Portfolio modelling of operational losses John Gavin 1, QRMS, Risk Control, UBS, London. April 2004. What is operational risk Trends over time Empirical distributions Loss distribution approach Compound distributions References 1 The views expressed are those of the author and necessarily those of UBS AG. Portfolio modelling of operational losses 1 of 20
What is operational risk ˆ Operational losses usually mean unexpected losses from the failure of normal business processes. There is no universal agreement on the definition of operational risk but, for banks, it usually includes losses from transaction processing error (e.g. fraudulent cheques), security (e.g. virus infection) and liability (e.g. sued for giving bad advice). ˆ Regulators will require banks to set aside capital to provide a buffer against such losses. Calculating this risk capital is the subject of this paper. ˆ Operational loss data typically consists of events where the vast majority of losses are small in magnitude, combined with a few losses several orders of magnitude higher. Portfolio modelling of operational losses 2 of 20
ˆ It is generally believed that the occasional large loss is what impacts the bank s reputation and what most concerns regulators, due to the possibility of systemic risk. R and UBS R is being introduced within UBS as a complement to S-Plus for cost reasons. It is an ideal platform for data analysis and statistical modelling for experienced users [1]. For example, this presentation was prepared using R, Sweave, XEmacs and ESS. R (on Windows) needs a GUI for less experienced users, who invariably rely on Excel. Portfolio modelling of operational losses 3 of 20
Cumulative loss (net of gains) 0 1 2 3 4 5 Line A (3078) Trends over time Jan Feb Mar Apr May Jun Jan Feb Mar Apr May Jun Time (daily) 0.0 0.5 1.0 1.5 2.0 2.5 Line B (783) Cumulative daily losses for two business lines (event counts in brackets). To illustrate the method, consider (rescaled) loss events arising from transaction processing of corporate trade settlements. Small losses steadily accumulate, with a few large losses. The latter drive overall costs and hence the risk. Portfolio modelling of operational losses 4 of 20
Frequency of daily events 0 10 20 30 40 Line A (3078) Line B (783) Jan Feb Mar Apr May Jun Jan Feb Mar Apr May Jun Time (daily) 0 5 10 15 20 Daily count of events In general, time trends and clustering are difficult to detect and are complicated by the definition of date (e.g. occurrence, identification or reporting). Here, daily counts are used because of the limited data. Typically, weekly or monthly figures are used for practical reasons. Portfolio modelling of operational losses 5 of 20
Empirical distributions Line A (3078) Line B (783) Percentile plots of event severity on a log- 10 scale. Event severity has a very skewed distribution. The verticle blue lines are the 25 th, 50 th and 75 th percentiles. The top 5 individual losses are shown as red tick marks. 0.5 0.0 0.5 1.0 1.5 Daily total losses (log 10 scale) Portfolio modelling of operational losses 6 of 20
B A 0 10 20 30 40 Daily frequency of events Percentile plots of event frequency are not skewed, compared to severity. For longer time horizons (e.g. monthly), the empirical frequency distributions tend towards a Poisson for high-frequency data, like transaction processing errors. Portfolio modelling of operational losses 7 of 20
Frequency of daily events Daily total losses (log 10 scale) 0 10 20 30 40 0.5 0.0 0.5 1.0 1.5 Line A (3078) 0 5 10 15 20 0.6 0.4 0.2 0.0 0.2 0.4 Line B (783) Dependence between frequency and severity In general, the largest total-daily losses are not due to a large number of small losses; typically they consist of one large loss combined with some small losses. There is no evidence of dependency between frequency and severity for longer time horizons. Portfolio modelling of operational losses 8 of 20
Loss distribution approach The LDA is based on an actuarial approach, fitting separate distributions to the frequency N and severity X of events, then combining them into a compound distribution, Z = N i=1 X i. Event frequency For comparison, two frequency distributions are fitted: Poisson and negative binomial. lambda size mu Line A (3078).estimate 24.0 13.4 24.0 Line B (783).estimate 6.3 9.1 6.3 Line A (3078).sd 0.4 2.9 0.7 Line B (783).sd 0.2 2.8 0.3 Table 1: Parameter estimates of event frequency - for the Poisson (lambda) and negative binomial (size and mu) distributions, by MLE, with standard errors on the bottom two rows. Portfolio modelling of operational losses 9 of 20
QQ-plots with (smoothed) confidence envelopes are used as a graphical goodness of fit test. The results are in figures 1 and 2. Event severity The severity distribution is based on the semiparametric model of Coles and Tawn (1991, 1994) and Heffernan and Tawn 2003 [2]. (The latter also discusses dependency in the tail between two marginals.) Univariate extreme value theory provides an asymptotic justification for the generalized Pareto distribution (gpd) as an appropriate model for the distribution of excesses over some sufficiently high threshold u [3]. So the (marginal) tail of the severity distribution, X is Pr(X > x + u X X > u X ) = (1 + ξx/β) 1/ξ, where x > 0 and β and ξ are the scale and shape parameters, respectively. Portfolio modelling of operational losses 10 of 20
