Operational risk is a common hazard faced by companies in their day-to-day functions. It is a business risk that comes into existence because of functional breakdowns in the company’s internal system, processes or people.
Unlike systematic risk which arises due to external problems like political or economic events, or some changes in a market segment or market, operational risk arises due to internal disruptions and is classified as an unsystematic risk. It is often unique to a particular industry or company.
Seven prominent Basel II events are categorized to understand the major types of operational risks. These incur from four leading causes. It includes a breakdown in human resources, failure of systems, process disruptions and external events. We shall understand all these aspects better.
Operational Risk: Key Takeaways
- Operational risk refers to the probability of financial losses a company faces due to a breakdown in its day-to-day functions, processes or systems.
- It is mainly dependent upon human factors and arises because of negligence, inefficient working, improper conduct, irregular monitoring, inadequate decision-making, etc.
- All these lead to system failures and operational risk arises. It can be classified into seven major categories.
- Companies and businesses use the identification of key risk indicators, cost/benefit analysis and strategic planning to mitigate operational risks.
What is Operational Risk?
Operational risk refers to the uncertainties a company or business faces in performing its day-to-day functions. These can occur due to failed systems, inefficient employees, process breakdown or external events.
The Basel Committee on Banking Supervisions (BCBS) has elevated the position of operational risks in banking and finances although it has existed in the industry forever.
It is the risk of financial loss due to inadequate operational systems, failed internal processes or people. This definition of operational risk given by the Basel Committee incorporates legal risk but excludes reputational and strategic risk.
Operational risks are always associated with the way decision-making happens in the company and focus on the way things are done or accomplished in a company or financial organization.
Since operational risks depend very much on human action, these can be defined as a type of human risk arising out of human error and leading to operational failure in a company or business.
Operational Risk vs. Strategic Risk
In banking, the stock market and overall finances, operational risks are often confused with strategic risks. However, both these financial risks are different from each other and should be mitigated differently as well.
For instance, the entry of a new competitor in the market (external) is an example of strategic risk but how the company or business manages it via its (internal) operations or how that disrupts its operations is an example of an operational risk.
The key differences between operational risk and strategic risk are as follows:
| Operational Risks | Strategic Risks |
| These risks are generally internal and short-term. | These risks involve more external events or parties and are long-term. |
| Operational risks are caused by failed systems, breakdown of processes, breaches, inefficient employees, frauds and external events that affect the internal operations of a company. | A technological change, consumer demand changes, or any new competitor’s entry are some of the causes of strategic risk. |
| Strategic risks can lead to operational risks. | Sometimes, operational risks lead to strategic risks as well. For instance, a new competitor may enter the market because he feels his operational risks are lower than others in the market. |
Operational Risk and Associated Causes
Four vital avenues become the cause of an operational risk. These are people, processes, external events and systems.
- People: Employee shortages or employee deficiencies become a leading cause of operational risk. Mitigation of such operational risks brings in more financial repercussions as employment and training costs can be high.
- Processes: Each company has its set process that must be performed adequately and in sequence for carrying out its operations well. However, process disruptions due to failed internal controls can put the company at risk of financial loss.
- Systems: Companies are reliant on systems and technology for their operations. Operational risks may arise when these systems are inappropriate, outdated, or improperly set up. Further, technical deficiencies, bugs, and low capacity constraints also pose an operational risk.
- External Events: External events such as natural disasters, political changes, cyberattacks, etc. can also lead to operational risks.
The Seven Major Categories of Operational Risk and Their Key Examples
The four leading causes of operational risk give birth to several aspects of operational risk that can be categorised into seven categories per Basel II Seven Event Type. Their names and significant specifications with certain examples associated with these risks are given as follows:
- Internal Fraud: It is when employees try to take internal controls into their own hands and misappropriate the company’s resources. Examples of internal fraud include tax evasion, position mismarking misappropriation of assets, and bribery.
