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FRM Part II · FRM Exam Part II · Range of Practices and Issues in Economic Capital Frameworks

A bank estimates operational risk economic capital by fitting a loss frequency distribution and a loss severity distribution to internal loss data, then combining them by simulation. The risk manager notes that internal data contain few large losses. Which is the most appropriate way to improve the severity tail estimate?

Combine internal losses with external data and scenario analysis, adjusted for relevance and scale. Internal data rarely capture rare, severe events, so the severity tail would be understated. Using averages, a single maximum, or ignoring severity does not produce a credible tail estimate for capital.

  1. ASupplement internal data with external loss data and scenario analysis, adjusting for scale and relevanceCorrect
  2. BUse only the average internal loss as the severity input
  3. CSet severity equal to the largest internal loss observed
  4. DDrop the severity distribution and model only frequency

Explanation

Internal data are sparse in the tail, so practice combines them with external data and scenario analysis, with adjustments for relevance and scale. The average loss ignores tail behavior. The largest observed loss is arbitrary and not a distribution. Omitting severity ignores loss size altogether.

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