Operational risk : A Basel II++ step before Basel III

Following the Banking Committee on Banking Supervision, operational risk quantification is based on the Basel matrix which enables sorting incidents. In this paper we analyze these incidents in depth and propose strategies for carrying out the supervisory guidelines proposed by the regulators. The objectives are as follows: • On the first hand, banks need to provide a univariate capital charge for each cell of the Basel matrix. That requires constructing Loss Distribution Functions (LDFs), which implies estimating a frequency and a severity distribution. We show that the choice of the theoretical distributions to build the LDFs has a tremendous impact on the capital charges, especially if we do not take into account extreme losses. • On the other hand, banks also need to provide a global capital charge corresponding to the whole matrix. We highlight that a lack of consideration or a poor appreciation of the dependence structure may lead to incorrect capital charges. • Finally, we draw the attention of regulators and managers to two crucial points: 1. The necessity of splitting information sets in two parts while adjusting the severity distribution. The first covering small and medium losses, and the latter containing extreme losses (this point implies problems of granularity mentioned in the last Basel II guidelines), 2. The choice of the risk measure which provides the capital amount. We emphasize that the expected shortfall measure enables a better anticipation of large incidents pertaining to operational risks.