Abstract

http://ssrn.com/abstract=1990376
 
 

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Estimating Operational Risk Capital: The Challenges of Truncation, the Hazards of MLE, and the Promise of Robust Statistics


J.D. Opdyke


DataMineit, LLC

Alexander Cavallo


Northern Trust Corporation

January 23, 2012

The Journal of Operational Risk, Forthcoming

Abstract:     
In operational risk measurement, the estimation of severity distribution parameters is the main driver of capital estimates, yet this remains a non-trivial challenge for many reasons. Maximum likelihood estimation (MLE) does not adequately meet this challenge because of its well-documented non-robustness to modest violations of idealized textbook model assumptions, specifically that the data are independent and identically distributed (i.i.d.), which is clearly violated by operational loss data. Yet even under i.i.d. data, capital estimates based on MLE are biased upwards, sometimes dramatically, due to Jensen’s inequality. This overstatement of the true risk profile increases as the heaviness of the severity distribution tail increases, so dealing with data collection thresholds by using truncated distributions, which have thicker tails, increases MLE-related capital bias considerably. Truncation also augments correlation between a distribution’s parameters, and this exacerbates the non-robustness of MLE. This paper derives influence functions for MLE for a number of severity distributions, both truncated and not, to analytically demonstrate its non-robustness and its sometimes counterintuitive behavior under truncation. Empirical influence functions are then used to compare MLE against robust alternatives such as the Optimally Bias-Robust Estimator (OBRE) and the Cramér-von Mises (CvM) estimator. The ultimate focus, however, is on the economic and regulatory capital estimates generated by these three estimators. The mean adjusted single-loss approximation (SLA) is used to translate these parameter estimates into Value-at-Risk (VaR) based estimates of regulatory and economic capital. The results show that OBRE estimators are very promising alternatives to MLE for use with actual operational loss event data, whether truncated or not, when the ultimate goal is to obtain accurate (non-biased) and robust capital estimates.

Number of Pages in PDF File: 70

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Date posted: January 23, 2012 ; Last revised: August 3, 2012

Suggested Citation

Opdyke, J.D. and Cavallo, Alexander, Estimating Operational Risk Capital: The Challenges of Truncation, the Hazards of MLE, and the Promise of Robust Statistics (January 23, 2012). The Journal of Operational Risk, Forthcoming. Available at SSRN: http://ssrn.com/abstract=1990376 or http://dx.doi.org/10.2139/ssrn.1990376

Contact Information

J.D. Opdyke (Contact Author)
DataMineit, LLC ( email )
17 McKinley Road
Marblehead, MA 01945
United States
617-943-6463 (Phone)
781-639-6463 (Fax)
HOME PAGE: http://www.DataMineIt.com/index.htm
Alexander Cavallo
Northern Trust Corporation ( email )
50 South LaSalle Street
Chicago, IL 60603
United States
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