Extreme risks are risks of very bad outcomes or "high consequence", but of low

probability Probability is a branch of mathematics and statistics concerning events and numerical descriptions of how likely they are to occur. The probability of an event is a number between 0 and 1; the larger the probability, the more likely an e ...

. They include the risks of

terrorist Terrorism, in its broadest sense, is the use of violence against non-combatants to achieve political or ideological aims. The term is used in this regard primarily to refer to intentional violence during peacetime or in the context of war aga ...

attack,

biosecurity Biosecurity refers to measures aimed at preventing the introduction or spread of harmful organisms (e.g. viruses, bacteria, plants, animals etc.) intentionally or unintentionally outside their native range or within new environments. In agricult ...

risks such as the invasion of pests, and extreme

natural disasters A natural disaster is the very harmful impact on a society or community brought by natural phenomenon or Hazard#Natural hazard, hazard. Some examples of natural hazards include avalanches, droughts, earthquakes, floods, heat waves, landslides ...

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 are scarce. Thus standard

statistical methods Statistics (from German language, German: ', "description of a State (polity), state, a country") is the discipline that concerns the collection, organization, analysis, interpretation, and presentation of data. In applying statistics to a s ...

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 theory Extreme value theory or extreme value analysis (EVA) is the study of extremes in statistical distributions. It is widely used in many disciplines, such as structural engineering, finance, economics, earth sciences, traffic prediction, and Engin ...

, 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.

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 Nassim Nicholas Taleb (; alternatively ''Nessim ''or'' Nissim''; born 12 September 1960) is a Lebanese-American essayist, mathematical statistician, former option trader, risk analyst, and aphorist. His work concerns problems of randomness, ...

argues in his

black swan theory The black swan theory or theory of black swan events is a metaphor that describes an event that comes as a surprise, has a major effect, and is often inappropriately rationalized after the fact with the benefit of hindsight. The term arose from ...

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 than

credit risk Credit risk is the chance that a borrower does not repay a loan In finance, a loan is the tender of money by one party to another with an agreement to pay it back. The recipient, or borrower, incurs a debt and is usually required to pay ...

s and

market risk Market risk is the risk of losses in positions arising from movements in market variables like prices and volatility. There is no unique classification as each classification may refer to different aspects of market risk. Nevertheless, the m ...

s. These risks, called

operational risk Operational risk is the risk of losses caused by flawed or failed processes, policies, systems or events that disrupt business operations. Employee errors, criminal activity such as fraud, and physical events are among the factors that can tri ...

s, include the major events most likely to cause bank failure, such as massive internal

fraud In law, fraud is intent (law), intentional deception to deprive a victim of a legal right or to gain from a victim unlawfully or unfairly. Fraud can violate Civil law (common law), civil law (e.g., a fraud victim may sue the fraud perpetrato ...

. The international compliance regime for banks,

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. It is now extended and partially superseded by Basel III. The Basel II Accord was publ ...

, requires that such risks be quantified using a mixture of statistical theory, such as

, and

scenario analysis Scenario planning, scenario thinking, scenario analysis, scenario prediction and the scenario method all describe a strategic planning method that some organizations use to make flexible long-term plans. It is in large part an adaptation and gen ...

conducted by internal committees of experts. A bank regulator (such as the

Federal Reserve The Federal Reserve System (often shortened to the Federal Reserve, or simply the Fed) is the central banking system of the United States. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a series of ...

in the United States) oversees the result. 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 Bias is a disproportionate weight ''in favor of'' or ''against'' an idea or thing, usually in a way that is inaccurate, closed-minded, prejudicial, or unfair. Biases can be innate or learned. People may develop biases for or against an individ ...

of pure expert opinion. Similar methods combining quantitative methods with moderated expert opinion have been used to evaluate

risks such as risks of

invasive species An invasive species is an introduced species that harms its new environment. Invasive species adversely affect habitats and bioregions, causing ecological, environmental, and/or economic damage. The term can also be used for native spec ...

that have potentially massive impacts on a country's economy or ecology.

Introduction

Extreme value theory

Black swan theory

Bank operational risk

See also

References

Further reading