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

A bank's operational risk team uses a loss distribution approach (LDA) to estimate capital. It has only 6 years of internal loss data, and large losses above USD 5 million are very rare in that history. Which statement best describes the main measurement challenge this creates?

The tail of the severity distribution will be poorly estimated because few large losses exist in a short internal history. Banks therefore supplement internal data with external loss data and scenario analysis to better represent severe events and stabilize capital estimates.

  1. AInternal data will overstate tail severity because small losses are recorded more often than large ones
  2. BThe tail of the severity distribution will be poorly estimated, so supplementing with external data and scenario analysis is appropriateCorrect
  3. CFrequency cannot be modeled because loss events are never Poisson distributed
  4. DCollection thresholds make it impossible to calculate any capital figure

Explanation

With a short history and few extreme losses, the severity tail is estimated from very few observations, producing unstable capital. Practitioners therefore add external loss data and scenario analysis to inform the tail. The first option reverses the issue: sparse data typically understates the tail.

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