Loss Distribution Approach for the Operational Risk Economic Capital

Following the Basel II Capital Accord, with the increased focus on operational risk as a distinct theme from credit and market risk, quantification of the operational risk has been a major challenge for the financial institutions. In this study, we propose a loss distribution based approach consistent with Basel II guidelines, to estimate the Economic Capital for the Operational Risk at the firm level. This approach accounts for both firm specific and industry related (‘Financial Services’) components of the operational risk. To serve this purpose, inline with the guidelines, the method utilizes internal loss data for the institution itself and the external loss data for the ‘Financial Services’ industry. The results suggest that, after addressing the selection bias in external data as suggested by the previous studies; proposed LDA based approach provides Economic Capital estimate within the expected range. Model’s EC estimation over the past nine quarters suggests that, two components of the proposed model are consistent and comparable overtime.