Introduction

In the realm of operational risk management, effectively allocating capital to different business units is essential for ensuring that an organization adequately addresses potential losses. Operational risk capital allocation provides a structured approach to distribute financial resources based on the inherent risks associated with each business unit. This chapter delves into the methodologies and considerations involved in allocating operational risk capital to various units within an organization.

Methods of Capital Allocation

• Relative Operational Risk Exposure (RORE): There are several methods for allocating operational risk capital, each with its own advantages and limitations. One commonly used approach is the Relative Operational Risk Exposure (RORE) method. In this method, the operational risk capital is allocated to business units in proportion to their level of risk exposure. This can be calculated as follows:

$$ RORE_i=\frac{\text{Operational Risk Exposure}_i}{\text{Total Operational Risk Exposure}} \times \text{Total Operational Risk Capital}$$

Here, $RORE_i$ represents the capital allocated to business unit $i$, Operational Risk Exposure$_i$ is the operational risk exposure of business unit $i$, and Total Operational Risk Exposure is the sum of operational risk exposures across all business units.

Considerations in Allocation

When allocating operational risk capital, it’s crucial to consider the unique characteristics of each business unit. Factors such as business complexity, historical loss data, risk appetite, and risk management practices play a significant role in determining the appropriate allocation. For instance, a business unit with a history of high-frequency operational losses might require a higher capital allocation than a unit with a relatively clean track record.

Example: Consider a financial institution with three business units: Retail Banking, Investment Banking, and Asset Management. The total operational risk capital allocated for these units is USD 10 million. The operational risk exposure of each unit is as follows: Retail Banking (USD 4 million), Investment Banking (USD 3 million), Asset Management (USD 2 million).

Using the RORE method: $$\begin{aligned} & RORE_{\text {RetailBanking }}=\frac{4}{9} \times 10= \text { USD 4.44 million } \\ & RORE_{\text{InvestmentBanking }}=\frac{3}{9} \times 10=\text {USD 3.33 million } \\ & RORE_{\text {AssetManagement }}=\frac{2}{9} \times 10= \text { USD 2.22 million }\end{aligned}$$