Operational Risk Models for Basel Pillar 2 Capital Assessment
Summary
The document asks what best practices and regulatory references should guide internal operational risk models for Basel Pillar 2, including models that produce value-at-risk or a similar capital measure. It lists components associated with the loss distribution approach: modelling event frequency and severity, handling heterogeneous losses and large losses, combining internal data with scenario analysis, and aggregating risks with numerical methods.
The response says the regulatory picture is uncertain and offers only partial guidance. It cites the Basel Committee’s move to a single Standardised Approach for Pillar 1, replacing earlier Pillar 1 methods, and suggests that an updated standard approach is expected there. It also notes that richer internal data and machine learning could eventually improve understanding of loss drivers and dependencies, but that this area remains under development. The answer does not establish what Pillar 2 supervisors require, nor does it give a complete model specification or authoritative Pillar 2 reference list.
Key ideas
- Loss distribution models commonly separate operational loss frequency from severity.
- Large losses may require heavy-tail methods or extreme value techniques.
- Scenario analysis and internal loss data can be combined using approaches such as Bayesian methods or credibility weighting.
- The cited Pillar 1 change concerns a standardised capital approach and does not settle Pillar 2 model requirements.
- Machine learning and enriched internal data are described as developing areas rather than established Pillar 2 methods.
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Full text
# Modelling operational risk for Basel pillar 2 (internal model for OpRisk VaR) # Modelling operational risk for Basel pillar 2 (internal model for OpRisk VaR) I am somewhat familiar with OpRisk for pillar 1. As far as I know OpRisk for pillar 1 will be replaced by standard approaches soon. So what is left is proper modelling in pillar 2. What are best practice and/or regulatory references on how an internal model for OpRisk (with the result of a value-at-risk or similar) for pillar 2 should look like? From a talk on the web I found the usual topics from a loss distribution approach (LDA): - Loss Distribution Approach (LDA): frequency/severity, models, heterogeneity - Modelling large losses: EVT, heavy tailed distributions, single loss approximation - Combining data and scenario analysis: Bayesian approach, p-boxes, credibility - Numerical methods for Aggregation of risks: MC, FFT, Panjer recursion Would the regulatory expect all of this for pillar 2? ## Answer by not2qubit (score 1) https://quant.stackexchange.com/a/41959 Not a complete answer put perhaps partial help. - What alternatives do we have for pillar 2? Hard to say. There doesn't seem to be any specific alternatives, apart adjusting your old procedures to whatever the institutions you are working with require. 2: Does it have to be a loss distribution approach (LDA) or could it be something between LDA and a standard approach (SA)? Something less challenging as an LDA but more sensitive than an SA? From the first § of Basel 4: the way ahead: > The BCBS has introduced a single non‑model based method for the calculation of operational risk (OpRisk) capital, the Standardised Approach (SA). This will replace all three existing approaches for OpRisk under Pillar 1: the Basic Indicator Approach (BIA), the (Alternative) Standardised Approach (TSA/ASA) and the Advanced Measurement Approach (AMA). The SA will apply from 1 January 2022. So, yes, it seem that it will be an updated SA. Also from here: > The simplicity of current approaches to loss event dependency warrants considerable improvement, and with machine learning techniques coming to the forefront of model construction, investing in enrichment of internal data – from systems to management surveys, employee satisfaction surveys and cultural assessments – may, in time, provide insights into loss drivers and the dependency of losses across an organisation. This area, however, is under development and some way off inclusion in Pillar 2 capital calculation methods.
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