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BUDGET ALLOCATIONS IN OPERATIONAL RISK MANAGEMENT

Published online by Cambridge University Press:  11 July 2017

Yuqian Xu ,
Jiawei Zhang  and
Michael Pinedo
Yuqian Xu
Affiliation:
College of Business, University of Illinois at Urbana-Champaign, Champaign, IL 61820, USA E-mail: yxu@stern.nyu.edu
Jiawei Zhang
Affiliation:
Stern Business School, New York University, New York, NY 10012, USA E-mail: jzhang@stern.nyu.edu; mpinedo@stern.nyu.edu
Michael Pinedo
Affiliation:
Stern Business School, New York University, New York, NY 10012, USA E-mail: jzhang@stern.nyu.edu; mpinedo@stern.nyu.edu
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Abstract

We consider a resource allocation model to analyze investment strategies for financial services firms in order to minimize their operational risk losses. A firm has to decide how much to invest in human resources and in infrastructure (information technology). The operational risk losses are a function of the activity level of the firm, of the amounts invested in personnel and in infrastructure, and of interaction effects between the amounts invested in personnel and infrastructure. We first consider a deterministic setting and show certain monotonicity properties of the optimal investments assuming general loss functions that are convex. We find that because of the interaction effects “economies of scale" may not hold in our setting, in contrast to a typical manufacturing environment. We then consider a general polynomial loss function in a stochastic setting with the number of transactions at the firm being a random variable. We characterize the asymptotic behaviors of the optimal investments in both heavy and light trading environments. We show that when the market is very liquid, that is, it is subject to heavy transaction volumes, it is optimal for a financial firm that is highly risk sensitive to use a balanced investment strategy. Both a heavier right tail of the distribution of transaction volume and a firm's risk sensitivity necessitate larger investments; in a heavy trading environment these two factors reinforce one another. However, in a light trading environment with the transaction volume having a heavy left tail the investment will be independent of the firm's sensitivity to risk.

Keywords

asymptoticconvexityheavy tailoperational riskrisk sensitivitystochastic resource allocation
Type
Research Article
Information
Probability in the Engineering and Informational Sciences , Volume 32 , Issue 3 , July 2018 , pp. 434 - 459
Copyright
Copyright © Cambridge University Press 2017 

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