An application of capital allocation principles to operational risk and the cost of fraud

• Allocation principles distribute cost across the units that generate operational risk.
• An application to fraud risk in the banking sector is presented.
• Choice of allocation principles and correlation scenarios are compared.

The costs of operational risk refer to the capital needed to cover the losses generated by a firm’s ordinary activities. In this paper several capital allocation principles are examined to demonstrate how such principles can be used to distribute aggregated capital across the various constituents that generate operational risk. Proportional allocation, for example, allows a cost per unit to be calculated. An application to fraud risk in the banking sector is presented and correlation scenarios between business lines are compared.