This post about extreme operational events was added by Maxime Laot supervisor at European Central Bank.

Another type of extreme events

Extreme events in finance do not consist in stock market crashes only. Unfortunately, their scope is much broader than the volatility of asset prices such as stocks, bonds, commodities or currencies. Extreme events occur as well in the normal run of financial institutions, or in other words, in their daily, trading and non-trading operations. Actually, one could argue that frauds, fat fingers errors, rogue traders, AML and conduct issues have caused – and are still causing – more harm to large financial institutions than any stock crashes have done in the past!

Operational risk

This type of risk is branded “operational risk” by the financial sector, and the Wiley Handbook on Extreme Events in Finance explains how it has been first formalized by the banking regulators (i.e. the Basel Committee) in 1999, and with much push back from the industry at the time! Since then, banks are required to set aside capital to create a buffer that would shield themselves from against potential operational losses. The Handbook details the methods available to banks to compute this amount of capital, from the basic indicator approach (as a percentage of the Operating Income, 15%) to the advanced measurement approach (or AMA), where the banks have internal models to estimate the level of operational risk they are exposed to (usually Monte Carlo simulations combining frequency and severity distributions). The models are subject to the supervisor’s approval, and rely on and internal and external loss databases. The Handbook insists on the quality of the data, and how important it is to institutions to ensure robust data collection processes. Garbage in, garbage out.

A new framework for operational risk

However, since the Handbook has been published, the regulatory framework has been further strengthened with the Basel III reforms being finalized in December 2017. The AMA will be stopped and all internal models for operational risk with it. It is the results of the industry failure to produce a homogeneous and reliable method to model extreme operational events. The new framework, or standardized measurement approach (SMA), will, as its name suggests it, be a single non-model-based method, akin to the former standardized approach in its simplicity and comparability, but embodying also risk sensitivity by scaling the capital requirements to the level of realized losses. It will be applicable as of January 2022.

Is it the end of modelling extreme events?

Is it the end of modelling extreme events? Probably not. Institutions will always have forecasting needs in that respect, and if some valid and robust industry method emerges, it is not inconceivable to think that Basel might give AMA a successor one day.

Maxime Laot
Supervisor at European Central Bank