The Binomial Bookstore

OPERATIONAL RISK:
MEASUREMENT AND MODELLING
by Jack L. King

(Subject: Finance & Investments / Financial Engineering)

“Operational risk is emerging as the third leg of an institutional risk strategy for financial
institutions. Now recognized as a potential source of financial waste, operational risk has
become the subject of surveys, analysis, and the search for a comprehensive set of
definitions and a shared framework. Written by a leading expert on operational risk
measurement, this important work puts forth a cradle-to-grave hands-on approach that
concentrates on measurement of risk in order to provide the needed feedback for managing
and mitigating it. Using both theoretical and practical material, he lays out a foundation
theory
that can be applied and refined for application in the financial sector and beyond which
includes a new technique called Delta-EVT(trademark). This technique is a combination of
two existing methods which provides for the complete measurement of operational risk loss.
The book contains comprehensive step-by-step descriptions based on real-world examples,
formulas and procedures for calculating many common risk measures and building causal
models using Bayesian networks, and background for understanding the history and
motivation for addressing operational risk.”

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“In this groundbreaking work, Jack L. King, Ph.D. provides the basis for an in-depth
understanding of operational risk by focusing on its measurement and modelling. Using both
theoretical and practical material, he lays out a foundation theory that can be applied and
refined for application in the financial sector and beyond.

OPERATIONAL RISK: MEASUREMENT AND MODELLING is a comprehensive
source
for understanding the effects of risk inherent in all operations. This book:

- Provides a set of assumptions, definitions, and methodology for quantifying
operational
risk.
- Uses comprehensive step-by-step descriptions based on real-world examples to
demonstrate the application and reinforce key ideas.
- Introduces Delta-EVT(tm), a new technique that allows firms to deal with losses
resulting
from routine errors, control breakdowns, and rare events.
- Relies on causality as the key for identifying operational risk that can be controlled
and
provides a basis for management action.
- Explains clearly the relation between the risk assessment, process engineering,
and
statistical loss models.
- Includes and explains in detail the formulas and procedures for calculating many
common risk measures and building causal models using Bayesian networks.

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“Dr King introduces practical solutions to a subject that is in danger of being drowned in
theory.” - Philip Martin, Managing Director, HSBC Operational Risk Consultancy

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“Jack King draws together a number of theoretical approaches to present, in a
comprehensive yet straightforward manner, a systematic framework that supports the
measurement and modelling of operational risk. As such, this book should prove thought
provoking and act as an invaluable reference for both practitioners and students of the
subject alike. A welcome addition to the debate.” -Tim Kent-Phillips, Executive Director,
Operations, Lehman Brothers International Europe Ltd.

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“Dr. King’s work shows clearly his first-hand experience in the financial sector and should
enable practitioners to do a superb job of building an operational risk measurement system.
The in-depth understanding you need to set things up from scratch is contained in this book.”
- Dr Gabor Laszlo, Vice President, Market Risk Management, J.P Morgan Chase & Co.

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“I believe this book makes a very valuable contribution to the ongoing discussion about how
operational risk should be addressed. Practitioners, regulators and academics will discover
useful elements to enhance their conceptual understanding of operational risk, from a
perspective of measurement, control and management, as well as how it is linked to the
calculation of economic capital requirements.” - Dr. Daniel Egloff, Arthur Andersen.

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“Risk to firms is increasing and can't be avoided. Dealing with this increased risk is essential
to financial institutions and the whole economy.

“The rapid pace of technological advancement and financial innovation has introduced new,
highly complex elements of risk.” - William McDonough, Chairman, Bank for International
Settlements, 20 September 2000

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“The redistribution of risk induces more investment in real assets and hence engenders
higher standards of living.” -Alan Greenspan, Chairman, US Federal Reserve, 14 October
1999

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“Recently a large focus of regulatory attention has been on what is known as operational risk.
Operational risk is concerned with the risk to the firm's performance due to how the firm is
operated as opposed to how the firm is financed.

“Operational risk is a topic which... for the great majority of banks now concerns them as
much as credit or market risk. It is a topic to which they will be devoting greater resources
and attention over the next few years. " -Tim Sweeney, Director General, British Bankers
Association, 1998

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“The general consensus is that much can be done to avoid future disasters by taking a
systematic approach to reducing the risk in current operations, but the challenge is finding a
way to identify the causes of operational risk and measuring their potential impact on the
earnings of
the firm. This major work by a leading expert in operational risk measurement puts forth a
cradle-to-grave hands-on approach that concentrates on measurement of risk in order to
provide the needed feedback for its management and mitigation.

“OPERATIONAL RISK: MEASUREMENT AND MODELLING represents a new approach to
increasing the value of the firm by providing a way to measure operational risk and enabling
firms to better control the variability or risk of earnings in their operations. It is an enlightening
introduction to a new way of looking at the operations of a business, and the theoretical
foundations ensure that the methodologies will be generally applicable and stable over time.”

