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Extreme Risks and the New Capital Allocation Charge for Operational Risks

Dr Elena Medova
Centre for Financial Research, The Judge Institute of Management, University of Cambridge
Email: e.medova@jims.cam.ac.uk|

Date: 26 February 2002
Time: 1:00pm - 2:30pm
: CARR Seminar Room, H615


One of the principal objectives of the current Basel proposal is prevention of 'the low-probability, high-severity event that can produce losses large enough to threaten a financial institution's health' [McDonough, 1998]. The complexity of the originating causes for such events and the rare nature of significant losses lead us to capital allocation rules based on results from Extreme Value Theory. A desire to integrate operational risk capital provision with that for market and credit risks is another motivation for the proposed framework. Common definitions of market and credit risks assume 'normal' conditions and do not include extreme events. We define operational risk as a consequence of critical contingencies leading to extreme losses. Such operational risk is captured by losses that exceed some statistically defined threshold value. Our operational risk capital allocation rule is derived from the statistics of the loss process and provides an estimate for the excess capital provision over existing allocation for market and credit risk. A combined allocation of economic capital for market, credit and operational risks reinforces a risk sensitive approach to management corresponding to the firm's mix of business, performance and level of capitalization.