The top-down approach and Bottom-up approach are two popular approaches that are used in order to measure operational risk. Operation risk is that type of risk that arises out of operational failures such as mismanagement or technical failures. Operational risk can be classified into Fraud Risk and Model Risk. Fraud risk arises due to the lack of controls and Model risk arises due to incorrect model application. In this article we will cover the following topics that give you a clear understanding of the differences between top down and bottom up approaches:
- What is top-down approach
- What is bottom-up approach
- Differences between top-down approach and bottom-up approach
In simple terms, a top-down approach is an investment strategy that selects various sectors or industries and tries to achieve a balance in an investment portfolio. The top-down approach analyzes the risk by aggregating the impact of internal operational failures. It measures the variances in the economic variables that are not explained by the external macro-economic factors. As such, this approach is simple and not data-intensive. The top-down approach relies mainly on historical data. This approach is opposite to the bottom-up approach.
A bottom-up approach, on the other hand, is an investment strategy that depends on the selection of individual stocks. It observes the performance and management of companies and not general economic trends. The bottom-up approach analyzes individual risk in the process by using mathematical models and is thus data-intensive. This method does not rely on historical data. It is a forward-looking approach unlike the top-down model, which is backward-looking.
[Related read: Risk Management Strategies]
Differences Between Top-Down Approach and Bottom-Up Approach
- The top-down approach analyzes risk by aggregating the impact of internal operational failures while the bottom-up approach analyzes the risks in an individual process using models.
- The top-down approach doesn’t differentiate between high-frequency low severity and low-frequency high severity events while the bottom-up approach does.
- The top-down approach is simple and not data-intensive whereas the bottom-up approach is complex as well as very data-intensive.
- Top-down approaches are backward-looking while bottom-up approaches are forward-looking.
These are the basics of the top-down approach and the bottom-up approach.
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