy) in 1999. He obtained a Master’s in Financial and Insurance Investments at the Department of Statistics—University of Bologna (Italy) in 2000 and a PhD in Economics in 2006 at the Department of Economics and Quantitative Methods, University of Pavia (Italy). Before joining the Moscow School of Economics, he was a research fellow at the Chair for Economics and Econometrics, University of Konstanz (Germany) and at the Department of Statistics and Applied Economics, University of Pavia (Italy). He is a specialist in time series analysis, financial econometrics, multivariate dependence in finance, and economics with more than 20 publications.
Nigel Finch is a lecturer in Management at the Macquarie Graduate School of Management, specializing in the areas of managerial accounting and financial management. His research interests are in the areas of accounting and management decision making, finance and investment management, and financial services management. Prior to joining Macquarie Graduate School of Management, Mr. Finch worked as a financial controller for both public and private companies operating in the manufacturing, entertainment, media, and financial services industries. Subsequently he worked as an investment manager specializing in Australian growth stocks for institutional investment funds.
Guy Ford is Associate Professor of Management at Macquarie Graduate School of Management, where he teaches in the areas of financial management, corporate acquisitions, corporate reconstructions, and financial institutions management. Formerly of the Treasury Risk Management Division of the Commonwealth Bank of Australia, he has published refereed research papers in a range of Australian and international journals and is the coauthor of two books, Financial Markets & Institutions in Australia and Readings in Financial Institutions Management. He is a founding coeditor of the Journal of Law and Financial Management.
Emmanuel Fragnière, CIA (Certified Internal Auditor), is a professor of service management at the Haute Ecole de Gestion of Geneva, Switzerland. He is also a lecturer at the Management School of the University of Bath, UK. He specializes in energy, environmental, and financial risk. He has published several papers in academic journals such as Annals of Operations Research, Environmental Modeling and Assessment, Interfaces, and Management Science.
Giampaolo Gabbi is Professor of Financial Markets and Risk Management at the University of Siena, Italy, and Professor SDA Bocconi Milan, where he coordinates several executive courses on financial forecasting and risk management. He coordinates the McS in Finance at the University of Siena and is also head of the Master’s in Economics at the same university. Professor Gabbi holds a PhD in Banking and Corporate Management. He has published many books and articles in refereed journals, including Managerial Finance, the European Journal of Finance, and the Journal of Economic Dynamics and Control.
Andrea Giacomelli is Professor of Contract in Risk Management at the Ca’ Foscari University of Venice, is collaborating with GRETA Consulting (a division of Ca’ Foscari FR s.r.l.), and is a partner in Financial Innovations, an Italian consulting firm specialized in risk management. He holds a degree from the Ca’ Foscari University of Venice (Laurea in Economics). His research interests are in risk measurement and management, pricing of assets subjected to credit risk, credit scoring models, back-testing of rating systems, statistical analysis of subjective information, Bayesian networks, and econometrics. His main advisory experiences concern the development of credit rating systems and the development of approaches for the subjective analysis of risks. He teaches risk management in the International Master’s in Economics and Finance program and Market and Credit Risk in the undergraduate program, and he is one of the local organizers of the CREDIT conference in Venice.
Werner Gleissner is currently the CEO of FutureValue Group AG and a Managing Director of RMCE RiskCon GmbH. The author of more than 100 articles and more than a dozen books, his current research and development activities and projects focus on risk management, rating, strategy development, the development of methods for aggregating risks, value-based management valuation, decision making under uncertainty, and imperfect capital markets. Dr. Werner lectures at various universities in the field of rating, risk management, value-based management, and entrepreneurship. Dr. Werner is also the editor of the well-known loose-leaf series on corporate risk management (“Risikomanagement im Unternehmen”). He holds a degree as a commercial engineer equivalent to a Master’s in Business Engineering and a PhD in Economics and Econometrics, both from the University of Karlsruhe, Germany.
Duc Pham-Hi, PhD, is Professor of Computational Finance at ECE Graduate School of Engineering in Paris, France, and Partner at R2M-Analytics. Formerly Senior Attach’ at French Commission Bancaire, member of the European Union’s CEBS Op Risk working group, and Basel Accord Implementation Group on Op risk (AIGOR), he was previously proprietary trader at Natexis Banque, then director at PriceWaterhouseCoopers.
