Scaling models for the severity and frequency of external operational loss data

Abstract

According to Basel II criteria, the use of external data is indispensable to the implementation of an advanced method for calculating operational risk capital. This article investigates how the severity and frequencies of external losses are scaled for integration with internal data. We set up an initial model designed to explain the loss severity by taking into account potential selection bias in the external data. Estimation results show that many variables have significant power in explaining the loss amount. We use them to develop a normalization formula. We develop a zero-inflated count-data model to scale the loss frequency. We compute an operational VaR and we conduct out-of-sample backtesting.