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FRM Part II · FRM Exam Part II · Risk Measurement and Assessment

A bank's operational risk modeler wants to combine internal loss data with external loss data when estimating severity for a rare event type. Which is the main issue to address before pooling the external data with internal data?

The main issue is scale and relevance bias: external losses come from institutions of different size, business mix and control environments, so they must be filtered and scaled to the bank's exposure, and threshold and reporting biases addressed, before being pooled with internal data.

  1. AExternal data should be ignored because it never reflects the bank's risk profile
  2. BScale bias, since losses from larger or differently structured institutions may not be comparable to the bank's own exposureCorrect
  3. CInternal data always overstates severity, so external data is a necessary correction
  4. DExternal data has no reporting threshold, so no adjustment is required

Explanation

External losses come from firms of different size, business mix and controls, so scaling and relevance filtering are needed, and reporting thresholds and biases must also be handled. Ignoring external data entirely forfeits tail information, and the other claims are unfounded.

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