Operational risk, capital regulation and model risk

Operational risk capital regulation is moving from internal to standardized models – from the advanced measurement approach to the standardized measurement approach. These proposed changes will lead to more of the same: politically connected banks will further decrease their equity financing, making bank failures and taxpayer-backed bailouts more likely. Yet the goal of operational risk modeling must be to create useful models that capture relevant aspects of reality and improve decision-making. Therefore, operational risk modeling should assimilate seven fundamental properties into an operational risk managerial framework: well-aligned incentives; awareness of of data inaccuracies; explanation of empirical realities; acknowledgement of unknown unknowns; communication of uncertainty; creation of feedback loops; and recognition of dynamics.