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Operational Risk – Overview, Importance, Features and Examples

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System faults, human errors, poor management, quality problems, and other operation-related failures are examples of operational risks for businesses. Operational risks are errors brought on by the system, human intervention, inaccurate data, or other technical issues. Each business or person must manage this operational risk to complete any task or delivery. Operational risk is a type of non-financial risk that can affect an organization’s ability to achieve its objectives and can result in financial losses, legal liabilities, and damage to reputation.

Did you know? Operational risk falls into the category of business risk; other such types of business risks include strategic risk.

Overview on Operational Risks 

Most firms recognise that mistakes will inevitably be made by their personnel and operational procedures. Practical corrective measures should be highlighted in evaluating operational risk to eliminate exposures and guarantee effective responses.

CIMA Official Terminology, 2005 also provides a definition for risk management as a process of understanding and managing the risks that the entity is inevitably subject to in attempting to achieve its corporate objectives. For management purposes, risks are usually divided into categories such as operational, financial, legal compliance, information and personnel. One example of an integrated solution to risk management is enterprise risk management.

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Types of Operational Risks

Operational risk refers to the potential for loss or damage due to people, processes, systems, or external events. It can originate from both internal and external sources, including human error, technology failures, natural disasters, or external attacks. Here is a list of operational risk :

  1. Human Error

This is also known as a fat finger input mistake. This mistake is the most frequent and serious risk to the company or person. It might be connected to a processor skill issue. Errors of this kind develop when human mistakes cause inaccurate input. Incomplete information, a lack of understanding, inadequate knowledge, uneven processing, a real input error, and more could all be causes of improper input. However, processing such inaccuracy could negatively impact the result and result in a loss.

  1. Technical Mistake

System flaws fall under this category. The system can occasionally experience problems such as slowdowns, network issues, system crashes, inaccurate application calculations, or missing bridges. It is sometimes possible for the output to differ from the desired outcome, although it may be difficult to detect because of unidentified technical flaws.

  1. Lack of Flow

Sometimes, information is absent from the source itself due to data lag or constraints. In certain situations, the result is impacted. The process could be risky because the needed production differs from the desired production.

  1. Unpredictable Events

These include external environmental influences that affect the performance and quality of processors and jeopardise the output, such as political scenarios, weather changes, syndromes that affect living things, old technology, etc.

  1. Deliberate Frauds

Most businesses have a policy that states that employees should have effective ways to avoid severe repercussions: they must fight against conflicts of interest and fraudulent acts. However, the company must bear financial and irrecoverable defamation losses if such a situation arises.

Examples on Operational Risks

Operational risk managers should continually monitor and assess risks in real time to minimize their potential impact.

1. Example 1

ABC Corp specialises in offering financial services to its clients. Based on various factors, they analyse the credit ratings of their clients. In one instance, the processor entered ₹5 Lakhs instead of 50 Lakhs with a typing error. The client’s credit rating went from B to AA as a result.

This led to an overestimation of the client’s ability to repay debt and provided an inaccurate picture of the client’s creditworthiness in the markets. This is one of the operational risks that ABC Co. must deal with because it could have disastrous effects if it happens again.

2. Example 2

Mahi is a technical analyst for her company who works on applications. Recently, she developed a tool to help the accounts department create invoices. Operation departments use such programmes to generate output.

The actual cash outflow at the end of the month exceeded the amount coming into this application. Further analysis revealed that one account payable input was being executed with a double value.

Such a technical error poses an operational risk and is only detectable after having a significant impact. 

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How is Operational Risk Measured?

Operational risk managers should continuously monitor and assess risks in real-time to reduce their potential impact as firms become more digital and use more data. To quantify operational risk, key risk indicators (KRIs) and data are typically needed. However, measurement can be particularly difficult when businesses are unable to combine all the many forms of data needed to comprehend their operational risk. This may be caused, among other things, by data silos built by organisational fiefdoms or the lack of software that facilitates the collecting and analysis of data from various systems.

Factors of Operational Risk

Operational risk is heavily dependent on the human factor ie., mistakes or failures due to actions or decisions made by a company’s employees.There are many factors that can contribute to operational risk within an organisation and some are listed below

  • Natural disasters like earthquakes, hurricanes, or wildfires; 
  • global health crises like the COVID-19 pandemic
  • man-made disasters like terrorism, cyberterrorism, and cybercrime; negligence and other workplace-related torts like sexual harassment, a hostile work environment, discrimination, etc.; 
  • Regulatory compliance violations, breach of contract, antitrust, market manipulation, and unfair trade practices;
  • Disruptions in the supply chain, ineffective cloud utilisation, unfair or inconsistent work policies, outdated or unpatched information technology (IT) systems and software, dangerous practices;
  • Defects in the product; 
  • mistakes made by people; 
  • missed deadlines; 
  • Internally developed procedures that were poorly thought out or inefficient.
  • Most operational risks are typically caused by individuals and actions made by people (human error).

Challenges  in Assessing Operational Risk 

Given the above factors, assessing and managing operational risk can be challenging due to the following reasons:

  • The necessary information is not easily accessible.
  • Enterprises are becoming increasingly operationally complicated.
  • The range of operational risk categories grows.
  • Operational risk management overlaps with other risk management activities, such as financial risk management and reputation risk management. 
  • presence of a duplicate risk function may make other risk functions feel threatened and resistant to cooperation.
  • Operational risk effects could result in losses that are not recoupable. 
  • Failures may also result in licence cancellations for the organisation and the accountable employee.
  • organisations may need to implement robust risk assessment processes, use advanced analytical tools and techniques, and allocate sufficient resources to risk management activities.

Limitations in Operational Risk 

The impact caused by operational risk can be discovered and evaluated only after considerable losses. Each company has a cap on immaterial losses only after a material loss is considered.

Once a mistake is discovered, it could or might not be possible to undo and fix it. It is, therefore, best to establish appropriate control checks at each stage of any process.

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How Does Operational Risk Management Work?

While some firms have a structured operational risk management department, some do not. However, these are the procedures businesses adhere to:

  1. Define the scope, aim, and purpose of operational risk management. Keep in mind that different industries have different definitions of operational risk.
  2. Define the roles essential to the function’s success; these roles may or may not include a chief operational risk officer.
  3. Together with those other functions, define operational risk management’s relationship to other risk management functions.
  4. Choose the methods for measuring and monitoring operational risk.
  5. Determine which tools will be required to support a successful operational risk function and whether the organization already has such tools or needs more. 
  6. To prevent adding unnecessary risk to the tech stack or unintentionally creating security vulnerabilities, only purchase what is necessary with the aid of IT and security.
  7. Establish secure access to the data required for operational risk management. Identify the appropriate data sources and their owners.
  8. Identify process-related risks and their corresponding causes by working with other risk functions and the company.
  9. Determine the processes’ associated risks, such as their ability to scale as required or suitability for the environment in which they operate.
  10. Set up categories for risk.

Conclusion

Operational risk is the danger of suffering losses due to poor or ineffective procedures, rules, plans, or circumstances that interfere with business operations. Various circumstances, including employee mistakes, criminal activities like fraud, and natural disasters, can cause operational risk. Operational risk consists of the chances and uncertainties a company faces in the course of conducting its daily business activities, procedures, and systems.
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