After studying this chapter, you should be able to:
1 Understand how the frequency and severity of risks are categorised
2 Understand the three basic methods used to estimate the frequency and severity of loss events: historical analysis, subjective risk assessment, and causal or statistical models
3 Have a basic understanding of the Basel II approach to operational risk capital charge
4 Explain the loss distribution approach and the challenges of collecting loss data
In many ways, identifying risk factors is the easy part of an operational risk management framework. Perhaps more challenging, once risk factors have been identified and categorised, is to put an estimated number to the potential losses associated with specific risk categories and events.
Operational risk managers typically take two main factors into consideration when working to determine the actual impact of a particular loss event: frequency and severity. In general, the more frequent loss events tend to be less severe. Small miscalculations in customer transactions are problematic when multiplied by several hundreds of thousands or even millions but they do not, individually, pose a significant risk to the operations of a bank. By contrast, as we discussed in Chapter 3, rare but huge events such as bombings or massive frauds happen rarely but can cripple an institution with a single blow if the right plans are not in place to handle the ...