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

A bank models operational risk economic capital using a loss distribution approach. Frequency is Poisson and severity is heavy-tailed. Which issue is most likely to cause the 99.9% capital estimate to be unstable?

The most likely cause is scarce data on extreme losses. The 99.9% capital depends on the heavy severity tail, which is fitted from very few observations, so adding or removing a single large loss can change the estimate sharply.

  1. AUsing a Poisson distribution for frequency, which has a single parameter
  2. BLimited tail loss data, so a few extreme losses strongly influence the fitted severity tailCorrect
  3. CAggregating losses over a one-year horizon
  4. DIncluding internal loss data in the calibration

Explanation

At the 99.9% level the result depends on the extreme severity tail, which is estimated from few observations; one large loss can shift fitted parameters materially. The other choices are standard features and not the main source of instability.

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