Georges Hübner, PhD, INSEAD, is the Deloitte Professor of Financial Management and cochair of the Finance Department at HEC Management School of the University of Liège. He is Associate Professor of Finance at Maastricht University and Academic Expert at the Luxembourg School of Finance, University of Luxembourg. He is also the founder and CEO of Gambit Financial Solutions, a financial software spin-off company of the University of Liège. Dr. Hübner has taught at the executive and postgraduate levels in several countries in Europe, North America, Africa, and Asia. He regularly provides executive training seminars for the preparation of the GARP (Global Association of Risk Professionals) and CAIA (Chartered Alternative Investment Analyst) certifications. His research articles have been published in leading scientific journals, including Journal of Banking and Finance, Journal of Empirical Finance, Review of Finance, Financial Management, and Journal of Portfolio Management. Dr. Hübner was the recipient of the prestigious 2002 Iddo Sarnat Award for the best paper published in the Journal of Banking and Finance in 2001. He is also corecipient of the Operational Risk & Compliance Achievement Award 2006 in the best academic paper category.
Andreas A. Jobst is a midcareer economist at the Monetary and Capital Markets Department (MCM) of the International Monetary Fund (IMF) in Washington, DC. His research focuses on structured finance, risk management, sovereign debt management, financial regulation, and time series econometrics. He previously worked at the Division for Insurance and Research at the Federal Deposit Insurance Corporation (FDIC), the Deutsche Bundesbank, the Center for Financial Studies (CFS) in Frankfurt/Main, the European Central Bank (ECB), the Bank of England, the Comisi’n Econ’mica para Am’rica Latina y el Caribe (CEPAL) of the United Nations, the European Securitization Group of Deutsche Bank, and the Boston Consulting Group (BCG). Mr. Jobst holds a PhD in Finance from the London School of Economics (LSE). He was also educated in Oxford, Cambridge, Leicester, and Maryland. Dr. Jobst is a regular speaker at professional and academic conferences on risk management and structured finance. His most recent research was published in Derivatives Use, Trading & Regulation, Journal of Derivatives and Hedge Funds, Managerial Finance, International Journal of Emerging Markets, Journal of Banking Regulation, Journal of Structured Finance, International Journal of Banking Law and Regulation, Journal of Operational Risk, Journal of Financial Regulation and Compliance, The Securitization Conduit, Operational Risk & Compliance, and Euromoney. He has also been one of the authors of the Global Financial Stability Report published by the Monetary and Capital Markets Department of the International Monetary Fund (2005-2007).
Meredith A. Jones is Director of Market Research at Strategic Financial Solutions, LLC, a software company founded in 1996 whose mission is to provide solutions relating to the technological needs of the financial industry. She is responsible for researching, speaking, and writing about alternative and traditional investments as well as developing and implementing marketing initiatives and strategic partnerships for SFS. She has written articles for a number of financial publications, including the Journal of the Alternative Investment Management Association, Alternative Investment Quarterly, the Investment Management Consultants Association’s Monitor, and the Managed Funds Association Reporter. Her research has appeared in the Wall Street Journal, Bloomberg Wealth Manager, Hedge Fund Alert, Infovest 21, and other publications. Prior to joining SFS, Ms. Jones was Vice President and Director of Research for Van Hedge Fund Advisors International, Inc., a global hedge fund consultant with $500 million under management. There she led a staff of 10 research analysts in manager selection, evaluation, and ongoing monitoring. Ms. Jones conducted quantitative and qualitative due diligence, on-site visits and portfolio construction, as well as a number of other research functions.
Claudia Klüppelberg holds the Chair of Mathematical Statistics at the Center for Mathematical Sciences of the Munich University of Technology. She has held positions at the University of Mannheim and in the Insurance Mathematics group of the Department Mathematik at ETH Zurich. Her research interests combine applied probability and statistics with special application to finance and insurance risk processes. She is an Elected Fellow of the Institute of Mathematical Statistics, a member of the Editorial Board of the Springer Finance book series, and associate editor of several scientific journals. Besides numerous publications in scientific journals, Dr. Klüppelberg coauthored the book Modelling Extremal Events for Insurance and Finance (Springer 1997) with P. Embrechts and T. Mikosch.
K. Ahmet Köse is Associate Professor in the Business Administration School of Istanbul University in Istanbul, Turkey. He received his PhD and Master’s degree in Finance from Istanbul University and was at the University of Illinois as a visiting scholar. His main interests are corporate finance and capital markets. His papers have been published in the Journal of Business Administration, International Journal of Business Management and Economics , and other journals. He served as the editor of Journal of Business in the B-School at Istanbul University and was vice-director of the Social Sciences Institute. He is a member of the Society of Certified Public Accountants of Istanbul. He is also a part-time adviser of a leading company in the Turkish Logistics industry.
