Scenario Analysis in the Measurement of Operational Risk Capital: A Change of Measure Approach

Abstract

At large financial institutions, operational risk is gaining the same importance as market and credit risk in the capital calculation. Although scenario analysis is an important tool for financial risk measurement, its use in the measurement of operational risk capital has been arbitrary and often inaccurate. We propose a method that combines scenario analysis with historical loss data. Using the Change of Measure approach, we evaluate the impact of each scenario on the total estimate of operational risk capital. The method can be used in stress-testing, what-if assessment for scenario analysis, and Loss Given Default estimates used in credit evaluations.

Keywords: Scenario Analysis, Operational Risk Capital, Stress Testing, Change of Measure, Loss Data Modeling, Basel Capital Accord

JEL Classification: G10, G20, G21, D81