Extreme risk
Encyclopedia
Extreme risks are risks of very bad outcomes or "high consequence", but of low probability
. They include the risks of terrorist attack,
biosecurity
risks such as the invasion of pests, and extreme natural disasters such as major earthquakes.
, developed for such purposes as predicting 100-year floods from a limited range of data of past floods. In such cases a mathematical function may be fitted to the data and extrapolated
beyond the range of the data to estimate the probability of extreme events. The results need to be treated with caution because of the possibility that the largest values in the past are unrepresentative, and the possibility that the behavior of the system has changed.
that the frequency and impact of totally unexpected events is generally underestimated. With hindsight, they can be explained, but there is no prospect of predicting them.
s and market risk
s. These risks, called operational risk
s, include the major events most likely to cause bank failure, such as massive internal fraud
. The international compliance regime for banks, Basel II
, requires that such risks be quantified using a mixture of statistical theory, such as extreme value theory
, and scenario analysis
conducted by internal committees of experts. The result is overseen by the bank regulator
such as the Federal Reserve
. Negotiations between the parties result in a system that combines quantitative methods with informed and scrutinized expert opinion. This gives the potential to avoid as far as possible the problems caused by the paucity of data and the bias
of pure expert opinion.
Similar methods combining quantitative methods with moderated expert opinion have been used to evaluate biosecurity
risks such as risks of invasive species
that will have massive impacts on a country's economy or ecology.
Probability
Probability is ordinarily used to describe an attitude of mind towards some proposition of whose truth we arenot certain. The proposition of interest is usually of the form "Will a specific event occur?" The attitude of mind is of the form "How certain are we that the event will occur?" The...
. They include the risks of terrorist attack,
biosecurity
Biosecurity
Biosecurity is a set of preventive measures designed to reduce the risk of transmission of infectious diseases, quarantined pests, invasive alien species, living modified organisms...
risks such as the invasion of pests, and extreme natural disasters such as major earthquakes.
Introduction
The estimation of the probability of extreme events is difficult because of the lack of data: they are events that have not yet happened or have happened only very rarely, so relevant data is scarce. Thus standard statistical methods are generally inapplicable.Extreme value theory
If there is some relevant data, the probability of events at or beyond the range of the data may be estimated by the statistical methods of extreme value theoryExtreme value theory
Extreme value theory is a branch of statistics dealing with the extreme deviations from the median of probability distributions. The general theory sets out to assess the type of probability distributions generated by processes...
, developed for such purposes as predicting 100-year floods from a limited range of data of past floods. In such cases a mathematical function may be fitted to the data and extrapolated
Extrapolation
In mathematics, extrapolation is the process of constructing new data points. It is similar to the process of interpolation, which constructs new points between known points, but the results of extrapolations are often less meaningful, and are subject to greater uncertainty. It may also mean...
beyond the range of the data to estimate the probability of extreme events. The results need to be treated with caution because of the possibility that the largest values in the past are unrepresentative, and the possibility that the behavior of the system has changed.
Black swan theory
In cases where the event of interest is very different from existing experience, there may be no relevant guide in the past data. Nassim Nicholas Taleb argues in his black swan theoryBlack swan theory
The black swan theory or theory of black swan events is a metaphor that encapsulates the concept that The event is a surprise and has a major impact...
that the frequency and impact of totally unexpected events is generally underestimated. With hindsight, they can be explained, but there is no prospect of predicting them.
Bank operational risk
Banks need to evaluate the risk of adverse events other that credit riskCredit risk
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....
s and market risk
Market risk
Market risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices...
s. These risks, called operational risk
Operational risk
An operational risk is, as the name suggests, a risk arising from execution of a company's business functions. It is a very broad concept which focuses on the risks arising from the people, systems and processes through which a company operates...
s, include the major events most likely to cause bank failure, such as massive internal fraud
Bank fraud
Bank fraud is the use of fraudulent means to obtain money, assets, or other property owned or held by a financial institution, or to obtain money from depositors by fraudulently representing to be a bank or financial institution. In many instances, bank fraud is a criminal offense...
. The international compliance regime for banks, Basel II
Basel II
Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision...
, requires that such risks be quantified using a mixture of statistical theory, such as extreme value theory
Extreme value theory
Extreme value theory is a branch of statistics dealing with the extreme deviations from the median of probability distributions. The general theory sets out to assess the type of probability distributions generated by processes...
, and scenario analysis
Scenario analysis
Scenario analysis is a process of analyzing possible future events by considering alternative possible outcomes . Thus, the scenario analysis, which is a main method of projections, does not try to show one exact picture of the future. Instead, it presents consciously several alternative future...
conducted by internal committees of experts. The result is overseen by the bank regulator
Bank regulation
Bank regulations are a form of government regulation which subject banks to certain requirements, restrictions and guidelines. This regulatory structure creates transparency between banking institutions and the individuals and corporations with whom they conduct business, among other things...
such as the Federal Reserve
Federal Reserve System
The Federal Reserve System is the central banking system of the United States. It was created on December 23, 1913 with the enactment of the Federal Reserve Act, largely in response to a series of financial panics, particularly a severe panic in 1907...
. Negotiations between the parties result in a system that combines quantitative methods with informed and scrutinized expert opinion. This gives the potential to avoid as far as possible the problems caused by the paucity of data and the bias
Cognitive bias
A cognitive bias is a pattern of deviation in judgment that occurs in particular situations. Implicit in the concept of a "pattern of deviation" is a standard of comparison; this may be the judgment of people outside those particular situations, or may be a set of independently verifiable...
of pure expert opinion.
Similar methods combining quantitative methods with moderated expert opinion have been used to evaluate biosecurity
Biosecurity
Biosecurity is a set of preventive measures designed to reduce the risk of transmission of infectious diseases, quarantined pests, invasive alien species, living modified organisms...
risks such as risks of invasive species
Invasive species
"Invasive species", or invasive exotics, is a nomenclature term and categorization phrase used for flora and fauna, and for specific restoration-preservation processes in native habitats, with several definitions....
that will have massive impacts on a country's economy or ecology.