Modeling and Measuring Operational Risk: General Principles

More than a century ago, the Irish mathematician and physicist Lord Kelvin (1842–1907) made the following statement (cited in King, 2001):

I often say when you can measure what you are speaking about, and express it in numbers, you know something about it; but when you cannot measure it, when you cannot express it in numbers, your knowledge is of a meager and unsatisfactory kind.

Lord Kelvin’s remarks relate to science, which is naturally more precise than trying to measure the “ghost” of operational risk. But before talking about the measurement of operational risk, it may be worthwhile to go back to 1707 when Britain, then the supreme naval force, lost four ships and 2000 sailors because of inadequate measurement. That happened on a foggy night of October that year, but there was no battle at sea then. Not knowing exactly where they were, the four ships under the command of Admiral Clowdisely Shovell smashed into the rocks of the Scilly Isles off the Southwest Atlantic coast of England. How did that happen under the watch of such an experienced admiral? He simply miscalculated his position (longitude and latitude) in the Atlantic because he did not have the instruments to do that, basing his calculations instead on an intellectual guess of the average speed of his ship.