Modeling operational risk for good and bad bank loans

ABSTRACT We demonstrate the operational risk associated with type II errors in typical lending decisions made by banks. Type II errors occur when loan officers misidentify healthy borrowing firms that are not destined to default and wrongly reject their legitimate loan requests. These periodic mistakes presumably carry opportunity costs to the lending institutions in the form of a loss of profitable business. We also explore several forms of operational risk associated with the corresponding type I errors. These errors occur when loan officers fail to identify borrowing firms that will eventually go bankrupt, wrongly approving their illegitimate loan applications. These occasional miscalculations naturally result in future financial losses to the lending institutions. We illustrate severalmodels for these ordinary problems, analyze their expected failure rates, compare their functionality, and further propose additional complexities within these models for general use by banks and other lending institutions.