Constraints of Operational Risk Measurement and the Treatment of Operational Risk Under the New Basel Framework

Abstract

Amid increased size and complexity of the banking industry, operational risk has a greater potential to transpire in more harmful ways than many other sources of risk. This paper provides a succinct overview of modeling constraints and critical issues of consistent risk estimation under current regulatory standards. In particular, we show how the varying characteristics of operational risk and different methods to identify, collect and report operational risk losses influence the reliability and consistency of operational risk estimates. The implications of our findings offer instructive and tractable recommendations for a more effective operational risk measurement.

Keywords: risk management, operational risk, risk management, financial regulation, Basel Committee, Basel II, fat tail behavior, extreme tail behavior

JEL Classification: G10, G21, K20