Combining Scenario and Historical Data in the Loss Distribution Approach: A New Procedure that Incorporates Measures of Agreement between Scenarios and Historical Data

32 Pages Posted: 30 Jun 2016

See all articles by Riaan de Jongh

Riaan de Jongh

North-West University

T de Wet

North-West University

Helgard Raubenheimer

North-West University

Johannes Hendrik Venter

North-West University - Center for Business Mathematics

Date Written: March 30, 2015

Abstract

Many banks use the loss distribution approach in their advanced measurement models to estimate regulatory or economic capital. This boils down to estimating the 99.9% value-at-risk of the aggregate loss distribution and is notoriously difficult to do accurately. Also, it is well-known that the accuracy with which the tail of the loss severity distribution is estimated is the most important driver in determining a reasonable estimate of regulatory capital. To this end, banks use internal data and external data (jointly referred to as historical data) as well as scenario assessments in their endeavor to improve the accuracy with which they estimate the severity distribution. In this paper, we propose a simple new method whereby the severity distribution may be estimated using both historical data and experts' scenario assessments. The way in which historical data and scenario assessments are integrated incorporates measures of agreement between these data sources, which can be used to evaluate the quality of both. In particular, we show that the procedure has definite advantages over traditional methods in which the severity distribution is modeled and fitted separately for the body and tail parts, with the body part based only on historical data and the tail part based on scenario assessments.

Keywords: loss distribution approach, severity distribution estimation, aggregate loss distribution estimation, combining historical data with scenario information, measures of agreement

Suggested Citation

de Jongh, Pieter Juriaan and de Wet, T and Raubenheimer, Helgard and Venter, Johannes Hendrik, Combining Scenario and Historical Data in the Loss Distribution Approach: A New Procedure that Incorporates Measures of Agreement between Scenarios and Historical Data (March 30, 2015). Journal of Operational Risk, Vol. 10, No. 1, 2015. Available at SSRN: https://ssrn.com/abstract=2802544

Pieter Juriaan De Jongh (Contact Author)

North-West University ( email )

Private Bag X6001
Potchefstroom, Northwest 2520
South Africa

T De Wet

North-West University ( email )

Private Bag X6001
Potchefstroom, Northwest 2520
South Africa

Helgard Raubenheimer

North-West University ( email )

Private Bag X6001
Potchefstroom, Northwest 2520
South Africa

Johannes Hendrik Venter

North-West University - Center for Business Mathematics ( email )

Potchefstroom Campus
POTCHEFSTROOM 2520
South Africa

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