Top-down Approach Vs. Bottom-up Approach
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 lack of controls and Model risk arises due to incorrect model application. Now, let’s look at top-down approach and bottom-up approach that is used in order to measures these types of risks.
In simple terms, 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. Top-down approach relies mainly on historical data. This approach is opposite to 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
- Top-down approach analyzes risk by aggregating the impact of internal operational failures while bottom-up approach analyzes the risks in individual process using models
- Top-down approach doesn’t differentiate between high frequency low severity and low frequency high severity events while bottom-up approach does
- Top-down approach is simple and not data intensive whereas 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 on top-down approach and bottom-up approach.
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