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CONTENTS

PREFACE

ACKNOWLEDGMENTS

SECTION I INTRODUCTION TO OPERATIONAL RISK

1 INTRODUCTION TO OPERATIONAL RISK
1.1 Introduction
1.2 Operational Risk Example: An Automobile Journey
1.3 Defining Operational Risk
1.4 Addressing Operational Risk
1.5 Measuring and Modelling Operational Risk
1.6 What are the Next Steps?
1.7 Overview of this Book
1.8 Further Reading

2 HISTORICAL LOSSES
2.1 Introduction
2.2 Attribution of Loss
2.3 Very Large Losses
2.4 Operational Risk Failures
2.5 Other Losses
2.6 Summary
2.7 Further Reading

3 REGULATION
3.1 Introduction
3.2 Background
3.3 Banking Supervision
3.4 Corporate Governance
3.5 Summary
3.6 Further Reading

SECTION II MEASURING OPERATIONAL RISK

4 A MEASUREMENT FRAMEWORK FOR OPERATIONAL RISK
4.1 Introduction
4.2 Framework Criteria
4.3 Current Framework Approaches
4.4 Framework Assumptions
4.5 Framework Definitions
4.6 A Framework for Measuring Operational Risk
4.7 Operational Risk Measures
4.8 How Delta-EVT(tm) Supports Operational Risk Management
4.9 Steps for Implementing the Framework
4.10 Summary
4.11 Further Reading

5 THE DELTA METHODOLOGY
5.1 Introduction
5.2 Key Concepts of the Delta Method
5.3 The Delta Method Implementation Steps
5.4 Calculating the Threshold
5.5 Advantages of the Delta Method
5.6 Detailed Examples of the Delta Method
5.7 Value at Risk for Operational Losses
5.8 Summary
5.9 Further Reading

6 THE EVT METHODOLOGY
6.1 Introduction
6.2 Basic Concepts
6.3 EVT Loss Model Example for Large Operational Losses
6.4 Summary
6.5 Further Reading
SECTION III MODELLING OPERATIONAL RISK

7 Delta-EVV Models for Operational Risk

7.1 Introduction
7.2 Business Model
7.3 Risk Models
7.4 Loss Models
7.5 Scenarios
7.6 Risk Measures
7.7 In-Depth Example-Genoa Bank
7.8 Summary
7.9 Further Reading

8 CAUSAL MODELLING
8.1 Introduction
8.2 What is Causality?
8.3 What are Causal Models?
8.4 Causal Modelling Concepts
8.5 Causal Relations
8.6 Using Causal Models
8.7 Causal Model for Settlement Risk
8.8 Assessing Possible Intervention
8.9 Scenario and Simulation with Causal Models
8.10 Practical Issues
8.11 Summary
8.12 Further Reading

9 CAUSAL MODELS FOR OPERATIONAL RISK
9.1 Introduction
9.2 Advantages of Causal Models for Operational Risk
9.3 Building a Causal Model for Operational Risk
9.4 Implementing Causal Models for Operational Risk
9.5 Example Calculations: Genoa Bank Example Using Causal Models
9.6 Advanced Uses of Causal Models for Operational Risk
9.7 Summary
9.8 Further Reading

SECTION IV MATHEMATICAL FOUNDATIONS

10 ERROR PROPAGATION
10.1 Introduction
10.2 Measurement Standards
10.3 Importance of Measurement Error
10.4 Basic Error Model
10.5 Direct Measurement
10.6 Indirect Measurement
10.7 Identifying Measurement Outliers
10.8 Other Measurement Topics
10.9 Summary
10.10 Further Reading

11 EXTREME VALUE THEORY
11.1 Introduction
11.2 Basic Concepts
11.3 Excess Loss Distribution
11.4 Time-Dependent Losses
11.5 EVT Applied to Internal Losses
11.6 Summary
11.7 Further Reading

12 BAYESIAN METHODS
12.1 Introduction
12.2 What are Bayesian Methods?
12.3 Key Concepts
12.4 Bayes' Theorem
12.5 Bayesian Networks
12.6 Summary
12.7 Further Reading

SECTION V APPENDICES

GLOSSARY

BIBLIOGRAPHY

INDEX

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ABOUT THE AUTHOR

“DR. JACK L. KING is the managing director of Genoa (UK) Limited, a consulting and
software company specialising in risk. He brings to the firm almost 30 years' experience in
technology and its application to risk.

“From August 1998 to November 2000 Dr King worked as Director, Operational Risk for
Algorithmics, Incorporated. Before joining Algorithmics, Dr King was a Director in the New
York Financial Consulting Practice of Price Waterhouse, with a concentration in market and
credit risk. From 1992--1996, Dr King was a scientist with the United Nations' International
Atomic Energy Agency in Vienna, Austria where he developed enhanced systems for the
measurement and control of global nuclear risk.

“Dr King's education includes a Ph.D. in Computer Science, MBA, MA Finance, BS
Computer Science, and BS Electrical Engineering. He is a member of IEEE and ACM and
is
a frequent contributor to risk-related magazines and newsletters.”

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2001, 261 pages. Order #DR554.
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