What Is Operational Risk?

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What Is Operational Risk?

Let me explain operational risk directly to you: it's the potential for loss from inadequate or failed internal processes, people, systems, or external events that impact your company's everyday business activities. As a type of business risk, it stems from breakdowns in your internal procedures, staff, and systems, unlike issues from external forces like political events or market-wide systematic risks. You need to address potential weaknesses in your organization's staff, systems, and controls to prevent disruptions and financial losses. This risk can also be seen as various unsystematic risks unique to your specific company or industry.

Understanding Operational Risk

Operational risk centers on how you accomplish tasks within your organization, not just what you produce or the inherent risks in your industry. These risks often tie to active decisions about how your organization functions and what it prioritizes. While they don't always cause failure, they can lead to reduced production or higher costs, with severity depending on your internal management choices. Since it reflects man-made procedures and thinking, I view operational risk as human risk—it's the chance of operations failing due to human error. This varies by industry and is crucial when considering investments; industries with less human interaction typically have lower operational risk. Managing these risks is essential, especially for financial institutions where losses can be unpredictable and significant. Traditional methods like internal audits, processes, and insurance work, but the banking sector uses advanced frameworks to handle growing complexities.

Important Note on Business Risks

Remember, operational risk is one type of business risk, alongside strategic risk from failing to follow a plan, compliance risk from not adhering to laws and regulations, and reputational risk from factors that could damage your organization's image or public perception.

Causes of Operational Risk

Operational risk typically comes from four sources: people, processes, systems, or external events. For many aspects, you must mitigate risks in each category as best as possible, accepting that some will always exist.

People

Risk from people arises due to employee deficiencies or shortages. For instance, your company might lack staff with the needed knowledge for a problem, or not have enough employees for peak seasons. You can hire from the market to mitigate this, but that introduces new risks like finding the right candidates, training them, and retaining them. These aspects are resource-intensive and tie closely to financial impacts.

Processes

Every company has unique processes—complex ones for manufacturers versus simpler for service firms. All require steps in sequence, or detrimental outcomes follow. With high turnover, processes might not be fully documented. Some are vulnerable to collusion or failed controls, risking theft and financial loss.

Systems

Companies increasingly rely on software and systems. Operational risk includes outdated, inadequate, or poorly set up systems. Performance issues arise if your systems are less efficient than competitors'. Technical bugs or deficiencies expose you to cybercrime, and capacity constraints increase risk if you overload expectations.

External Events

Operational risk often occurs outside your company, from natural disasters impeding shipping to political changes restricting operations. Some classify these separately, like geopolitical risk, while others are just business nature, such as a third-party defaulting on a contract.

Fast Fact on Risk Elimination

You can never eliminate operational risk 100%, so decide what level you're comfortable accepting. While contracts reduce risk, external factors like supplier reliability still challenge you.

The 7 Categories of Operational Risk

Internal fraud: Employees conspire to override controls and misappropriate resources.
External fraud: Outside parties attempt bribery, theft, forgery, or cyberattacks.
Technology failures: Deficiencies in systems, hardware, software, or their interactions.
Execution, delivery, and process management: Inability to assess and deploy or execute strategies properly.
Employee practices and workplace safety: Violations of safety measures, physical or mental.
Natural disasters and damage to physical assets: Weather or conditions risking assets and tasks.
Clients, products, and business practices: Activities harming customers, misleading info, negligence, or non-compliance.

How to Assess Operational Risk

Assess operational risk using key risk indicators (KRIs) and data. KRIs are metrics you set as risk benchmarks to monitor levels, signal changes, assess controls, and stay within risk appetite. For example, if you target creditworthy vendors, set a KRI limiting defaults to three, then track and mitigate. KRIs should be quantifiable for tracking. Data is essential; without it, you can't evaluate KRIs. Build robust data processes via automation, surveys, financials, or industry info. For some, like banks, standards define KRIs and data, making assessment easier.

How to Manage Operational Risk

Manage operational risk through overarching strategies. Here are four primary ways.

Avoid Unnecessary Risk

Evaluate if you're taking risks without rewards. For vendors prone to default, switch to better ones. Risk often correlates with returns, so eliminate processes that incur risk without compensation.

Do a Cost/Benefit Analysis

Use data to weigh if benefits outweigh costs. Be mindful of rewards from risks. Expanding internationally involves high risk, but if researched, rewards may exceed it. Sometimes, taking risk is necessary.

Delegate Decisions to Upper Management

Upper management should handle operational risk decisions for wisest choices. They have insights into strategies. Assign seniors to expansions, coordinating across teams for risks.

Anticipate Risk

Understand approaching risks and anticipate outcomes to decide on acceptance, mitigation, or avoidance. Research geographical, political, or preference risks in new markets to plan ahead.

Operational Risk vs. Other Types of Risk

Compare operational risk to others for clarity.

Operational Risk vs. Financial Risk

Financial risk is inadequate cash flow for obligations, tied to leverage and debt, distinct from operational risk focused on daily profitability efforts.

Operational Risk vs. Market Risk

Market risk involves price movements from investor sentiment, rates, or economics, while operational risk targets internal operations, resources, and people.

Operational Risk vs. Strategic Risk

Strategic risk is long-term, often external; a new competitor is strategic, but daily handling is operational.

Examples of Operational Risk

Consider system maintenance: affording only one of two needed activities alters risk based on what's neglected. Maintaining subpar staff for cost savings is operational risk, as is not having qualified mechanics, causing delays. Employee fraud participation is also operational risk due to business operation decisions.

What Are the 5 Levels of Risk?

Gauge risk as highly likely (>90%), likely (>50%), possible, unlikely, or highly unlikely. Use percentages to evaluate mitigation costs against detrimental outcomes.

How Do You Identify Operational Risk?

Identify by assessing daily aspects that could go wrong, like system breakdowns or supplier delays. Management decides priorities for mitigation or acceptance.

What Are the 4 T's of Risk Management?

Tolerate: Accept certain risks. Terminate: Stop risky activities. Treat: Implement maneuvers to decrease risk. Transfer: Use third parties like insurance to bear risk.

Who Is Responsible for Managing Operational Risk?

Senior management oversees risks and strategies, while lower managers handle daily aspects.

The Bottom Line

Operational risk is loss from failed processes, unskilled employees, inadequate systems, or external events—part of normal business. You can't avoid it entirely, but reduce, mitigate, or accept it as needed.

What Is Operational Risk?

Highlights