Kimberly D. Krawiec is a Professor of Law at the University of North Carolina and has taught at many other law schools, including Harvard, Virginia, and Northwestern. She teaches courses in securities, corporate, and derivatives law. Professor Krawiec’s research interests span a variety of fields, including the empirical analysis of contract disputes; the choice of organizational form by professional service firms, including law firms; banned commercial exchanges; corporate compliance systems; insider trading; derivatives hedging practices; and “rogue” trading. Prior to joining academia, she was a member of the Commodity & Derivatives Group at the New York office of Sullivan & Cromwell. Professor Krawiec has served as a commentator for the Central European and Eurasian Law Initiative (CEELI) of the American Bar Association and on the faculty of the National Association of Securities Dealers Institute for Professional Development at the Wharton School of Business. Representative recent publications include: “Common-law Disclosure Duties and the Sin of Omission: Testing the Meta-theories” (with K. Zeiler), 91 VA. L. REV. 1795 (2005); “Organizational Misconduct: Beyond the Principal-Agent Model,” 32 FL. ST. L. REV. 571 (2005); “The Economics of Limited Liability: An Empirical Study of New York Law Firms” (with S. Baker), 2005 U. ILL. L. REV. 107 (2005); “Cosmetic Compliance and the Failure of Negotiated Governance,” 81 WASH. U. L. Q. 487 (2003); and “Accounting for Greed: Unraveling the Rogue Trader Mystery,” 72 OR. L. REV. 301 (2000).
Wilhelm K. Kross is currently Senior Vice President at Marsh GmbH, Germany, with previous working experience in Africa and North America. He holds a postgraduate degree in engineering from RWTH Aachen, Germany, an executive MBA from Athabasca University, Canada, and a PhD in Finance from the European Business School (EBS) International University, Germany. He is a recognized expert in the fields of project and risk management and is the author of numerous publications, including Organized Opportunities: Risk Management in Financial Services Operations (Wiley, 2006).
Mar’a Dolores Mart’nez Miranda is Associate Professor at the Faculty of Sciences in the University of Granada (Spain). She received her PhD in Mathematics from the University of Granada in 2000. Her current research interests include nonparametric density and regression estimation, mixed-effects model, and survey sampling.
Jens Perch Nielsen is Professor of Actuarial Statistics at Cass Business School, London, and CEO of the Danish-based knowledge company Festina Lente. He holds a degree in actuarial science from Copenhagen and in statistics from UC-Berkeley. He is former research director of Royal@SunAlliance with responsibilities in life as well as in non-life insurance. He is coauthor of about 50 scientific papers in journals of actuarial science, econometrics, and statistics.
Loriana Pelizzon is Associate Professor of Economics at the Ca’ Foscari University of Venice. She graduated from the London Business School with a PhD in Finance. She also holds a degree from the University of Venice (Laurea in Business Administration). She was Assistant Professor in Economics at the University of Padova from 2000 until 2004. Her research interests are on risk measurement and management, asset allocation and household portfolios, hedge funds, financial institutions, and financial crisis. Her work includes papers published in the Journal of Financial and Quantitative Analysis, Journal of Banking and Finance, European Journal of Finance, Journal of Economics and Business, Journal of Empirical Finance, and presentations at the Western Finance Association and European Finance Association. Professor Pelizzon has been awarded the EFA 2005—Barclays Global Investor Award for the Best Symposium paper and FMA European Conference 2005 best conference paper. She participates in many research projects and has acted as a referee for many prestigious journals. Moreover, she is a member of the Program Committee of the European Finance Association Conferences, coordinator of the EFA Doctoral Tutorial, and a member of the Teaching Committee of the PhD in Economics, University of Venice. She teaches Financial Economics and Investments in the International Master in Economics and Finance program as well as Economics and Financial Economics in the undergraduate program. She has been awarded the Best Teacher 2006 at the Ca’ Foscari University of Venice. She frequently advises banks and government agencies on risk measurement and risk management strategies through her collaboration at GRETA Consulting, a division of Ca’Foscari FR s.r.l., and she is one of the local organizers of the CREDIT conference in Venice.