Line A (3078) Line B (783) 20 40 Empirical quantiles 30 20 10 Empirical quantiles 15 10 5 0 0 15 20 25 30 35 Poisson quantiles 5 10 Poisson quantiles Figure 1: QQ-envelopes for Poisson fits - The lines are smoothed upper and lower 2.5, 12.5 and 25 percent confidence envelopes, for the theoretical distributions, via Monte Carlo. Days when lots of events occur are of interest but the Poisson tends to underestimate those. Days with no events are less of a concern economically. Portfolio modelling of operational losses 11 of 20
Line A (3078) Line B (783) 60 20 Empirical quantiles 40 20 Empirical quantiles 15 10 5 0 0 10 20 30 40 50 Negative binomial quantiles 0 5 10 15 Negative binomial quantiles Figure 2: QQ-envelopes for negative binomial fits - The negative binomial is less likely to underestimate the largest number of events that might occur on a day. It is a more conservative choice than a Poisson, from a risk capital viewpoint. Portfolio modelling of operational losses 12 of 20
With F X as the empirical distribution of X, the unconditional distribution is ˆF X (x) = { 1 {1 F X (u X )}{1 + ξ(x u X )/β} 1/ξ, for x > u X F X (x) for x u X. Fitting is based on probability weighted moments. (MLE and method of moments are also considered but not shown in detail.) Given specific numbers of exceedences above a threshold, sample threshold values are: 15 30 60 Line A (3078) 0.031 0.012 0.006 Line B (783) 0.035 0.012 0.005 Portfolio modelling of operational losses 13 of 20
Given different threshold levels, parameter estimates of event severity for both lines are: subport numexceed xi beta threshold probltthres worstlosses 1 Line A (3078) 60 0.84 0.01 0.006 0.981 1,0.9,0.3,0.1 2 Line A (3078) 29 0.77 0.02 0.012 0.991 1,0.9,0.3,0.1 3 Line A (3078) 15 0.74 0.05 0.031 0.995 1,0.9,0.3,0.1 4 Line B (783) 15 0.67 0.02 0.035 0.981 0.5,0.2,0.1,0.1 5 Line B (783) 60 0.65 0.01 0.005 0.923 0.5,0.2,0.1,0.1 6 Line B (783) 30 0.49 0.02 0.012 0.962 0.5,0.2,0.1,0.1 Estimates are via probability weighted moments. Portfolio modelling of operational losses 14 of 20
Line A (3078) Line A (3078) 4 4 Empirical quantiles 3 2 Empirical quantiles 3 2 1 1 0 0 0.0 0.2 0.4 0.6 Gpd quantiles 0.0 0.2 0.4 0.6 Gpd quantiles Figure 3: QQ-envelopes of Gpd fits for line A - with 15 and 30 points in the tails, respectively. The level of uncertainty generated by fat-tailed distributions is very material. (These gpd confidence envelopes are unsmoothed.) Portfolio modelling of operational losses 15 of 20
Line B (783) Line B (783) 1.0 1.0 Empirical quantiles 0.5 Empirical quantiles 0.5 0.0 0.0 0.05 0.10 0.15 0.20 0.25 0.30 Gpd quantiles 0.05 0.10 0.15 0.20 0.25 0.30 Gpd quantiles Figure 4: QQ-envelopes of Gpd fits for line B - with 15 and 30 points in the tails, respectively. Portfolio modelling of operational losses 16 of 20
β = (beta parameter of the gpd) 0.020 0.022 0.024 0.026 0.028 0.030 0.032 max at (0.413,0.027) 0.30 0.35 0.40 0.45 0.50 0.55 ξ = (shape parameter of the gpd) Profile of the MLE for business line B, with 30 exceedences in the tail. Typically, the MLE surface if fairly flat, especially for the shape parameter, ξ. This large standard error can result in materially different capital charges, see [4] for more. Compare estimates to probability weighted moments in table. Portfolio modelling of operational losses 17 of 20
UL = 8 99% VaR = 12.9 EL = 4.95 UL = 3.3 99% VaR = 8.2 EL = 4.87 UL = 6.6 99% VaR = 11.4 EL = 4.83 Compound distributions 0.005thres,60excd 0.012thres,30excd 0.035thres,15excd 0 50 100 150 Annualised aggregated loss Percentile plots of annualised loss distributions for line B with different thresholds. Expected loss (EL), value at risk (VaR) and capital charge (Unexpected Loss) are annotated. UL is very sensitive to the shape (ξ) parameter. (Scaling from daily to annual (252) and 99% VaR are heroic assumptions.) Portfolio modelling of operational losses 18 of 20
References References [1] R Development Core Team (2004). R: A language and environment for statistical computing. R Foundation for Statistical Computing, Vienna, Austria. ISBN 3-900051-00-3. URL: Comprehensive R Archieve Network http://www.r-project.org. 3 [2] A conditional approach for multivariate extreme values, J. E. Heffernan and J. A. Tawn, RSS Research Section Ordinary Meeting, Wednesday, October 15th, 2003. 10 [3] Pickands, J. (1975) Statistical inference using extreme order statistics. Ann. Statist., 3, 119 31. 10 [4] Using Loss Data to Quantify Operational Risk, Patrick de Fontnouvelle, Virginia DeJesus- Rueff, John Jordan, Eric Rosengren, Federal Reserve, Bank of Boston, April, 2003. See section VI (page 19) and Table 5 (page 32). 17 Portfolio modelling of operational losses 19 of 20
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