Modeling operational risk incorporating reputation risk: An integrated analysis for financial firms

Abstract

It has been shown in the empirical literature that operational losses of financial firms can cause severe reputational losses, which, however, are typically not taken into account when modeling and assessing operational risk. The aim of this paper is to fill this gap by assessing the consequences of operational risk for a financial firm including reputational losses. Toward this end, we extend current operational risk models by incorporating reputation losses. We propose three different models for reputation risk: a simple deterministic approach, a stochastic model using distributional assumptions, and an extension of the second model by taking into account a firm’s ability to deal with reputation events. Our results emphasize that reputational losses can by far exceed the original operational loss and that neglecting reputational losses may lead to a severe underestimation of certain operational risk types and especially fraud events.