Jean-Philippe Peters is Manager at Deloitte Luxembourg, working in the Enterprise Risk Services unit. His expertise focuses on risk measurement and management for financial institutions, and he was actively involved in numerous Basel II-related assignments for institutions in Luxembourg, Belgium, Norway, United Arab Emirates, and South Korea. Beside his practical experience, Mr. Peters is the author of several academic publications on operational risk modeling. He is also corecipient of the Operational Risk & Compliance Achievement Award 2006 in the best academic paper category. Mr. Peters holds a Master’s in Business Management from University of Liège, and he is a certified Financial Risk Manager (FRM) by the Global Association of Risk Professionals. He is finishing his PhD in Finance at the HEC Management School of the University of Liège.
Omar Rachedi received a BA degree and a MSc in Economics from the University of Pisa (Italy). He was an assistant of Professor Carlo Bianchi, Department of Economics at the University of Pisa (Italy) and now is a consultant in quantitative risk management for Deloitte Italia S.p.A. Mr. Rachedi’s research interests include practical and theoretical aspects of multivariate models for risk management, with a focus on operational risk.
Fabrice Douglas Rouah is a Vice President for State Street Corporation in Boston, Massachusetts. He received his PhD in Finance and his M.Sc. in Statistics from McGill University, and his B.Sc. in Applied Mathematics from Concordia University. Dr. Rouah is the coauthor and coeditor of five books on hedge funds and option pricing, and his research is published regularly in peer-reviewed academic journals.
Daniela Russo has been Deputy Director General of the Directorate General Payment Systems and Market Infrastructure since June 2005, having joined the European Central Bank in 1998. She is a member of the SWIFT Oversight Groups; the Clearing, the Settlement Advisory and Monitoring Expert (CESAME) Group; and the Monitoring Group on the implementation of the Code of Conduct. Ms. Russo is chairperson of various internal working groups of the Eurosystem (including the Contact Group on Euro Securities Infrastructure [COGESI]) and of the CPSS working group on cross-border collateral arrangements.
Gianfausto Salvadori holds a PhD in Applied Mathematics and is Researcher of Probability and Mathematical Statistics at the University of Salento (Lecce, Italy). His research interests and publications concern the application of the theory of extreme values to geophysical phenomena and the modeling of multivariate extreme events via copulas.
John L. Simpson has a PhD from the University of Western Australia and a Master’s of Commerce from Curtin University. He is currently an Associate Professor in the School of Economics and Finance at Curtin University in Western Australia. He is well published in international refereed journals of economics and financial economics on the broad research areas of international banking and finance and international risk management.
M. Nihat Solakoğlu is Assistant Professor in the Banking and Finance Department of Bilkent University in Ankara, Turkey. Previously he was assistant professor in the Department of Management at Fatih University. Before joining Fatih University, he worked for American Express in the United States in international risk management, international information management, information and analysis, and fee services marketing departments. He received his PhD in Economics and Master’s in Statistics from North Carolina State University. His main interests are applied finance and international finance. His papers have been published in Applied Economics, Journal of International Financial Markets, Institutions & Money, and Journal of Economic and Social Research, and others.
Stefan A. Sperlich is Chair of Econometrics at the Georg August University Göttingen, Faculty of Economic Sciences. He holds degrees from Göttingen and Humboldt University, Berlin. His primary research interest is in applied econometrics, econometric theory, and nonparametric inference.
Pietro Stecconi graduated in Economics at the University of Rome “La Sapienza” and postlaureate specialized in Banking and Finance. After working at a commercial bank as portfolio manager, he joined the Banca d’Italia in 1989 in the payment systems area, where he has been dealing primarily with financial markets policy issues. Currently he is responsible for the regulation and supervision of the Italian securities settlement system and central clearing counterparty. Over the last years he took part in several national and international groups in the field of financial markets posttrading systems. Currently he is member of the ECB Securities Settlement Working Group and Contact Group on Euro Securities Infrastructures (COGESI) and, at national level, represents the bank at the Monte Titoli Express Users Group. Publications: “Le procedure di liquidazione dei titoli in Italia,” Banca d’Italia (1991); “Guida al prestito titoli in Italia,” Bancaria Editrice (1996); “Mercati dei derivati, controllo monetario e stabilità finanziaria,” Il Mulino (2000).
