Article

Journal of Financial Services Research

, Volume 41, Issue 3, pp 145-161

A Theoretical Framework for Incorporating Scenarios into Operational Risk Modeling

  • Bakhodir A. ErgashevAffiliated withThe Federal Reserve Bank of Richmond Email author 

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Abstract

In this paper, I introduce a theoretically justified framework that incorporates scenario analysis into operational risk modeling. The basis for the framework is the idea that only worst-case scenarios contain valuable information about the tail behavior of operational losses. In addition, worst-case scenarios introduce a natural order among scenarios that makes possible a comparison of the ordered scenario losses with the corresponding quantiles of the severity distribution that research derives from historical losses. Worst-case scenarios contain information that enters the quantification process in the form of lower bound constraints on the specific quantiles of the severity distribution. The framework gives rise to several alternative approaches to incorporating scenarios.

Keywords

Operational risk Scenario analysis Constrained estimation The Markov chain Monte Carlo method (MCMC) Stochastic dominance

JEL Classification

G21 G14 G20