Operational Risk Management: Preventive vs. Corrective Control

39 Pages Posted: 20 Dec 2017

See all articles by Yuqian Xu

Yuqian Xu

University of Illinois at Urbana-Champaign - College of Business

Lingjiong Zhu

University of Minnesota - Minneapolis

Michael Pinedo

New York University (NYU) - Leonard N. Stern School of Business

Date Written: November 1, 2017

Abstract

In this paper, we propose a general modeling framework for operational risk management of financial firms. We consider operational risk events as shocks to a financial firm's value process, and then study capital investments in preventive and corrective controls to mitigate risk losses.

The optimal decisions would be made under three scenarios:

(i) preventive control only,

(ii) corrective control only, and

(iii) joint controls.

We characterize the optimal control policies under a general modeling framework under these three scenarios, and then discuss an exponential risk reduction function. We conclude our work with an implementation of our model to a data set from a commercial bank. We find that through a proper investment strategy, we can achieve a significant performance improvement, especially when the risk severity level is high. At the bank we analyze, we find that within a certain range of the frequency reduction efficiency we can achieve up to 2.5% improvement in the expected bank revenue; within a proper range of risk severity reduction efficiency, we can achieve an improvement of up to 1.5%. In general, our modeling framework, which combines a typical operational risk process with stochastic control, may suggest a new research direction in operations management and operational risk management.

Keywords: operational risk, stochastic control, jump process, investment

Suggested Citation

Xu, Yuqian and Zhu, Lingjiong and Pinedo, Michael, Operational Risk Management: Preventive vs. Corrective Control (November 1, 2017). Available at SSRN: https://ssrn.com/abstract=3088729 or http://dx.doi.org/10.2139/ssrn.3088729

Yuqian Xu (Contact Author)

University of Illinois at Urbana-Champaign - College of Business ( email )

Champaign, IL 61820
United States

Lingjiong Zhu

University of Minnesota - Minneapolis ( email )

206 Church Street SE
Minneapolis, MN 55455
United States

Michael Pinedo

New York University (NYU) - Leonard N. Stern School of Business ( email )

44 West 4th Street
Suite 9-160
New York, NY NY 10012
United States

Register to save articles to
your library

Register

Paper statistics

Downloads
165
Abstract Views
673
rank
180,518
PlumX Metrics