Maike Sundmacher is a Lecturer in Finance at the School of Economics & Finance, University of Western Sydney. She teaches in Corporate Finance, Bank Management, and Credit Risk Management. Ms. Sundmacher is enrolled in a PhD degree at the Macquarie Graduate School of Management and researches in the areas of capital markets and risk management in financial institutions.
Niklas Wagner is Professor of Finance at Passau University, Germany. Former teaching positions were at Hannover, Munich, and Dresden. After receiving his PhD in Finance from Augsburg University in 1998, Professor Wagner held postdoctoral visiting appointments at the Haas School of Business, University of California Berkeley, and Stanford GSB. Academic visits also led him to the Center of Mathematical Sciences at Munich University of Technology and to the Faculty of Economics and Politics, University of Cambridge. Professor Wagner has coauthored several international contributions, for example, articles in Economic Notes, Quantitative Finance, the Journal of Banking and Finance, and the Journal of Empirical Finance. He regularly serves as a referee for finance and economics journals. His research interests include empirical asset pricing, applied financial econometrics, and market microstructure as well as banking and risk management. His industry background is in quantitative asset management with HypoVereinsbank and Munich Financial Systems Consulting.
Thomas Wenger is Senior Associate in Financial Risk Management at KPMG Germany, which he joined in 2006. His experience in projects at small, medium, and large European banks is in economic capital management, regulatory issues in the Basel-II framework, and model quality assurance in derivatives pricing and rating models. Dr. Wenger earned his PhD in Mathematics from Muenster University in 2000. He was a Boas Assistant Professor of Mathematics at Northwestern University from 2001 to 2004, after visiting Northwestern with a research grant from the German Research Council in 2001. In 2005 he was awarded a EU grant and visited the University of Genoa. His research interests include the mathematical study of questions in integrated risk management and credit risk management.
Jennifer Westaway has a degree in law and a Master’s in Bioethics from Monash University and a PhD from Curtin University. She is currently an academic in the School of Business Law at Curtin University. Her research interests and strong publication areas include international comparative law and banking law as well as industrial and human rights law.
Operational Risk toward Basel III
PART One
Operational Risk Measurement: Qualitative Approaches
CHAPTER 1
Modeling Operational Risk Based on Multiple Experts’ Opinions
Jean-Philippe Peters and Georges Hübner
ABSTRACT
While the Basel II accord has now gone live in most parts of the world, many discrepancies still remain on advanced modeling techniques for operational risk among large international banks. The two major families of models include the loss distribution approaches (LDAs) that focus on observed past internal and external loss events and the scenario-based techniques that use subjective opinions from experts as the starting point to determine the regulatory capital charge to cover operational risk. A major methodological challenge is the combination of both techniques so as to fulfill Basel II requirements. In this chapter we discuss and investigate the use of various alternatives to model expert opinion in a sound statistical way so as to allow for subsequent integration with loss distributions fitted on internal and/or external data. A numerical example supports the analysis and shows that solutions exist to merge information arising from both sources.
Georges Hübner gratefully acknowledges financial support from Deloitte Luxembourg.
1.1 INTRODUCTION
The revised Framework on Capital Measurement and Capital Standards for the banking sector, commonly referred to as Basel II, has now gone live in most parts of the world. Among the major changes introduced in this new regulatory framework are specific capital requirements to cover operational risk, defined by the Accord as the “risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk” (BCBS 2005).
Operational risk management is not new to financial institutions: stability of information technology (IT) systems, client claims, acts of fraud, or internal controls failures have been closely monitored for years. However, these elements have historically been treated separately. Basel II combines all items into one single integrated measurement and management framework.
Three methods are proposed by Basel II to measure the capital charge required to cover operational risk. The two simplest ones—the basic indicator approach and the standardized approach—define the operational risk capital of a bank as a fraction of its gross income; the advanced measurement approach (AMA) allows banks to develop their own model for assessing the regulatory capital that covers their yearly operational risk exposure within a confidence interval of 99.9% (henceforth this exposure is called operational value at risk, or OpVaR).
To comply with regulatory requirements, a sound AMA framework combines four sources of information:
1. Internal operational risk loss data
2. Relevant external operational risk loss data
3. Scenario analysis of expert opinion
4. Bank-specific business environment and internal control factors
The relative weight of each source and the way to combine them together are up to the banks; Basel II does not provide a regulatory model.
This chapter mainly relates to the third element—operational risk quantification using experts’ opinion—and how it can successfully be addressed so as to produce outcome that can be combined with other elements (i.e., internal and external loss data).