Flexible Dependence Modeling of Operational Risk Losses and Its Impact on Total Capital Requirements

Abstract

Operational risk data, when available, are usually scarce, heavy-tailed and possibly dependent. In this work, we introduce a model that captures such real-world characteristics and explicitly deals with heterogeneous pairwise and tail dependence of losses. By considering flexible families of copulas, we can easily move beyond modeling bivariate dependence among losses and estimate the total risk capital for the seven- and eight-dimensional distributions of event types and business lines. Using real-world data, we then evaluate the impact of realistic dependence modeling on estimating the total regulatory capital, which turns out to be, as often expected, up to 38% smaller than what the standard Basel approach would prescribe.

Keywords: operational risk, risk capital, dependence modeling, zero inflation, Student's t copula, vine copula

JEL Classification: C1, C5, C30