Operational Risk Capital Provisions for Banks and Insurance Companies

Operational risk has become recognized as a major risk class because of huge operational losses experienced by many financial firms over the last past decade. Unlike market risk, credit risk, and insurance risk, for which firms and scholars have designed efficient methodologies, there are few tools to help analyze and quantify operational risk. The new Basel Revised Framework for International Convergence of Capital Measurement and Capital Standards (Basel II) gives substantial flexibility to internationally active banks to set up their own risk assessment models in the context of the Advanced Measurement Approaches (AMA). This paper investigates the implications for using the AMA as amethod to assess operational risk capital charges for banks and insurance companies within Basel II paradigms and with regard to U.S. regulations. The AMA developed in the paper uses actuarial loss
models complemented by the extreme value theory to determine the empirical probability distribution function of the aggregated capital charges in the context of various classes of copulas. Publicly available operational risk loss data set is used for the empirical exercise.