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Lay out what goes into an operational risk report and set out good practice in reporting such risk.

FRM® Part II · Operational Risk and Resilience · Risk Reporting · FRM2.ORR.6.b

The idea

An operational risk report normally combines backward-looking and forward-looking information. Backward-looking items are internal loss events with gross loss, recoveries and net loss, trends by event type and business line, and relevant external loss events. Forward-looking items are key risk indicators with thresholds, often shown as green, amber and red, results of risk and control self-assessments, scenario analysis outcomes, emerging risks, near misses, and capital held against operational risk. Good practice is to link each item to risk appetite, show trends over time, give root causes and named owners with remediation dates, and escalate breaches clearly. Reports should be accurate, timely, concise and comprehensible, using the same definitions each period. A report that only lists past losses is the classic weakness. The exam favours reports that support action and early warning.

Formulas

Net operational loss after recoveries

net loss = gross loss − recoveries

gross loss
the direct write-off plus external costs such as legal fees, before recoveries
recoveries
all amounts recovered, from insurers and from third parties such as counterparties or customers

Reports should show gross, recoveries and net so the effect of mitigation is visible, and state which basis each figure uses.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which item is a standard component of an operational risk report?

  1. The ten-day, 99% VaR of the trading bookWhy not: Market risk report content; it is not an operational risk measure.
  2. The weighted average credit rating of the loan portfolioWhy not: Credit risk report content, unrelated to operational events or controls.
  3. The duration gap of the banking bookWhy not: Interest rate risk content, not operational risk reporting.
  4. Internal loss events and their trends - correct

Operational risk reports present loss events, trends, key risk indicators, self-assessment and scenario results, and capital. Market, credit and rate measures sit in their own reports.

A harder one

A reporting team wants to remove near misses from the quarterly operational risk report because they caused no loss. What is the best argument for keeping them?

  1. They are required to be added to gross loss so that the operational risk capital figure is conservativeWhy not: Near misses create no loss; adding them to loss totals would distort the figures.
  2. They reveal control weaknesses that could have led to losses, giving early warning - correct
  3. They replace the need for external loss data when internal history is shortWhy not: External data and near misses serve different purposes; near misses do not substitute for external events.
  4. They improve the accounting treatment of recoveries by showing the potential insurance claimWhy not: Confuses near misses with insurance accounting; no claim arises from a near miss.

Near misses show where controls failed or nearly failed, so they provide forward-looking information on where losses may come from.

The hardest tier

A loss event involved a direct write-off of USD 4.2 million and external legal fees of USD 0.3 million. The firm recovered USD 1.1 million from insurance and USD 0.5 million from the counterparty. Following the usual convention of reporting gross loss before recoveries and net loss after recoveries, which pair is correct?

  1. Gross USD 4.5 million, net USD 2.9 million - correct
  2. Gross USD 4.2 million, net USD 2.6 millionWhy not: Leaves out the external legal fees, which are a direct cost of the event and part of gross loss.
  3. Gross USD 4.5 million, net USD 3.4 millionWhy not: Deducts only the insurance recovery (4.5 - 1.1) and ignores the USD 0.5 million from the counterparty.
  4. Gross USD 4.5 million, net USD 6.1 million, as recoveries add to lossWhy not: Adds the recoveries instead of subtracting them (4.5 + 1.6).

Gross loss = 4.2 + 0.3 = 4.5. Recoveries = 1.1 + 0.5 = 1.6. Net loss = 4.5 - 1.6 = 2.9. Reports should show gross, recoveries and net so the effect of mitigation is visible.

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