Outline how operational risk capital is allocated across business units.
The idea
Operational risk capital is first estimated for the whole bank and must then be allocated to business units, so that managers face a charge for the risk they generate and have a reason to reduce it. Allocating by gross income, as the basic indicator and standardized approaches implicitly do, is simple but ignores how well a unit controls its risks, so improvements bring no reward. Better schemes tie the charge to the unit's own loss experience and to scorecards built from RCSA results and KRIs, so that stronger controls lower the allocation. Stand-alone capital of the units usually sums to more than the bank-level figure because of diversification. A common method therefore scales each unit pro rata, as follows: Allocation = stand-alone capital × bank capital ÷ sum of stand-alone capitals. Beware allocating purely on reported losses, which encourages units to hide losses and near misses.
Formulas
Pro rata allocation of operational risk capital
allocationᵢ = stand-aloneᵢ × bank capital ÷ Σ stand-alone
- stand-aloneᵢ
- unit i's stand-alone capital
- bank capital
- the bank-level capital after diversification
- Σ stand-alone
- the sum of all units' stand-alone capitals
Every unit gets the same diversification discount. Allocation keys based purely on reported losses invite units to hide losses.
A practice question
What is the main weakness of allocating operational risk capital to business units in proportion to gross income?
- It allocates more capital in total than the bank holdsWhy not: Proportional allocation always sums to the bank total.
- It cannot be applied because gross income is not reported by business lineWhy not: Gross income by business line is standard in Basel approaches.
- It ignores how well each unit controls its risks, so improving controls does not reduce its charge - correct
- It places too much weight on each unit's loss historyWhy not: Gross income is a size measure; loss history plays no role in this scheme.
A gross-income key is easy but is blind to control quality, so there is no reward for reducing risk.
A harder one
Stand-alone operational risk capital is USD 60 million for unit A, USD 90 million for unit B and USD 150 million for unit C. Bank-level capital, reflecting diversification, is USD 240 million. Allocating pro rata to stand-alone capital, unit C receives:
- USD 150 millionWhy not: Reports the stand-alone figure, ignoring diversification.
- USD 120 million - correct
- USD 80 millionWhy not: Splits the bank-level capital equally among three units.
- USD 90 millionWhy not: Subtracts the entire USD 60 million diversification benefit from unit C.
Pro rata: 150 / 300 x 240 = 120. Each unit gets the same diversification discount of 20 percent.
The hardest tier
Stand-alone capital is USD 80 million (unit A), USD 100 million (B) and USD 120 million (C), and bank-level capital is USD 255 million, allocated pro rata, so B receives USD 85 million. Unit B improves its controls and its stand-alone capital falls to USD 70 million; A and C are unchanged, and the ratio of bank-level to total stand-alone capital stays constant. B's allocation falls by:
- USD 30 millionWhy not: Takes the fall in stand-alone capital, ignoring diversification and the change in the pro rata base.
- USD 18.9 millionWhy not: Holds bank-level capital fixed at 255 and re-spreads it pro rata, ignoring the bank-level saving.
- USD 8.5 millionWhy not: Spreads the bank-level saving of USD 25.5 million equally over three units.
- USD 25.5 million - correct
Ratio = 255/300 = 0.85. New total stand-alone = 270, bank capital = 229.5. B new = 70/270 x 229.5 = 59.5; old = 85.0; fall = 25.5.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Operational Risk
- Outline the types of operational risk, with an account of how each type can arise.
- Contrast three ways of arriving at regulatory capital for operational risk: the advanced measurement approach, the standardized approach and the basic indicator approach.
- Explain why the Basel Committee introduced the standardized measurement approach and describe what it involves.
- Explain how Monte Carlo simulation builds a loss distribution out of a suitable loss frequency distribution and loss severity distribution.
- Outline the data problems commonly seen that make estimates of loss frequency and severity distributions inaccurate or biased.
- Outline using scenario analysis as a substitute when there is little data to work with.
- Outline how causal relationships are identified, and the roles that education, Risk and Control Self-Assessment (RCSA) and Key Risk Indicators (KRIs) play in understanding and managing operational risks.
- Explain how operational risk can be measured with the power law.
- Explain the link between insuring against operational risk and the moral hazard and adverse selection problems that insurance companies face.