Ops Risk Capital – High Severity Low Frequency Risk

[Anonymous]

Hi,

In Question 239, it says that “High severity very low frequency risk” is likely to have ops risk capital = zero.
But in question 237, Low Severity/High Frequency is LOWER than High Severity/Low Frequency. How can this be if High Sev/Low Freq is already zero?

I understand it like this… do I have something wrong?
Low Severity/High Frequency (such as credit cards) = Lowest Ops Risk Capital
Medium Severity/Medium Frequency (‘fat-finger’ errors) = Medium Ops Risk Capital
High Severity/Low Frequency (risk of rogue trader) = Highest Ops Risk Capital

Thanks
Jeff

Question 239 : When compared to a medium severity medium frequency risk, the operational risk capital requirement for a high severity very low frequency risk is likely to be:
(a) Higher
(b) Lower
(c) Zero
(d) unaffected by differences in frequency or severity

The correct answer is choice ‘c’

Question 237 : When compared to a high severity low frequency risk, the operational risk capital requirement for a low severity high frequency risk is likely to be:

(a) Lower
(b) Zero
(c) Higher
(d) unaffected by differences in frequency or severity
Your Answer is Correct The correct answer is choice ‘a’

[Jeffrey Chudy]

Ops Risk Capital – High Severity Low Frequency Risk

[Anonymous]

Jeff,
On first reading this, my view was that your understanding was totally correct. But there is one issue that just struck me – the VERY in “very low frequency risk” (as opposed to just “low frequency risk”). Maybe what it’s saying here is that we don’t necessarily provide for risk capital in respect of “VERY low probability” events of a cataclysmic nature?

Jim

[Anonymous]

Jeff,

Jim is right, the way it would work is:

For high frequency/low severity loss events, the losses would generally be borne as the cost of doing business and mostly built into the P&L as regular operational charges accrued. No risk capital will be required for that. These are no different from say, salary or utility bill payments for the business. No capital requirements. A little beyond this would require some capital, but not as much as that for a low frequency but high severity event.

On the other end of the spectrum, very low frequency/high severity events, such as a meteor strike, would lie beyond the confidence level desired. For example, if we are looking at the 99% confidence level, such events would lie in the 1% for which no capital is reserved. Because if firms have to be prepared for *everything*, then they can’t do business at all. You keep capital only till the 99th (or 95th) percentile of your loss distribution, and not beyond that. The ‘very low frequency’ events lie beyond this level, and are not provided for in the capital calculations.

And in the middle, beyond regular expected operational losses and upto the desired confidence levels, for low, medium & high frequency events, we keep capital.

Hope this helps.

[Author]

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