LO 43.3: Describe the loss distribution approach to modeling operational risk

LO 43.3: Describe the loss distribution approach to modeling operational risk capital.
The loss distribution approach (LDA) relies on internal losses as the basis of its design. A simple LDA model uses internal losses as direct inputs with the remaining three data elements being used for stressing or allocation purposes. However, according to Basel II, a bank must have at least five years of internal loss data regardless of its model design but can use three years of data when it first moves to the AMA.
The advantage of the LDA is that it is based on historical data relevant to the firm. The disadvantage is that the data collection period is likely to be relatively short and may not capture fat-tail events. For example, no firm can produce 1,000 years of data, but the model is supposed to provide a 99.9% confidence level. Also, some firms find that they have insufficient loss data to build a model, even if they have more than five years of data. Additionally, banks need to keep in mind that historical data is not necessarily reflective of the future because firms change products, processes, and controls over time.

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