Risk Capital Reserve and Measurement Precision in Modeling Heavy-Tailed Single Operational Losses

25 Pages Posted: 28 Jan 2020

See all articles by Jianming Mo

Jianming Mo

Southwestern University of Finance and Economics (SWUFE)

Xiang Gao

Shanghai Business School

Date Written: 2019

Abstract

Heavy and long tails of loss distributions, an extremely high confidence level and parameter-estimation-based measurement techniques can lead to measurement errors in the calculation of capital reserve for external risks faced by financial institutions. However, studies on the connectedness between the capital reserve and the measurement uncertainty are surprisingly sparse. Our paper attempts to simultaneously quantify single operational losses using a general convolution approach and compute the precision of the quantification output using an error propagation theory. By linking these two models up, we find a nonmonotonic and uncertain relationship between the risk capital estimate and its precision, with exact patterns determined by a set of characteristic parameters of the loss distributions chosen. Such patterns are substantiated by the empirical evidence from the literature. This paper provides a rationale for adopting quantitative buffer capital, designed to absorb variations due to measurement errors, especially those originating from the estimation risk.

Keywords: operational risk, loss distribution approach (LDA), measurement precision, error propagation theory, capital buffer requirements

Suggested Citation

Mo, Jianming and Gao, Xiang, Risk Capital Reserve and Measurement Precision in Modeling Heavy-Tailed Single Operational Losses (2019). Journal of Operational Risk, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3526220

Jianming Mo

Southwestern University of Finance and Economics (SWUFE) ( email )

55 Guanghuacun St,
Chengdu, Sichuan 610074
China

Xiang Gao (Contact Author)

Shanghai Business School ( email )

Shanghai Business School
2271 West Zhongshan Road
Shanghai, 200235
China

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