Functional Correlation Approach to Operational Risk in Banking Organizations

TL;DR

This paper introduces a physics-inspired, correlation-based model for operational risk in banks, capturing complex failure dynamics and providing a new way to estimate capital reserves needed for risk coverage.

Contribution

It presents a novel, physics-inspired correlation model for operational risk, incorporating collective failure phenomena, which differs from traditional Gaussian-based models.

Findings

Model captures bursts and avalanches of failures

Provides a new framework for operational risk quantification

Highlights collective phenomena in process failures

Abstract

A Value-at-Risk based model is proposed to compute the adequate equity capital necessary to cover potential losses due to operational risks, such as human and system process failures, in banking organizations. Exploring the analogy to a lattice gas model from physics, correlations between sequential failures are modeled by as functionally defined, heterogeneous couplings between mutually supportive processes. In contrast to traditional risk models for market and credit risk, where correlations are described by the covariance of Gaussian processes, the dynamics of the model shows collective phenomena such as bursts and avalanches of process failures.