Back-Testing Operational Risk?

It will be some time before the back-testing that we know in market risk comes to operational and business risk measures.

Significant standardisation of terms and identification and public disclosure of economic impacts of various risk incidents are pre-requisites before a reliable database can begin to be compiled. Attempts to date to share and collect data from several financial institutions are at the early stages only, particularly with broad or holistic definitions of risk. Collection of data on a consistent economic basis within one institution is hard enough.

It is possible that trust will be placed in a collective "independent" judgment for major operational and business risks. These may be generated by regulators or by independent rating agencies. This external benchmark model is more likely in the short to medium term than serious statistical back-testing for most operational and business risks.

Operational risk rating agencies may emerge, or evolve from existing rating agencies, provided they can both prove their independence of judgment and provide reasonable indicators by which diverse financial institutions can calibrate this independent judgment to their particular organisation.

Nonetheless back-testing remains a key goal, and will be encouraged for banks by the Basel January 2001 proposals that emphasise loss data collection and modelling. Given the data definitional difficulties, and the amount of data required, back-testing will most likely include judgmental elements rather than just being a statistical test of fit.

Measuring operational risk is still very young - it will undoubtedly evolve.

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Last updated:16/5/07

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