Operational Risk
Robert A. Jarrow, Cornell University

This paper studies operational risk. We discuss its economic and mathematical characterization and its estimation. The insights for this characterization originate in the corporate finance and credit risk literature. Operational risk is of two types, either (i) the risk of a loss due to the firm’s operating technology, or (ii) the risk of a loss due to agency costs. These two types of operational risks generate loss processes with completely different characteristics. The mathematical characterization of these operational risks is modeled after the risk of default in the reduced form credit risk literature. We show that although it is conceptually possible to estimate the operational risk processes’ parameters using only market prices, the non-observability of the firm’s value makes this an unlikely possibility, except in rare cases. Instead, we argue that data internal to the firm, in conjunction with standard hazard rate estimation procedures, provides a more fruitful alternative. Finally, we show that the inclusion of operational risk into the computation of fair economic capital (as with revised Basel II) without the consideration of a firm’s NPV, will provide biased (too large) capital requirements.

Market risk, credit risk, liquidity risk and operational risk are the four significant risks of loss to a firm or a portfolio. Of these, market and credit risk are generally well understood, and liquidity risk is actively being studied. However, operational risk has not received much formal attention. Since much of our membership regularly values corporations and portfolios of corporations, this study about corporate valuation methods-and their limitations, should be of substantial interest to our membership.