Using Bayesian Networks to Model Expected and Unexpected Operational Losses

This report describes the use of Bayesian networks (BNs) to model statistical loss distributions in financial operational risk scenarios. Its focus is on modeling "long" tail, or unexpected, loss events using mixtures of appropriate loss frequency and severity distributions where these mixtures are conditioned on causal variables that model the capability or effectiveness of the underlying controls process. The use of causal modeling is discussed from the perspective of exploiting local expertise about process reliability and formally connecting this knowledge to actual or hypothetical statistical phenomena resulting from the process. This brings the benefit of supplementing sparse data with expert judgment and transforming qualitative knowledge about the process into quantitative predictions. We conclude that BNs can help combine qualitative data from experts and quantitative data from historical loss databases in a principled way and as such they go some way in meeting the requirements of the draft Basel II Accord (Basel, 2004) for an advanced measurement approach (AMA).