Benchmarking Operational Risk Models

Abstract

The 2004 Basel II accord requires internationally active banks to hold regulatory capital for operational risk, and the Federal Reserve's Comprehensive Capital Analysis and Review (CCAR) requires banks to project operational risk losses under stressed scenarios. As a result, banks subject to these rules have measured and managed operational risk more rigorously. But some types of operational risk - particularly legal risk - are challenging to model because such exposures tend to be fat-tailed. Tail operational risk losses have significantly impacted banks' balance sheets and income statements, even post crisis. So, operational risk practitioners, bank analysts, and regulators must develop reasonable methods to assess the efficacy of operational risk models and associated equity financing. We believe benchmarks should be used extensively to justify model outputs, improve model stability, and maintain capital reasonableness. Since any individual benchmark can be misleading, we outline a set of principles for using benchmarks effectively and describe how these principles can be applied to operational risk models. Also, we provide some examples of the benchmarks that have been used by US regulators in assessing Advanced Measurement Approach (AMA) capital reasonableness and that can be used in CCAR to assess the reasonableness of operational risk loss projections. We believe no single model's output and no single benchmark offers a comprehensive view, but that practitioners, analysts, and regulators must use models combined with rigorous benchmarks to determine operational risk capital and assess its adequacy.