The Bayesian Approach to Capital Allocation at Operational Risk: A Combination of Statistical Data and Expert Opinion

Mohamed Habachi,Saã¢D Benbachir

doi:10.3390/ijfs8010009

Abstract

Operational risk management remains a major concern for financial institutions. Indeed, institutions are bound to manage their own funds to hedge this risk. In this paper, we propose an approach to allocate one’s own funds based on a combination of historical data and expert opinion using the loss distribution approach (LDA) and Bayesian logic. The results show that internal models are of great importance in the process of allocating one’s own funds, and the use of the Delphi method for modelling expert opinion is very useful in ensuring the reliability of estimates.

Highlights

Since the 1990s, the Basel Committee and researchers have tried to define an incontestable framework for modelling and managing operational risk
With regard to the minimum capital requirement, the legislator under the Basel II offered banks several approaches and methods for calculating operational risk depending on the degree of control and the availability of the information required for internal modelling
We show the interest of internal models in the allocation of equity capital based on the loss distribution approach (LDA) approach and propose a practical approach based on the Delphi method to adjust historical data by expert opinions, using Bayesian logic to determine the risk measure to be used in the capital allocation and applying the proposed approach for the allocation of capital for the retail banking business line of a Moroccan banks

Summary

Introduction

Since the 1990s, the Basel Committee and researchers have tried to define an incontestable framework for modelling and managing operational risk. The efforts made have shown that theoretical and practical mastery of this risk is far from being achieved. Operational risk management practice is based on an approach composed of four steps: Identification, assessment of impact, classification of risks, and implementation of action plans. The risk management process must be able to ensure perfect knowledge and control of operational risk at the level of the various activities exercised. With regard to the minimum capital requirement, the legislator under the Basel II offered banks several approaches and methods for calculating operational risk depending on the degree of control and the availability of the information required for internal modelling. The regulator proposes, on the one hand, simple, unified, and standardized approaches whose characteristics are provided by him and, on the other hand, complicated and sophisticated approaches whose characteristics are determined by banks

Methods

Discussion

Conclusion