A Loss Distribution for Operational Risk Derived from Pooled Bank Losses

Abstract

The Basel II accord encourages banks to develop their own Advanced Measurement Approaches (AMA). However, the paucity of loss data implies that an individual bank cannot obtain a probability distribution with any reliability. We propose a model, targeting the regulator initially, by obtaining a probability distribution for loss magnitude using pooled annual risk losses from the banks under the regulator’s oversight. We start with summarized loss data from 63 European banks and adjust the probability distribution obtained for losses that go unreported by falling below the threshold level. Using our model, the regulator has a tool for understanding the extent of annual operational losses across all the banks under its supervision. The regulator can use the model on an ongoing basis to make comparisons in year-on-year changes to the operational risk profile of the regulated banking sector.

Keywords: Basel II, AMA, loss distribution model, empirical data