Operational Risk Management: Preventive vs. Corrective Control
39 Pages Posted: 20 Dec 2017
Date Written: November 1, 2017
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
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