Connectivity and measurement of operational risk: an input-output approach

Source: Soft Computing

Title: Connectivity and measurement of operational risk: an input-output approach

Date: 2003

Author: S. Scandizzo

The author proposes a model that focuses on cause side rather than effect side of the operational risks.

With this focus, these proposal estates that both externally and internally originated changes have effects among the different components of the organization. These effects cannot be separated: the combined effect of the changes will not be equal to the sum of the single effects, but will in general be greater.

Basically, it is an accounting framework that can be used as a framework for the analysis of the interdependencies within an institution.

Connectivity requires the modeling process to develop a ‘connectivity matrix’ that can then be used to estimate the likelihood of failure (or potential losses) for the process as a whole. And by estimating a “multiplier” created by the internal level of connectivity, it can also be a tool that can complement a statistical risk model.

To do so, it is necessary to identify the various components and the technology structure in each of their components.

The economic activities of a company can be broken up into a number of separate, but interactive individual cost centers. The data needed are flows of products and services amongst these cost centers.

We can construct this model by using the internal cost allocation model and transfer pricing information

Input–output models where firstly theorized by Leontiev and have ever since received wide attention and recognition in the world of economics. The framework is also called ‘‘inter-industry analysis’’ and focuses on modeling the interdependencies among industries in an economy.

This input-output model relies on the basic idea that as an additional unit of a product is demanded, a certain combination of other intermediate products is required to produce that unit. One of the interests in the field of input-output economics lies with the fact that it is very concrete in its use of empirical data and also very compact. All changes in the endogenous sectors of an input-output table are results of changes in the exogenous sectors.

The overall effect of these interdependencies is that a change in demand causes a change in the overall production. This is called the Leontiev multiplier.

It implies that:

• The total output depends on the final “sales” as well as on the interdependencies amongst the units.
• The impact of an external shock either a change in D (demand for one or more units’ output) or a change in M (as a consequence of technology, process or people change) cannot be understood unless all the existing linkages are taken into account.