External Loss Data in Operational Risk Management

In the previous article, we studied how a firm can collect internal loss data about the adverse events that take place within its boundaries. However, all operational risk managers know that internal events are not the only ones that can have a negative outcome. Over the years, companies have realized that even if they do everything alright internally, they could still be hit by an adverse external event. This is the reason that proper management of operational risk management also includes a collection of data from outside agencies and then using it to mitigate risks.

In this article, we will have a closer look at how external loss data is collected and then used to mitigate internal losses.

What is External Loss Data?

External loss data is the data relating to losses that were suffered by other firms in the same industry or even in different industries as a result of operational risk. The key point to note here is that the loss happens because of operational risks. Also, it is important to note that since the data is generated outside the boundaries of the organization, the company has no way to capture the data directly.

Why is External Loss Data Important?

External loss data helps a company in benchmarking its risk management standards to peer companies. It helps risk managers introspect and consider that if an event can happen in another company why wouldn't it happen in their company and what are the measures they are taking to protect themselves

External loss data is also useful in getting the necessary resources sanctioned from the senior management. Senior management is much more receptive to a pitch for resources if they see that a similar event has already happened at a peer firm. Hence, external loss data helps drive the culture of risk management in the firm's DNA

Over time, external loss data has become extremely reliable. This is because of the fact that the data is being collected for a period of more than thirty years. Hence, now it can be subject to statistical analysis and risk modeling. If data is collected over larger periods of time, it becomes more accurate since the effects of any specific variables that distort the results wear out over time. The reliability of external loss data makes money well spent for the organization

External loss data is widely used to develop scenarios for scenario analysis. This is because the data has been collected over a long period of time and hence the probability of various scenarios can be accurately collected. The profile of risk that the organization would be facing in different scenarios as well as the monetary loss that it would impose are points of contention.

External loss data helps to find the correlations between the operational risk faced by an individual firm with the risks being faced by an industry as a whole. This correlation helps them to understand the nature of the risks and investigate their root causes. For instance, some risks may be cyclical and may appear in every economic downturn regardless of the level of operational preparedness.

How is External Loss Data Collected?

External loss data is data that originates in other companies. Hence, companies do not have any mechanism to access the data directly. They have to pay to access the data from other sources. This generally happens in one of the two ways.

Companies can buy access to a subscription loss database. Here the company has to pay cash in order to be able to access risk data related to other organizations. The name of the other organizations is generally kept anonymous. There is some sort of analysis that has already been conducted on the data. It is not uncommon for the data to be divided into different categories of risks, products, and lines of business. It is important to note that in this case cash is being exchanged for data

Companies can also decide to give access to their data in exchange for the data of other companies. There are consortiums in which companies can join and share their own data and at the same time get access to the data of other companies. It is important to note that here the company may not have to pay cash. Generally, a small amount has to be paid for the maintenance and upkeep of the consortium. However, it costs much less as compared to subscription databases.

Limitations of External Loss Data

External loss data is helpful to a certain extent. However, it is important to note that the basic driving factors such as humans, processes, and systems are different in each company. Hence, even if firms operate within the same industry, they may face different risks. This is because of the quality of people or the systems that they may have deployed. Also, companies within the same industries operate with different types of vendors and clients. This makes their external risk profile somewhat unique. Hence, external loss data should be considered as a beginning point of an analysis which may have to be refined further.

The bottom line is that external loss data is considered mandatory since it has become a part of the Basel risk norms. However, many companies still find its usefulness to be limited.