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What is the loss distribution approach for operational risk assessment?

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Operational risk is the risk of loss resulting from inadequate or failed internal processes, people, systems, or external events. It can affect any organization, regardless of its size, industry, or location. One of the methods to assess operational risk is the loss distribution approach (LDA), which uses historical data to model the frequency and severity of operational losses. In this article, you will learn what the LDA is, how it works, what are its advantages and disadvantages, and what are some best practices for applying it.

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Jay Rathi

AVP at HSBC | CA | FRM | Certified ISO:31000 Risk Manager

1 What is the LDA?

The LDA is a statistical technique that estimates the distribution of operational losses based on historical data. The LDA assumes that the operational losses are driven by two independent factors: the frequency and the severity. The frequency is the number of loss events that occur in a given period, such as a year. The severity is the amount of loss associated with each event. The LDA uses different probability distributions to model the frequency and severity, such as the Poisson, the negative binomial, the lognormal, or the Pareto. The LDA then combines the frequency and severity distributions to obtain the loss distribution, which represents the probability of different levels of total loss in a period.

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Jay Rathi

AVP at HSBC | CA | FRM | Certified ISO:31000 Risk Manager
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Tool that helps banks figure out how much money they might lose from unexpected problems. First, they list different types of risks, like fraud or system failures. Then, they estimate how often these issues could happen and how much money they could cost. By putting all this together, they create a kind of map showing possible losses. It's like predicting the financial impact of things that could go wrong. This helps banks decide how much money they need to set aside to cover these potential losses. For instance, if they know there's a chance of fraud occurring a certain number of times with a specific financial impact, LDA helps them plan for that financially

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2 How does the LDA work?

The LDA works by collecting historical data on operational losses, such as the date, the amount, the type, and the cause of each loss event. These events are then classified into different categories, such as internal fraud, external fraud, execution errors, systems failures, or legal issues. After a frequency and severity distribution is fit to each category using statistical tests and criteria, a convolution or simulation method can be used to combine the distributions for each category. To obtain the overall loss distribution for the organization, a copula or simulation method is used to aggregate the loss distributions for all categories.

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Jay Rathi

AVP at HSBC | CA | FRM | Certified ISO:31000 Risk Manager
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LDA asically works like this: first, you list out all the things that could go wrong for a company, like fraud or system glitches. Then, you figure out how likely each problem is and how much money it could cost. Next, you mix all this info together to create a sort of overall map showing the possible losses. Finally, based on this map, the company decides how much money it needs to have on hand, kind of like a safety net, to cover unexpected financial hits from these potential issues. It's a way to be ready for the what-ifs in the business world

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3 What are the advantages of the LDA?

The LDA has several advantages as a method for operational risk assessment, such as its empirical data-based structure which captures tail risk, provides a quantitative measure of the operational risk exposure, and can accommodate different types of operational losses. Additionally, it can be updated and refined with new data available to improve the accuracy and reliability of the estimates.

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4 What are the disadvantages of the LDA?

The LDA has some drawbacks as a method for operational risk assessment, such as the need for a large amount of reliable and consistent data, which may not be available or accessible. Furthermore, it involves complex and subjective choices of the distributions, the parameters, the methods, and the assumptions, which can affect the validity and comparability of the results. Additionally, it may not capture future or emerging risks that differ from historical patterns or trends. Moreover, it may not account for mitigating factors like controls, policies, or actions that reduce the likelihood or impact of losses. Lastly, it may not reflect qualitative or non-financial aspects of operational risk such as reputation, culture, or customer satisfaction.

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5 What are some best practices for applying the LDA?

When applying the LDA, it's important to define the scope and objectives of the operational risk assessment, such as the level of detail, the time horizon, and the risk appetite. Additionally, you should establish a data collection and management system that ensures data quality and completeness. The appropriate distributions, parameters, methods, and assumptions should also be selected to reflect the characteristics of the data and operational risk. Furthermore, it's necessary to validate and test the LDA model to evaluate its accuracy and performance. Finally, you should communicate and report the LDA results to explain the methodology and provide recommendations for the operational risk assessment.

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Jay Rathi

AVP at HSBC | CA | FRM | Certified ISO:31000 Risk Manager
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Using the Loss Distribution Approach involves thinking broadly about potential risks, relying on accurate data to estimate the likelihood and cost of each problem, and considering various scenarios to understand how factors interact. Regularly check and adjust your models, assess how well your approach handles extreme situations, and keep detailed records for transparency. Collaboration with experts and clear communication of findings are crucial. Stay current by updating your approach to reflect changes in the business landscape, and strive for continuous improvement by learning from experiences and feedback. The goal is to create a robust and adaptable method for understanding and managing operational risks.

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6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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What is the loss distribution approach for operational risk assessment?

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1 What is the LDA?

2 How does the LDA work?

3 What are the advantages of the LDA?

4 What are the disadvantages of the LDA?

5 What are some best practices for applying the LDA?

6 Here’s what else to consider

Risk Management

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What is the loss distribution approach for operational risk assessment?

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2

3

4

5

6

1 What is the LDA?

2 How does the LDA work?

3 What are the advantages of the LDA?

4 What are the disadvantages of the LDA?

5 What are some best practices for applying the LDA?

6 Here’s what else to consider

Risk Management

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