We perform operational risk capital calculations using any of the following advanced approaches based on the respective financial institutions’ requirements:
Loss Distribution Approach:
- LDA is based on the assumption that there is a fixed and stable relationship (linear or non linear) between expected and unexpected losses.
- In a linear relationship, the capital charge is a simple multiple of expected losses, whereas in a non-linear relationship, the capital charge is a complex function of expected losses
- Overall distribution of losses is derived from the frequency and severity distribution for each business line / risk-type cell over some future horizon (generally, one year)
- The resulting capital charge is based on a very high percentage of the loss distribution.
Scenario Based Approach:
- This approach calculates the impact of extreme, but plausible events, that may not have occurred previously
- We define the scenarios, which are tailored to the institution’s business environment, and capture changes in internal and external situations.
- We derive the business environment and internal control factors from the KRI or the self-assessment results.
Many financial institutions began their operational risk assessments with a pure Loss Distribution Approach (LDA) for economic and regulatory capital, while others, due to lack of sufficient data, used the Scenario Based Approach (SBA). However, as of now, many banks and FIs are converging towards a Hybrid Measurement Approach (HMA), which includes both LDA and SBA concepts.