- External Fraud: It refers to the interference of external parties to disrupt the functioning of the company by cyberattacks, bribes, etc. Major examples of external fraud include theft of information, bribery, third-party forging and theft, cyberattacks like hacking, etc.
- Technology and Systems Failure, Business Disruptions: It denotes the deficiency in the systems of the company like computers, hardware, software or their interconnection, etc. that leads to business disruptions. Examples include software and hardware failures, utility disruptions, etc.
- Delivery, Process Execution and Management: It refers to the inability of the management to adequately assess a situation, or properly execute the set strategy. Its examples are data entry errors like accounting errors etc., report failures, and negligent client assets loss.
- Damage to Physical Assets: It refers to the damage caused to physical assets such that it becomes impossible to carry out the day-to-day functions of the company. Natural disasters like fire, inclement weather, etc., terrorism and vandalism are some of its examples.
- Workplace Practices and Employment Safety: It denotes the risk of workplace safety measures violation which can cause failure in proper functioning. Major examples incorporate employee safety and health, compensation to workers, and discrimination.
- Products, Clients and Business Practices: It refers to the operational events that may harm clients, lead to negligence, or may not be in compliance. Prominent examples include product defects, improper trade, market manipulation, account churning, antitrust, and fiduciary breaches.
How to assess Operational Risk?
Now that we have learned about operations risks, their major types and examples, it is quintessential to look into ways to assess and manage them.
Even though companies are now much more efficient in managing financial risks, they could be more effective at mitigating operational risks. With new and efficient ways of assessment, the management of operational risk has become much more achievable.
Assessment of operational risks involves two key aspects. These are Key Risk Indicators (KRIs) and Data.
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Key Risk Indicators
These are metrics applied and used by a company to assess operational risk. For instance, a company may set the metric that it will only trade with most creditworthy clients. Or it may set the number of vendors it can take into default, not more than that.
Companies can then manage the KRIs, try to achieve their KRI goals and assess operational risks. In other cases, KRIs are already set. For instance, banks may have banking standards such as to have some cash in hand or processes in place already set.
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Data
Since Key Risk Indicators are quantifiable, data is used to assess operational risk better since it is trackable and measurable. Data is required to find out if the KRIs are deficient or on track.
Companies can use surveys and financial or industrial data to build a proper information gathering process.
Strategic Ways to Manage Operational Risk
Though there are several ways to manage operational risk, here are four common ways banks, businesses and companies commonly use to mitigate operational risk. These are as follows:
Avoidance of Unnecessary Risk
Companies must evaluate if the risks they are taking are even bringing enough gains. If not, such risks must be avoided.
A simple example would be a company trading with a low-creditworthy client who often defaults. Instead, it should deal with clients with more creditworthiness. There is still a risk involved but it is not unnecessary as it offers a high probability of returns.
Cost/Benefit Analysis
A proper cost/benefit analysis is a suitable way to mitigate operational risks. Companies should measure and assess the risks they are taking in comparison to the benefits or profits they bring in.
Instead of completely ignoring the risk on hand, it suggests a way to use it most profitably while mitigating it. After all, risk is mandatory for growth!
For instance, if a company wants to expand internationally, it knows there are several operational risks involved. However, proper knowledge of the risks and their use also offers greater financial gains.
Decision Delegation to Upper Management
It is generally best for the upper management to decide on the way to manage operational risk in the best way possible for the company.
For instance, if a company wants to expand internationally, the operational risks involved would include, shipment, logistics, procurement and legal risks. Decisions associated with such key aspects should be taken by the higher delegation.
Risk Anticipation
An important aspect of operational risk management is to identify its approach and to anticipate its possible effects. This serves to set a preconceived plan and act on it when it comes. For instance, if one anticipates that an electricity failure is to come to the city, the company in that city can set up electricity reserves to keep its operations running.
Thus, it is important to keep an eye on international and national movements in the finance industry, market changes, political risks, geographical limitations, differences in the preferences of consumers around the region, etc.
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